What is this fiscal cliff? Why are economists so frightened of it? The term refers to a sudden change in a lot of different tax policies that is scheduled to take place automatically at midnight on December 31st. As soon as the clock strikes twelve, the Bush-era tax cuts will expire, eliminating the 10% tax bracket altogether, and moving the current 25%, 28%, 33% and 35% brackets up to 28%, 31%, 36% and 39.6% respectively. At the same time, the 0% capital gains tax rate would bump up to 10%, and the tax rate on dividends would rise to 15% or 28%, depending on the recipient’s income tax bracket.
Also expiring: a provision that eases the so-called “marriage penalty,” some deductions for college tuition, child tax credits, dependent care credits and a particularly harsh phase-out would eliminate up to 80% of some taxpayers’ itemized deductions for mortgage interest, state and local taxes, and charitable donations. Making the cliff a bit steeper, the Budget Control Act of 2011 calls for automatic government spending cuts of $1.2 trillion from the federal budget over the next 10 years. The Obama-era payroll tax cuts (reducing taxes by about 2% for workers) are also set to expire.
All of this would boost government revenues and lower government spending–the opposite of a government stimulus–and suck some of the spending power out of consumer balance sheets. How much? The Congressional Budget Office estimates that if we go over the cliff–that is, if Congress doesn’t act between now and the end of the year–a total of $560 billion would exit the economy to pay down the government deficit. That’s the good news. The bad news is that the CBO estimates that this would reduce America’s total economic activity in 2013 by four percentage points. To put that in perspective, last year our economy grew at a 1.7% rate.
So is a recession inevitable? What are the odds that Congress will take bold, decisive action during a Presidential election year? Some believe the magnitude of the economic consequences has gotten the attention of Congress, and no matter who gets elected, something will be done. The most likely possibility is yet another stop-gap measure which might extend some of the tax cuts but repeal some of the automatic spending cuts, pushing the cliff out so that future lawmakers will have to deal with it.