Admit it. You can’t make any sense of this “fiscal cliff” talk. You’ve heard the term associated with economic doomsday, but have never gotten a concise explanation as to what it really means. And with time, you’ve only become more convinced that the “fiscal cliff” is one of those things that everyone simply pretends to understand, but nobody actually does, like poetry or rugby.
But it’s not as mysterious as it seems. Let’s take a look:
Q: So what is the fiscal cliff?
A: The fiscal cliff is the convergence of two events on Jan. 1, 2013 — a scheduled reduction in government spending and the expiration of almost every tax cut enacted since 2001 — that, according to experts, when taken together will kick-start a recession, cost millions of jobs, and from the sound of things, potentially knock Earth off its orbit, sending it hurtling through cold, dark space.
Q: That sounds rough. But given our deficit, shouldn’t cutting spending and increasing tax revenue be a good thing?
A: While going over the fiscal cliff would improve our current deficit by adding net inflows, according to the Congressional Budget Office, the short-term impact on the economy would be painful. Real GDP would drop by 0.5 percent in 2013 and unemployment would rise to 9.1 percent with the loss of 2.6 million jobs. The reasons why depend on which component — the spending cuts or tax increases — we’re talking about.
Q: Start with the spending cuts. How did they come to be?
A: The cuts are the result of the “debt ceiling crisis” of 2011. When the government wants to build a bridge, wage a war, or buy extra padlocks for Area 51, it needs a way to finance the expenditure. These funds come from either tax revenue or borrowings.
For years, the government has spent significantly more than it collected in tax revenue, forcing it to borrow the excess. And as you might imagine, being dependent on borrowing is a rather bad thing. Higher debt leads to a reduction in national savings, undermines investor and consumer confidence, and jeopardizes the government’s ability to continue to borrow at reasonable interest rates.
In light of these potential consequences, there is a maximum amount of debt that can be incurred by the government, often referred to as the debt ceiling. During 2011, years of rampant spending and borrowing finally caught up with the government, and it ran up against this ceiling.
In response, rather than risk defaulting on its debt the government decided to raise the debt ceiling. But because Congress rightfully doesn’t trust itself, it built in a safety measure in the form of a bi-partisan “super-committee” that was charged with trimming $1.5 trillion off the national deficit over the next decade. In the event the committee failed to reach an agreement by November 2011, required spending cuts would take hold in 2013. November came and went, and no agreement was reached. So here we are.
Q: What spending is being cut?
A: Defense spending for 2013 will be reduced by $24 billion, leaving America ripe for an attempted British re-colonization. With regards to non-defense programs, the government will be shelling out $40 billion less next year, with the reductions focused primarily on Medicare programs.
Q: How can $64 million less in spending be a bad thing?
A: When the government is spending less, the government is buying less. Those goods and services that would have been purchased are now taken out of the economy, which contributes to a short-term recession.
To illustrate, imagine that the government would have built a bridge with $40 million of the cut funds. To construct the bridge, the government would have purchased raw materials and labor, making for a banner year for one lucky contractor. Kill the bridge, and all those inflows to the economy go with it.
Extrapolating further, the construction would require a team of laborers, who would earn more disposable income that they could pump into the economy by buying disposable razors, decorative throw pillows and the like. Without the bridge, these guys hit the unemployment line.
Q: How do the tax increases fit in?
A: They are the other half of the fiscal cliff equation. On Jan. 1, 2013, the Bush tax cuts will expire and the President’s “Obamacare” legislation, which contains additional tax provisions, will take hold. As a result, federal tax revenue will increase by $438 billion in 2013 over 2012.
Q: And let me guess … somehow this increased revenue is a bad thing?
A: In the short-term, yes. If tax rates go up, people have less money to spend, which hurts the economy. More importantly, if employers are uncertain about the state of the economy in general, they tend to lack confidence that there will be more demand for their products in the future. As a result, they may defer hiring or increasing wages, which adds to unemployment and further dilutes the economy.
Q: So the fiscal cliff would cause a short-term recession. But what will it do in the long-term?
A: If we go over the cliff, the projected $1 trillion deficit in 2013 would be reduced by $500 billion, and the government could presumably get its borrowing under control. If this were to occur, the CBO predicts that after 2013 economic growth will pick up and the labor market will improve. As a result, the unemployment rate will drop to 5.5 percent by 2018.
Q: What’s the most likely solution/outcome?
A: I honestly don’t know, and even if I told you my recommendation, you probably shouldn’t listen to it. But some hard decisions will need to be made. The more interesting aspect is to what extent a divided Congress will be willing to attack the issue and reach a meaningful agreement before year-end. If neither side is willing to budge, we may just go hurtling off this fiscal cliff, Wile E. Coyote style. Which would be awful. Or great. Depending on your point of view.
Tony J. Nitti, CPA, MST, is a partner with WithumSmith+Brown, PC in Aspen. Read more of his columns about tax policy at blogs.forbes.com/anthonynitti.