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Blog: Here we go again. By now most readers have probably heard about the so-called fiscal cliff that the U.S. economy is headed for at the end of the year.
So what exactly is this fiscal cliff and why has it become such a focus of attention for investors and politicians? In short, the fiscal cliff is a series of tax hikes and spending cuts that will automatically kick in at the beginning of next year unless U.S. lawmakers can come up with some sort of plan (anything, please) to solve the country's long-term budgetary problems -- namely, its ever-growing budget deficit.
And how did we get to a situation where lawmakers are once again allowed to play gamesmanship with the world's largest economy?
Think back to the very public and acrimonious battle between U.S. Democrats and Republicans in the summer of 2011 when they were asked to raise the country's debt ceiling and prevent a default.
On one side you had lawmakers who believed the time was now for the U.S. to rectify its free-spending ways. They wanted a plan put in place to control spending and tame the deficit before agreeing to raise America’s borrowing limit. On the other side you had lawmakers who wanted to avoid playing games with the borrowing limit, saying those plans should be shelved until the debt ceiling limit was.
In the end the two sides took the battle to the last minute (with the politics of attack on full display) and nearly brought the U.S. to default on its debt. In the process, America's credit rating was cut by Standard and Poor's – the first time in history that has happened.
The eventual compromise saw some automatic spending cuts, but also established a committee of lawmakers tasked to find $1.2 trillion US in spending cuts over the next decade. If a compromise is not reached, a host of spending cuts and tax hikes will automatically kick in at the beginning of 2013.
Federal Reserve chair Ben Bernanke eventually coined those automatic tax hikes and spending cuts as a "fiscal cliff."
WHAT'S THE BIG DEAL
The non-partisan budget watchdog the Congressional Budget Office (CBO) says that if the full package of spending cuts and tax hikes kick in, the U.S. economy will likely slide back into a recession. They expect real GDP to decline 0.5 percent between the end of 2012 and the end of 2013.
They also expect the unemployment rate -- currently sitting at about 7.9 percent -- to rise to about 9 percent in the second half of next year.
Ratings agency Fitch estimated that the fiscal cliff could chop about $800 billion, or 5 percent, from U.S. GDP on an annualized basis.
"The U.S. fiscal cliff represents the single biggest near-term threat to a global economic recovery," the agency warned in a recent report.
All told, the fiscal cliff will cut the U.S. federal deficit by about 50 percent to $641 billion next year, according to the CBO. About two-thirds of those cuts will come from changes in tax policy, while the rest will come from direct spending cuts.
What are some of these cuts?
A host of tax measures put in place in the wake of the financial crisis and many of the so-called ‘Bush Tax Cuts’ put in place over the last decade are set to expire. A 2 percentage-point cut in the payroll tax which first went into effect in January 2011 will also come to an end.
As for the straight spending cuts, those include automatic spending cuts to the defense budget and unemployment benefits, as well as fees paid to doctors on the public health system.
Here’s hoping Washington can get its act together in time.