FISCAL CLIFF

Fiscal Cliff is the popular shorthand term used to describe the conundrum that the U.S. Government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012, are:

• The end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers)
• The end of certain tax breaks for businesses
• Shifts in the alternative minimum tax that would take a larger bite
• The end of the tax cuts from 2001-2003 and
• The beginning of taxes related to President Obama’s health care law

At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect. According to Barron’s, over 1,000 government programs – including the defense budget and Medicare are in line for “deep, automatic cuts.”

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Choices Available

In dealing with the fiscal cliff, U.S. lawmakers have a choice among three options, none of which are particularly attractive:

• They can let the current policy scheduled for the beginning of 2013 – which features a number of tax increases and spending cuts that are expected to weigh heavily on growth and possibly drive the economy back into a recession, go into effect. The plus side: the deficit, as a percentage of GDP, would be cut in half.
• They can cancel some or all of the scheduled tax increases and spending cuts – which would add to the deficit and increase the odds that the United States could face a crisis similar to that which is occurring in Europe. The flip side of this, of course, is that the United States’ debt will continue to grow
• They could take a middle course, opting for an approach that would address the budget issues to a limited extent, but that would have a more modest impact on growth.

Can a Compromise be reached

The oncoming fiscal cliff is a concern for investors since the highly partisan nature of the current political environment could make a compromise difficult to reach. The problem is not new as the lawmakers had three years to address this issue but the tussle of the congress did not allow reaching a common consensus. Congress mired in political gridlock has largely put off the search for a solution rather than seeking to solve the problem directly.

Republicans wanted to cut the spending and also favored avoiding raising taxes whereas, the Democrats looked for a combination of spending cuts and tax increases. Despite being the fact that both the parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve. A strong possibility of Congress not acting until the eleventh hour is seen.

Result

Most likely result is another set of stop-gap measures that would delay a more permanent policy change until 2013 or later. It was estimated by the Congressional Budget Office (CBO) that if congress takes the middle ground by extending the Bush-era tax cuts but cancelling the automatic spending cuts, it would result in modest growth with no major economic hit for the short term.

Thus it is important to keep in mind that while the term “cliff” indicates an immediate disaster at the beginning of 2013, the impact of the changes while destructive over a full year will be gradual at first. As a result, the fiscal cliff won’t necessarily be an impediment to growth even if Congress does not address the issue until after 2013.

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