What Is the Fiscal Cliff?

The pending "fiscal cliff," or "taxmageddon," threatens to push the U.S. economy into a recession. The fiscal cliff is a set of policies due to go into effect in January, unless Congress and the president act to change them. Here is a rundown of all the policies contributing to the fiscal cliff.

Tax Increases

The tax cuts enacted in 2001 and 2003, during the President George W. Bush administration, were not made permanent. Rather they were set to expire in 2010. At the end of 2010, President Barack Obama signed a two year extension of those tax cuts. On Jan. 1, 2013, therefore, income taxes will increase for all tax brackets, and return to the rates they were at before the Bush tax cuts.

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Spending Cuts

Last August, the Budget Control Act of 2012 was passed as part of a negotiation to increase the nation's debt limit. Republicans insisted that the debt limit not be increased without spending cuts equal to or greater than the amount of the debt limit increase.

The BCA set up a "super committee" to negotiate a "grand bargain" debt deal that would reform taxes and entitlements to reduce the long term growth in government spending. As an incentive for the super committee to complete its work, the BCA put in place automatic spending cuts that would go into effect if the super committee failed to reach an agreement. The super committee did fail, so about $1 trillion of automatic spending cuts over 10 years will begin on Jan. 1. Half of those cuts will be in the Department of Defense budget.

Debt Limit

Since the BCA only increased the debt limit enough to get past the next election, Congress will face another debt limit increase early next year. Republicans, particularly those representing the Tea Party Movement, will likely use this vote to again force Congress to reduce deficit spending. If Congress fails to reach an agreement and does not increase the debt limit, the federal government will likely default on promised payments.

Unemployment Benefits Expire

Since the recession that began in 2008, Congress has extended the number of months that one can receive unemployment benefits. The last extension, passed early this year, is set to expire at the end of 2012. By itself, this would not normally be an issue, but combined with the other fiscal cliff issues, it will contribute to a recession because beneficiaries will not have that money to spend.

What Can Be Done?

Congress could prevent the recession by simply extending all the tax cuts, rescinding the spending cuts, extending unemployment benefits and increasing the debt limit to pay for it with more borrowed money. This problem with the course, a Congressional Budget Office report points out, is that it will cause more problems in the future by making the debt unsustainable.

The path that can both prevent the fiscal cliff recession in the short term and the debt crisis in the long term, is the "grand bargain" that the super committee failed to reach an agreement on. The "grand bargain" would reform entitlements to slow their growth in the long term and reform the tax code to broaden the tax base and encourage the economic growth needed to deal with the nation's fiscal challenges.

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