What is the “Fiscal Cliff?”

By Andrew H. Friedman, Principal at The Washington Update LLC, published by Eaton Vance

In recent months, a new phrase has entered the national lexicon, a phrase that is likely to reverberate with increasing intensity in the months ahead. That phrase is “fiscal cliff”. The “fiscal cliff” refers to the abrupt slowdown in the economy that could occur in 2013 if taxes rise and government spending falls as currently scheduled.

The fiscal cliff has a number of components. Among them are:

  • Expiration of the Bush tax cuts

    The Bush tax cuts—the lower tax rates in effect for the past decade—are scheduled to expire at the end of 2012. Republicans believe the Bush tax cuts should be extended for all taxpayers. Democrats believe they should be extended only for middle and lower income families. President Obama has said he will veto any further extension of the Bush tax cuts for upper income families.

  • Expiration of the payroll tax cut

    In 2010, to secure the President’s assent to a two-year extension of the Bush tax cuts, the Republicans agreed to reduce the employee Social Security tax rate in 2011 from 6.2% to 4.2%. Subsequently, the Republicans grudgingly agreed to extend this lower Social Security tax rate through 2012 as well. Perhaps surprisingly, Congressional Republicans did not require that this extension be “paid for” (offset with tax increases or spending cuts elsewhere).
    Another extension of the payroll tax cut is unlikely. The President believes the lower employment tax rate puts money in workers’ pockets, which they will spend and help revive the economy. But many Republicans are concerned about the deficit implications and do not believe that allowing workers to retain a small additional portion of their paychecks actually grows the economy. Many legislators also believe that it is not good policy to deplete the funds available for the Social Security program.

  • New health care reform taxes

    To help finance the health care reform law, Congress approved a new tax on investment income to take effect in 2013. Beginning next year, to the extent a family’s overall income is above $250,000 ($200,000 for individual taxpayers), taxable investment income—e.g., interest, dividends, capital gains, rents, royalties—will be subject to an additional tax of 3.8%. This additional tax will not apply to nontaxable income such as tax-exempt municipal bond interest, or to amounts withdrawn from qualified retirement plans and IRAs.
    Unless the Supreme Court strikes down the entire health care reform law as unconstitutional, the additional tax on investment income will take effect in 2013, as the Democrats are unlikely to accept any change to their signature legislation.

  • Spending cuts

    The compromise reached last August to increase the national debt ceiling (thereby allowing the United States to avoid defaulting on Treasury securities) calls for cuts in discretionary government spending of $2.1 trillion over ten years, including about $1 trillion of defense cuts. The bulk of these cuts are slated to begin in 2013.
    Republicans now assert that the compromise merely set a “floor” and are seeking to implement cuts in excess of the agreed-upon amounts. At the same time, they want to reduce the portion of the cuts allocated to defense. Congressional Democrats have made clear they will not support cuts to social programs above those enumerated in the compromise. The President has said he will veto any effort to unwind the spending cut agreement reached last August.

Congress need not pass a single piece of tax legislation in 2012 for the tax increases and spending cuts outlined above to take effect in 2013. They will happen by default.

If Congress fails to stop the implementation of these provisions, the higher taxes and lower spending are likely to cause a significant slowdown in the economy in 2013. Economists differ in their estimates, but many expect the slowdown to be around a 3.5 percentage point reduction in GDP. See, e.g., U.S. Fiscal Cliff Notes, J.P. Morgan (April 26, 2012). With GDP currently growing at less than that rate, the full brunt of the fiscal cliff threatens to throw the economy back into recession for at least the first half of 2013, a consequence affirmed last week by a report from the impartial Congressional Budget Office. Economic Effects of Reducing the Fiscal Restraint That Is Scheduled to Occur in 2013, Congressional Budget Office (May 2012).

In the current tumultuous campaign environment, Congress is unlikely to pass any significant legislation before Election Day. Thus, the fate of the tax increases and spending cuts will be decided, if at all, by a “lame duck” Congress convening between Thanksgiving and Christmas in 2012. The Congress that returns for that session will be the existing Congress—a Republican-led House and Democratic-led Senate—regardless of the election results. President Obama, too, will still be in office at the end of 2012: either he will have been re-elected—feeling newly-empowered to enact his policies—or he will be a lame-duck president who can do what he believes is right without concern for the consequences.

The hope is that, standing on the edge of the fiscal cliff, the parties will negotiate a compromise during the lame duck session. The most likely candidate for compromise is the pending expiration of the Bush tax cuts. The Republicans have suggested a compromise that would extend all the tax cuts for one more year to give Congress the opportunity to enact tax reform in 2013. Tax reform—lowering tax rates, eliminating loopholes, simplifying the tax code, eliminating the AMT—is universally popular in theory, but difficult to implement in practice. The Democrats almost certainly would insist that any agreement designate a “trigger” to take effect if Congress fails to agree on tax reform next year. The most likely trigger would be the expiration of the Bush tax cuts for all but middle- and lower-income families. The Republicans are unlikely to accept such a trigger; they refused to allow a tax increase as the trigger if (as subsequently happened) the “Super Committee” failed to agree on spending cuts in the wake of the August budget compromise last year.

A more obvious compromise is to extend the tax cuts for all but the most affluent taxpayers. In the past the President has insisted on ending the cuts for families with income over $250,000. However, his recent insistence on the “Buffett rule”—which would require families with income over $1 million to pay tax at a rate no lower than the rate imposed on the middle class—suggests that he might accept a $1 million threshold for application of the tax increase. The Republicans will have to swallow hard to accept any tax increase, but if the President maintains his threat to veto a tax cut extension that includes affluent families, Republicans may view a compromise as preferable to having the tax cuts expire for everyone next year.

Compromise on the spending cuts is more problematic. The Democrats (at least so far) are insisting on implementing the budget agreement of last August, and the Republicans actually are seeking cuts in addition to those agreed upon. Standard & Poor’s and Moody’s have announced that a failure to implement the agreed-upon cuts will result in another downgrade in U.S. debt. The President seems to feel it a point of pride to make sure the compromise takes effect.

Given the rancor that will infuse the campaign, the possibility of a deadlock in the lame duck session cannot be dismissed. If Congress fails to compromise and the tax increase and spending cuts take effect, Congress conceivably could roll back the changes next year. As a practical matter, however, this is likely to happen only if the Republicans win the White House and both houses of Congress. Even in that case, there are procedural maneuvers in the Senate the Democrats might try to avoid or delay such a roll-back.

One final point: Given the uncertainty surrounding the election and the fiscal cliff, the markets are likely to remain volatile for the remainder of the year. Historically, markets have been volatile before a national election, but calm down once the election is over (regardless of who wins) because uncertainty is reduced. This year, however, volatility may actually increase after the election due to uncertainty about whether and how Congress will address the expiring tax cuts and the fiscal cliff. Moreover, the threat of rising capital gains tax rates could prompt investors to sell assets to lock in gains near year end, further adding to market volatility.