Definition:

This refers to the simultaneous expiry of tax breaks and the introduction of tax increases and
spending cuts that were due at the end of 2012, the cumulation of which were expected to
push the US back into recession.
The Fiscal Cliff Explained
Fiscal cliff is the popular shorthand term used to describe the conundrum that the U.S.
government faced at the end of 2012, when the terms of the Budget Control Act of 2011 were
scheduled to go into effect.
Among the changes that were set to take place at midnight on December 31, 2012 were the
end of last years 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 Obamas health care law.
At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 - a
total of $1.2 trillion over ten years - were scheduled to go into effect.
The Fiscal Cliff Deal
Three hours before the midnight deadline on January 1, the Senate agreed to a deal to avert
the fiscal cliff. The Senate version passed two hours after the deadline, and the House of
Representatives approved the deal 21 hours later. The government technically went "over the
cliff," since the final details weren't hashed out until after the beginning of the New Year, but
the changes incorporated in the deal were backdated to January 1.
The key elements of the deal were:

an increase in the payroll tax by two percentage points to 6.2% for income up to
$113,700, and
a reversal of the Bush tax cuts for individuals making more than $400,000 and
couples making over $450,000 (which entails the top rate reverting from 35% to
39.5%).
Investment income was also affected, with an increase in the tax on investment
income from 15% to 23.8% for filers in the top income bracket and a 3.8% surtax on
investment income for individuals earning more than $200,000 and couples making
more than $250,000.
The deal also gives U.S. taxpayers greater certainty regarding the alternative
minimum tax, and a number of popular tax breaks - such as the exemption for interest
on municipal bonds - remain in place.

The Congressional Budget Office estimated that the plan would include $330.3 in new
spending during the next ten years, and it will increase the deficit by $3.9 trillion in that time
period despite raising taxes on 77.1% of U.S. households.

Bloomberg reported, "More than 80 percent of households with incomes between $50,000
and $200,000 would pay higher taxes. Among the households facing higher taxes, the average
increase would be $1,635, the policy centre said. A 2 percent payroll tax cut, enacted during
the economic slowdown, is being allowed to expire as of (December 31)." The twopercentage point increase in the payroll tax was expected to take about $120 billion out of the
economy, which should have had a negative impact of about seven-tenths of one percent on
GDP growth.
Did the Deal Accomplish Anything?

The fiscal cliff agreement is good news to some extent, - an unnecessary, self-inflicted
burden on the economy and financial markets. What's more, the agreement addressed
only the revenue side (taxes) but postponed any discussion of spending cuts - the socalled "sequester"
Also, due to higher taxes which were the most important element of the cliff, the taxes
are in fact going up as part of the deal. While the problem is therefore "solved" in the
sense that the deadline has passed, a portion of the concerns related to the cliff indeed
came to fruition. And on a longer-term basis, the cliff deal did little to address the
country's debt load - which currently stands at $16.4 trillion and counting.

The 2012 Fiscal Cliff Debate

In dealing with the fiscal cliff, U.S. lawmakers had a choice among three options, none of
which were particularly attractive:

They could have let the policies scheduled for the beginning of 2013 which featured
a number of tax increases and spending cuts that were expected to weigh heavily on
growth and possibly drive the economy back into a recession go into effect. The
plus side: the deficit would have fallen significantly under the new set of laws.

They could have cancelled some or all of the scheduled tax increases and spending
cuts, which would have added to the deficit and increased the odds that the United
States would face a crisis similar to that which is occurring in Europe. The flip side of
this, of course, is that the United States' debt would have continued to grow.

They could have taken 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. This is ultimately the course lawmakers choice in the agreement reached on
December 31, 2012.

The fiscal cliff was a concern for investors and business since the highly partisan nature of
the political environment made a compromise difficult to reach. Lawmakers had well over a
year to address this issue, but Congress mired in political gridlock put off the search for a
solution until the last minute rather than seeking to solve the problem directly.
In general, Republicans wanted to cut spending and avoid raising taxes, while Democrats
sought a combination of spending cuts and tax increases. The agreement on the table raised
tax rates to 39.6% from 35% on individual with income of more than $400,000 and on
couples with incomes of more than $450,000. It also let the 2% payroll tax cut expire and

delays spending cuts for another two months. The likely outcome of these changes were to be
that economic growth will be pressured modestly, but the country will not face the severe
economic downturn it would have if all of the laws related to the fiscal cliff had gone into
effect.
The Worst-Case Scenario
If the current laws slated for 2013 had become law, 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 estimated that the policy would have reduced
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 predicted that 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 estimated 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. Amid an already-fragile recovery and elevated unemployment, the
economy was not in a position to avoid this type of shock.
The Term "Cliff" Was Misleading
It's important to keep in mind that while the term cliff indicated an immediate disaster at
the beginning of 2013, this wasn't a binary (two-outcome) event that would have ended in
either a full solution or a total failure on December 31. There were 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, the chances that such a deal wouldn't be
reached were slim despite the length of time it took to come to an agreement.
2) Even if the deal did not occur before December 31, Congress had the options to change the
scheduled laws retroactively to January 1 after the deadline.
With this as background, it's important to keep in mind that the concept of "going over the
cliff" was largely a media creation, since even a failure to reach a deal by December 31 never
ensured that a recession and financial market crash would occur.