A Brief Primer on the Fiscal Cliff

With the end of 2012 approaching, Americans across all income groups are eagerly counting the developments in Washington regarding the much-hyped ‘fiscal cliff’. However, what exactly is the fiscal cliff paradox? How is it going to affect the average American? Why is there so much confusion about the fiscal cliff? This article attempts to answer these questions.

The confusion over fiscal cliff

The term refers to the after effects of a set of existing financial regulations that are set to expire on December 31, 2012. When these existing laws expire, new regulations come into effect, which could result in increase in taxes (for the wealthy and the middle class alike), and implementation of Government spending cuts. These two cornerstones, the tax increases and the spending cuts would cause a corresponding reduction in US budget deficit. The sharp decrease in budget deficit over a short period due to the implementation of the spending cuts and the tax increase is termed as the fiscal cliff, the cliff referring to the sharpness of the decrease.

Although the reduction of federal budget deficit sounds all good, yet the contradictory arguments over the approaching fiscal cliff are also tumultuous. According to some economic observers, the fiscal cliff could have a negative effect on a vulnerable economy, raising fears of sending the economy into another official recession of 2013, as it would reduce investor confidence (tax hike), cut household incomes (due to tax increase again) and increase unemployment rates (due to the recession that may follow). Because of both positive and negative inferences on fiscal cliff, currently the position is that of an economic stalemate as policymakers continue to urge a defiant president Obama to reconsider the decision of implementing the tax hike and the spending cuts. While the stalemate continues to evolve, presented here are some projections of the fiscal cliff as is supposed to happen.

A brief understanding of the legal provisions

The key laws that expire on December 2012 are the Bush tax cuts and the laws that are going to be implemented are the provisions in the Budget Control Act of 2011. The Budget Control Act of 2011 exempts some and implements some. Among the exemptions are included Medicaid, Social Security, Federal Pay (military pensions and payments) and veterans’ benefits. Among the implementations of spending cuts, include the expenditure on defense, cabinet departments and federal agencies through a process called the Budget Sequestration.

The possible effects of the fiscal cliff

According to the Tax Policy Center, if the fiscal cliff is to take shape, middle-income families would have to pay an average of $2000 more in taxes in 2013. Many existing tax credits like credit on earned income, credit on child tax, and credits on American Opportunity will be diminished. Retirement accounts like 401(k) will also be subject to higher taxes. If you are earning more, you have to brace yourself to paying more taxes, as the marginal tax rates (the tax bracket) rise.

In addition, the estimates from the Congressional Budget Office refer to the fact that unemployment will be on the rise because of the recession that may follow. According to the CBO, up to 3.4 million jobs would be lost, due to a slowing economy and layoffs through cuts in defense budget among other things.

The conclusion

However, these changes do not undermine the fact that the implementation of this pioneering policy by President Obama, would reduce the budget deficit by approximately $560 billion. This must be what the president is looking forward to, to give a major overhaul to the shaky economy suffering from huge National Debt. No wonder, this worthiness of the fiscal cliff solution projected by the President is preventing doomsayers from going for an all round opposition of the proposed policy.

However, not everyone is consenting with the doomsayers. A section of economic observers are of the view that the short term problems arising from the fiscal cliff would be nullified in effect due to the long term gains like lower deficit, better growth prospects and lower debt. What is certainly evident that the US economy is set to see a major overhaul in the coming year, the effects of which would perpetuate to the Global economy as well. Revitalized and brimming in confidence from the Election Victory, the world is all set to watch how President Obama plans to recover America from its economic burdens.

Guest post by Owen

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