What Is the Fiscal Cliff: Explanation and Causes

The Self-Imposed Economic Meltdown That Never Happened

fiscal cliff
Fortunately, Congress didn't fall off the fiscal cliff in 2013. But it was too close.. Illustration: mathisworks/Getty Images

Definition: The fiscal cliff is a combination of four tax increases and two spending cuts. They were scheduled to take place automatically on January 1, 2013. The four tax increases would have occurred with the expiration of the Bush tax cuts, the 2% payroll tax holiday enacted by the 2010 Obama tax cuts, and the alternative minimum tax patch. The fourth was the enactment of Obamacare taxes. That was a 3.8% hike on capital gains and dividends for high-income brackets.

 (Source: CNBC, Wealthy Dump Assets, November 12, 2012)

The two spending cuts would have occurred with the expiration of the extended unemployment benefits and the onset of the across-the-board 10% Federal budget cut known as sequestration.

Also, Federal spending was going to exceed the $16.394 trillion debt ceiling early in 2013. If Congress didn't raise the ceiling, the nation would have defaulted on its debt. President Barack Obama tried to make raising the debt ceiling part of the fiscal cliff negotiations. 

Uncertainty about the fiscal cliff started slowing economic growth as early as May 2012. However, everyone knew that nothing would be done until after the election. The two candidates held widely different philosophies on the best way to reduce the debt. Obama favored raising taxes on the wealthy, and Romney favored reduction in non-defense spending. As the closely contested campaign raged on, business leaders waited.

 

Fiscal Cliff Explained

The fiscal cliff was created by a failure of fiscal policy. It nearly pushed the economy off a cliff by suddenly increasing taxes and decreasing spending at one time.

Taxes would have gone up $2,000 to $3,000 per household on average. ESxpiration of the Bush Administration tax cuts EGTRRA and JGTRRA would have increased taxes as follows:

  • Income taxes: revert to Clinton-era rates.
  • Capital gains tax: from 15% to 20%.
  • Dividend taxes: from 15% to more than 43%.
  • Estate taxes: from 35% to 55%, depending on the size of the estate.

If the payroll tax cut expired, workers would have seen an additional 2% taken out of their paychecks to go toward Social Security.

The AMT would have snared 21 million more workers making as little as $50,000 a year. The AMT was initially set up to capture wealthy tax dodgers. But since it wasn't indexed for inflation, it would have raised taxes for many middle-income taxpayers by as much as $3,700.

The spending cut in extended unemployment benefits would have affected around two million jobseekers. Sequestration would hit military spending with a $55 billion cut. Most other departments would be cut 8%. That included aid to states, highway construction, and the FBI. (Source: CNBC, Cliff Plunge: All But Impossible to Avoid the Pain, November 13, 2012; Forbes, The Fiscal Cliff Explained, November 10, 2012)

Federal Reserve Chairman Ben Bernanke used the term in February 2012. He he warned the House Financial Services Committee,"Under current law, on Jan. 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases..." (Source: The Hill, Bernanke Warns of Massive Fiscal Cliff, February 29, 2012)

In 1987, the Boston Globe used it to describe a local utility's financial situation. It was used again in 1991 by California Representative Henry Waxman, referring to Oregon's budget. (Source: Oxford Dictionary)

Causes

In 2010, the President and a Democrat-controlled Senate disagreed with the Republican-controlled House on the best ways to reduce the deficit and debt. As government spending approached the debt ceiling, both parties agreed to appoint a bipartisan commission to propose a solution. The President appointed the Commission on February 18. He charged it to lower the budget deficit to 3% of GDP. 

The final Simpson-Bowles Report was submitted on December 1, 2010. Congress ignored it, instead passing the Budget Control Act in August 2011. It mandated a 10% spending cut that was intended to be so severe that it would force Congress to act.  

The impasse was centered on three areas:

  1. The Democrats refused to extend the Bush tax cuts for families making $250,000 or more. The Republicans declined to extend the tax cuts for anyone if everyone can't have them.
  2. The Democrats would rather cut more out of defense spending, while the Republicans would rather cut Social Security, Medicaid, and Medicare.
  3. The Republicans wanted to repeal the Obamacare taxes.

This standoff was political posturing in advance of the 2012 Presidential election. After the November election, the stock market dropped. That's because stockholders began taking profits to avoid the tax rate increases on capital gains and dividends from the expiration of the Bush tax cuts and the imposition of Obamacare taxes. Without a fiscal cliff solution, businesses continued to cut back on growth and hiring. They didn't want to expand in the face of a potential recession. Furthermore, some business owners sold their companies in 2012, to avoid capital gains tax increases in 2013.

That' why President Obama said his highest priority after winning the election was to work with Congress to resolve the fiscal cliff. Goldman Sachs CEO Lloyd Blankfein said that there businesses were sitting on more than $1 trillion in cash, waiting for Washington to sort it out. Once the uncertainty about tax rates was resolved, that money would be put to work, expanding companies and creating jobs.  ​

On November 22, the leaders of the House and Senate met with President Obama, and it seemed a deal was imminent. Senate Majority Leader Harry Reid said the talks went so well that he thought it would be done before Christmas. It seemed the two sides were more than willing to compromise -- the Democrats would cut a little more than they wanted, and the Republicans would allow a little more tax increases than they wanted. 

First President Obama developed a plan A. In early December, the two parties were pretty close in some areas. For example, no one wanted sequestration. However, Obama included some stimulus spending, such as building roads, that he surely knew wouldn't get passed. This initial proposal left room for negotiation and compromise. 

On December 12, JP Morgan Chase CEO Jamie Dimon said that the business community was OK with a higher tax rate IF the Federal government would cut entitlement spending. This showed that businesses were more relaxed about tax increases than many Tea Party Republicans. He went on to add that the economy would immediately leap to a 4% growth rate once the cliff was resolved. His prediction indicated just how much the uncertainty around the fiscal cliff was hurting the U.S. economy. 

In late December, Boehner lost support from his own party for a Plan "B." This included a compromise to allow the Bush tax cuts to expire for incomes above $1 million. Many Republicans were worried that, if they voted for ANY tax increase, they would lose the mid-term elections in 2014. Stock market futures dropped more than 200 points on the news. Congress adjourned for the holidays, promising to find a solution before the end of the year. Uncertainty around the outcome kept economic growth too slow reduce unemployment. Most businesses had to be conservative and follow operational plans that included the fiscal cliff scenario.

Negotiations to avoid the fiscal cliff dominated the news in 2012. The Republican-controlled House wanted spending cuts, while the Democrat-controlled Senate and the White House focused on tax hikes. This bitter stalemate reflected a shift in political power that occurred after the 2012 Presidential election.

The difficulty in reaching a compromise showed just how far both sides had dug into their ideology. While they tried to work things out, the uncertainty over the outcome slowed economic growth, keeping millions unemployed.

During the final days of the year, Congress did not find a solution. However, this was partly because many Republicans had signed a pledge that they could not vote for tax increases. Instead, they would find it much easier to vote for a tax decrease after the Bush tax cuts had officially expired. For these political reasons, it would be easier to find an agreement if the country slipped off the cliff for a few days or even a week. This wouldn't be disastrous, as any agreement would be retroactive.

It Was Unnecessary

The greatest irony about the fiscal cliff crisis was that is was all self-imposed. True, the U.S. debt-to-GDP ratio was more than 100%, an unsustainable level. But for an economy as strong as the U.S., it wasn't an immediate threat. In fact, investors were more than happy to keep buying U.S. debt, keeping interest rates at 200-year lows.

No, the debt crisis was created by a Congress that didn't understand economics. In 2012, the U.S. was barely in the expansion phase of the business cycle. That wasn't the time to worry about national debt. Instead, the best time to raise taxes OR cut spending is toward the end of the expansion phase, to prevent a bubble. If the Republicans had waited a year, and let the economy fully recover, they could have been heroes -- and economic experts to boot. 

As 2012 wound down, it looked increasingly like a solution would not be found. Even if the tax hikes and spending cuts were enacted, there was still time for the newly elected officials to negotiate a solution in January. It could be retroactive to January 1, avoiding the $600 billion impact on GDP. 

How the Fiscal Cliff Affected the Economy

The tax hikes and spending cuts would have removed $607 billion from the economy in the first nine months of 2013 (the remainder of the 2013 Fiscal Year), according to the Congressional Budget Office. Although it's good long-term to reduce the deficit, in the short term it will severely retard economic growth. That's because government spending is a component of the Gross Domestic Product (GDP). Suddenly cutting it by 10% or so would mean broken contracts with businesses, fewer government jobs, and reductions in benefits.

The tax increases would reduce consumer spending by that amount. The net effect, according to the CBO, would be a 1.3% contraction in the economy for the first half of the year. In other words, a recession. Although the economy would recover in the second half, the growth would be anemic -- barely 2%, or the low end of a healthy economy. Fortunately, the cliff was largely avoided. For the terms of the deal that was hammered out, see Fiscal Cliff 2013

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