What is the “fiscal cliff”?

The term “fiscal cliff”, which is believed to have originated in Congressional testimony by Federal Reserve Chairman Ben Bernanke, refers to the substantial changes to tax and spending policies that are scheduled to automatically take effect in January 2013. The changes are intended to significantly reduce the federal budget deficit.

What are the tax and spending policies that will change?

Several major tax provisions are set to expire at year’s end:

The 2001/2003 Bush tax cuts: Although these tax cuts were scheduled to end in 2010, they were extended for two years because of the negative effect letting them expire would have on the economy. Currently the individual marginal e tax rates are 10, 15, 28, 33, and 35 percent. In January they are scheduled to revert to 15, 25, 28, 36, and 39.6 percent. The capital gains rate will also increase to 20% and dividends will be taxed at ordinary e rates.

American Recovery and Reinvestment Act of 2009: This “stimulus” act included several tax changes, including an expansion of the higher education credit, earned e tax credit, homebuyer credit, home energy credit, and child tax credit. Each of these would revert back to their pre-2009 levels. For example, the child tax credit would be reduced from $1,000 to $500 per child.

Payroll tax holiday: In 2010, Congress passed a “payroll tax holiday” to help offset the e lost due to high unemployment. The payroll tax rate shifted from 6.2 percent to 4.2 percent in 2011 and 2012, allowing someone making the median e of about $50,000 to save $1,000 a year in taxes.

Alternative Minimum Tax: Each year a taxpayer must pay the greater of an Alternative Minimum Tax (AMT) or regular tax. Since 2003 Congress has passed one-year “patches” to the AMT, aimed at minimizing the impact of the tax. However, because the AMT is not indexed for inflation, it would lead to an increase for middle-class taxpayers.

Additionally, a number of automatic spending cuts would take effect. For instance, the Budget Control Act of 2011 (i.e., the debt promise) institutes a 2 percent cut in physician and other providers’ Medicare payments, and a 7.6 to 9.6 percent across the board cut in all discretionary spending, except programs for e Americans. The cuts are evenly divided between defense and nondefense programs. The act also sets a firm limit on discretionary spending within which policymakers must operate.

What effect would the policy changes have on the economy?

If all these changes take place, the mostly likely effect will be that the economy will slide back into a recession. According to the Congressional Budget Office, if all of that fiscal tightening occurs, inflation-adjusted gross domestic product (GDP) will drop by 0.5 percent in 2013—reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year. That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1 percent in the fourth quarter of 2013.

But when the recession would occur is a matter of dispute. Some economists believe that if the financial markets react negatively the recession could occur as soon as the first quarter of 2013. Others believe the impact would only be felt later in the year.

How will individual taxpayers be affected?

The Heritage Foundation estimates that if we go over the fiscal cliff, the average American will see their tax bill rise by over $4,100 in 2013.

See also: The FAQs: The Fiscal Cliff Proposals