What is a 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, a rollback of the "Bush 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."

In dealing with the fiscal cliff, 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 would fall significantly.
• 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. This problem isn’t new, after all: lawmakers have had over a year to address this issue, but Congress – mired in political gridlock – has largely put off the search for a solution rather than seeking to solve the problem directly. In general, Republicans want to cut spending and avoid raising taxes, while Democrats are looking for a combination of spending cuts and tax increases. Although both parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve – particularly in an election year. Currently, it appears that a meaningful deal won't be reached until after the December 31 deadline.

The most likely outcome is another set of stop-gap measures that would delay a more permanent policy change. Still, the non-partisan Congressional Budget Office (CBO) estimates that if Congress takes the middle ground – extending the Bush-era tax cuts but cancelling the automatic spending cuts – the result, in the short term, would be modest growth but no major economic hit.

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Possible Effects of the Fiscal Cliff

If the current laws slated for 2013 went into effect permanently, the impact on the economy would be dramatic. While the combination of higher taxes and spending cuts would reduce the deficit by an estimated $560 billion, the CBO also estimates that the policy would reduce gross domestic product (GDP) by four percentage points in 2013, sending the economy into a recession (i.e., negative growth). At the same time, it predicts unemployment would rise by almost a full percentage point, with a loss of about two million jobs.

A Wall St. Journal article from May 16, 2012 estimates the following impact in dollar terms: “In all, according to an analysis by J.P. Morgan economist Michael Feroli, $280 billion would be pulled out of the economy by the sunsetting of the Bush tax cuts; $125 billion from the expiration of the Obama payroll-tax holiday; $40 billion from the expiration of emergency unemployment benefits; and $98 billion from Budget Control Act spending cuts. In all, the tax increases and spending cuts make up about 3.5% of GDP, with the Bush tax cuts making up about half of that, according to the J.P. Morgan report.” Amid an already-fragile recovery and elevated unemployment, the economy is not in a position to avoid this type of shock.

The Term "Cliff" maybe misleading

It's important to keep in mind that while the term “cliff” indicates an immediate disaster at the beginning of 2013, this isn't a binary (two-outcome) event that will end in either a full solution or a total failure on December 31. There are two important reasons why this is the case:

1) If all of the laws went into effect as scheduled and stayed in effect, the result would undoubtedly be a return to recession. However, Congress continues to work toward a deal that will alleviate the effects in some form. The chances that such a deal won't be reached at some point are slim.

2) Even if the deal does not occur before December 31, as appears likely, Congress can - and almost certainly will - act to change the scheduled laws retroactively to January 1 after the deadline.

At the same time, even a "solution" isn't necessarily positive, since a compromise will likely involve higher taxes or reduced spending in some form - both of which would help reduce the debt, but would be negative for economic growth.

With this as background, it's important to keep in mind that the concept of "going over the cliff" is largely a media creation, since even a failure to reach a deal by December 31 doesn't mean that a recession and financial market crash will occur.

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Unfortunately, the fiscal cliff isn't the only problem facing the United States right now. At some point in the first quarter, the country will again hit the "debt ceiling" - the same issue that roiled the markets in the summer of 2011 and prompted the automatic spending cuts that make up a portion of the fiscal cliff.

Finally, 3rd January 2013, President Barack Obama has signed with an autopen a bill that boosts taxes on the wealthiest Americans, while preserving tax cuts for most American households. The bill, which averts a looming fiscal cliff that had threatened to plunge the nation back into recession, also extends expiring jobless benefits, prevents cuts in Medicare reimbursements to doctors and delays for two months billions of dollars in across-the-board spending cuts in defence and domestic programmes.

The Republican-run House approved the measure by a 257-167 vote late on Tuesday, nearly 24 hours after the Democratic-led Senate passed it 89-8.  Mr Obama, who is vacationing in Hawaii, signed the bill using an autopen, a mechanical device that copies his signature. The US leader also signed a US$633 billion (S$772.5 billion) defence bill for next year that tightens penalties on Iran and bolsters security at diplomatic missions worldwide after the deadly attack in Benghazi, Libya.

Mr Obama had threatened to veto the measure because of a number of concerns, including limits on his authority to transfer terrorist suspects from the US military prison at Guantanamo Bay, Cuba, for one year.  US actions to avoid the fiscal cliff did not go far enough to address the country's long-term fiscal deficit and debt problems, the International Monetary Fund (IMF) said in a reaction to the the political deal.  "In the absence of congressional action the economic recovery would have been derailed," IMF spokesman Gerry Rice said.

China has a strong interest in a healthy US economy. It sits on the world's biggest pile of foreign exchange reserves, worth US$3.3 trillion (S$4 trillion), and as much as 70 per cent of the holdings are invested in US dollar assets, including US Treasuries, according to analysts.

Noting that the US will grapple with the debt ceiling next month, after which the "austerity time-bomb" will begin ticking again, Germany's Der Spiegel said: "We are... witnessing a superpower losing its way in a maze of details, propelled forward by grandstanding politicians".

After the fiscal deal signed by President Barack Obama, there is a "feel good" effect - most Americans can breathe easier now that they will not have to pay higher income tax and that a recession seen as inevitable has been avoided. But economists were less reassured, warning that it was still going to hurt, with slower growth and fewer jobs.

Most Americans will see no change in their income tax rates after the deal which included tax increases on the country's wealthiest 2 per cent and higher pay cheque deductions for all workers.

The biggest impact, say economists, will be from an increase in how much employees see deducted from their pay cheques for social security: After having been cut to stimulate growth in recent years, the rate goes back to 6.2 per cent from 4.2 per cent.

Mr Gregory Daco of IHS Global Insight estimated that will pull US$113 billion (S$138 billion) out of the economy - money that mostly would have otherwise been spent on goods and services.

"That is the measure that is going to hit the most people," he said - by itself cutting 0.4 per cent from potential growth.

An increase in tax rates for Americans earning more than US$400,000, to 39.6 per cent from 35 per cent, will not have as large an impact, he said: "A dollar for them is not the same as a dollar for someone earning US$50,000."

Moreover, politicians still face a battle over cutting federal spending - put off for two months in the wrangling over the cliff deal finally passed on Tuesday - that could further crunch the economy this year. That means more tepid expansion of gross domestic product (GDP) this year, with equally slow job creation as in 2012, by most estimates.

Economist Mark Zandi of Moody's Analytics said the tax increases and spending cuts still to be agreed will take about one percentage point from what growth could have been, had the 2012 tax rates and spending plans stayed in place.

"The result is that the US economy will grow just over 2 per cent in 2013, about the same as in 2012," Mr Zandi said.

In addition, he added, it will hold back job creation, "with 700,000 fewer net new jobs created and an unemployment rate about half a percentage point higher than it would have been if last year's policy had simply been extended".

Though the deal significantly raises taxes on the rich, with no expiration date. It extends tax credits for the poor and middle class. It provides more jobless benefits. Largely overlooked, it extends an alternative-energy tax credit that has helped create a clean-energy boom. And it includes almost no spending cuts.

For President Barack Obama and his Democratic allies in Congress, the fiscal deal reached this week is full of small victories that further their largest policy aims.

Above all, it takes another step towards Mr Obama's goal of orienting federal policy more towards the middle class and poor, at the expense of the rich. Yet the deal also represents a substantial risk for the president.Throughout the negotiations of the past two months, Mr Obama pushed for a larger agreement, one that would have cancelled other looming budget deadlines, starting with one on the debt ceiling.

He and his aides saw the so-called fiscal cliff, with its trillions of dollars in scheduled tax increases that Republicans abhorred, as leverage to start fresh in a second term and avoid more deadline-driven partisan fights.

When House Republicans made it clear that they opposed a big deal, however, Mr Obama decided to take the smaller deal, bank a series of victories and wait to fight another day. The alternative - debated inside the White House, but not ultimately a close call - would have been to go over the cliff in the hope of forcing Republicans into a larger deal.

Without that larger agreement, Mr Obama will be left to find solutions to future budget deadlines without the leverage that came with the prospect of automatic tax increases.

"The best world would have been a bigger agreement," an administration official acknowledged. "This is a big win in a second-best world."

As part of this week's deal, Mr Obama did make several major compromises. He accepted much less in overall tax revenue than the government would have received without any deal. He allowed a payroll tax cut, which applied to most households, to expire.

And he yielded both on aspects of the estate tax and on the level at which the top marginal income-tax rate would start, moving it to US$450,000 (S$550,000) for couples, from US$250,000.

Still, using inequality as a yardstick, he won much of what he had wanted. By holding firm to a top rate of 39.6 per cent - up from 35 per cent - he locked in a substantial tax increase for the very richest, who have received the biggest pre-tax raises in recent years.

The question that hangs over the deal for Democrats is whether they will have to play defence on the budget for the rest of Mr Obama's presidency.

But some of Mr Obama's allies wonder if he should have taken the risk of a confrontation now. A stalemate next time will bring no threat of higher taxes, and Republicans may stand firmer, demanding cuts that undo Mr Obama's recent gains.