Plain English: The Fiscal Cliff Explained

By Tim Parker | Investopedia – Wed, Nov 21, 2012 10:41 AM EST

There's no escaping it. The fiscal cliff is everywhere. From water coolers at the workplace to the mainstream media, everyone is talking about it. However, like most conversations that involve Washington, important facts are often missing. Let us look beyond the noisy details of Capital Hill press conferences and social media opinions. Instead, let's view the fiscal cliff through the lens of simple fact. What is the fiscal cliff and how will it affect your life?

Who Coined the Term?
Who actually first uttered the words "fiscal cliff" is not clear. Some believe that it was first used by Goldman Sachs economist, Alec Phillips. Others credit Federal Reserve Chairman Ben Bernanke for taking the phrase mainstream in his remarks in front of Congress. Others credit Safir Ahmed, a reporter for the St. Louis Post-Dispatch, who in 1989 wrote a story detailing the state's education funding and used the term "fiscal cliff."

What Is the Fiscal Cliff?
The fiscal cliff refers to a number of tax hikes and spending cuts that will go into effect on Jan. 1, 2013. If Congress and President Obama do not act to avert this perfect storm of legislative changes, America will, in the media's terms, "fall over the cliff." Among other things, it will mean a tax increase the size of which has not been seen by Americans in 60 years.

How Big Are We Talking?
The Tax Policy Center reports that middle-income families will pay an average of $2,000 more in taxes in 2013. Many itemized deductions will be subject to phase-out, and popular tax credits like the earned income credit, child tax credit, and American opportunity credits will be reduced. 401(k) and other retirement accounts will be subject to higher taxes.

In addition, the Congressional Budget Office estimates that 3.4 million or more people will lose their jobs. This will result from a combination of a slowing economy and reduced government spending. Many people disagree about the details, but virtually everybody agrees that all Americans will feel the effects of the fiscal cliff.

What Are the Bush Era Tax Cuts?
At the heart of the fiscal cliff are the Bush Era Tax cuts passed by Congress under President George W. Bush in 2001 and 2003. These include a lower tax rate and a reduction in dividend and capital gains taxes as the largest components. These are set to expire at the end of 2012 and represent the largest part of the fiscal cliff.

Is There a Bright Side to This?
Yes. According to the Congressional Budget Office, by 2022, the budget deficit would fall to $200 billion from its current level of $1.1 trillion. That would all be welcome news, but in order to get there, the nation would face almost certain financial turmoil.

How Do We Fix It?
Recently, lawmakers met at the White House over this issue. Both sides called the meeting productive, but neither side indicated that a deal was imminent. Democrats want to see more revenue (tax increases), especially from the nation's wealthy, as part of any deal. Republicans favor more spending cuts, especially to entitlements like Medicare. While both sides subscribe to different philosophies concerning taxation, each have indicated that they are willing to compromise on many of the more critical issues leading to Jan. 1.

Cliff or no cliff, deal or no deal, Americans will almost certainly pay more taxes, according to CNBC. It is just a matter of how much more. Therefore, any compromise will probably include tax increases, just not to the magnitude of those mandated by the fiscal cliff.

Will Fixing the Fiscal Cliff Solve the Economy's Current Woes?
Not at all. The Bush Era tax cuts and other stimulus measures have propped up the economy, as it continues to recover from the 2008 recession. Some investors believe that much of the most recent stock market decline has to do with the looming fiscal cliff. They believe that once a deal is announced, and economic uncertainty is removed, then the market may recover to near its recent highs. Others believe that if the deal includes another one-year extension (or something similar to the debt ceiling negotiations), investors will not be impressed.

The Bottom Line
When will a deal come? Nobody knows, but both sides of the aisle are admitting that fighting and bickering is not the answer. A more conciliatory political environment will give both parties a better chance at gaining control of Washington in 2016. Ultimately, when the deal comes, it will almost certainly result in some combination of tax rate increases and spending cuts. The willingness of both sides to compromise is crucial to any final agreement.