Some Native American tribes used to hunt buffalo by driving them off the edge of a cliff to their deaths.
Let's hope the same fate isn't in store for the American economy.
Of course, the term "fiscal cliff" doesn't exactly inspire confidence in our economic resilience. That term, which you've probably heard floating around during election season, refers to the end of 2012 (coincidentally, around the time of that pesky apocalypse), when a series of major fiscal policies will either expire or begin, making a sudden impact on the American economy.
The cliff was an election issue because both parties (Democrats in the Senate and Presidency; Republicans in the House) have to decide how best to address it and how to mitigate damage to the already shaky post-recession economy. Things didn't exactly start on a good note: Wednesday, the day after the election, worries about the fiscal cliff led the stock market to plunge--the Dow Jones hit its lowest level since August after its biggest one-day fall since November 2011. But on Wednesday, major players involved in the negotiations all expressed a desire to work together (although they also remained committed to their principles).
What could the fiscal cliff mean for your wallet?
What Exactly Is the Fiscal Cliff?
Basically, the fiscal cliff is the moment when most taxpayers will suddenly be asked to pay, according to some estimates, 5% more in taxes.
If the current laws slated for 2013 go into effect, the impact on the economy could be dramatic, totaling $7 trillion. The combination of $7 trillion in higher taxes and spending cuts would reduce the deficit by an estimated $560 billion while spending is simultaneously cut in government-funded areas such as the military and schools.
The cliff itself consists of a handful of fiscal policies, including:
The end of the payroll tax holiday. ($95 billion in 2013 alone) This measure, which began in 2010, reduced employee contributions to Social Security by 2% (for households with incomes under $110,000) in order to give middle-class families a little more cash on payday during the recession. When it's revoked, those same middle-class families will stop getting that money. The end of the holiday could mean the typical American family pays another $1,000 per year in taxes.
The end of tax cuts and deductions that have been in place since 2003. ($200 billion over 10 years) Known as the Bush tax cuts (after being put in place by President George W. Bush in 2001 and 2003 to lower income taxes), the expiration of these cuts will lead to higher income taxes for all Americans, increased estate tax and increased capital gains rate, among other things, and could cost an American household up to $5,700 more a year. To figure out your tax bracket and estimate how much you'll pay, use this calculator.
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The start of budget cuts meant to alleviate the debt ceiling. ($1.2 trillion in ten years) The Budget Control Act, established in 2011, requires spending cuts which start--you guessed it--at the new year. It was a particularly contentious issue in this week's election because the half of the spending cuts ($55 million) will come from defense spending. The other half will come from nondefense spending, including education, food inspections and air travel safety.
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The end of the Alternative Minimum Tax. ($864 billion over 10 years) The Alternative Minimum Tax (AMT) was created in 1969 as a way to make sure that very wealthy people with access to a lot of write-offs and tax shelters would pay their fair share of taxes. Congress has been “patching” the AMT for the past few years by passing temporary increases to the lower income thresholds where it kicks in so it doesn't start to hit the middle class. It requires taxpayers who earn over a certain household income to calculate owed taxes with two different sets of calculations, then pay the higher of the two results. At the end of 2012, that income limit will lower, and about 30 million people (compared to the current four million) will have to adhere to the AMT and pay more.
The start of taxes related to the Affordable Care Act. ($84 billion over 11 years) As part of the Affordable Care Act, signed into law by President Obama, households with incomes over $200,000 a year ($250,000 for married couples) will start paying a Medicare tax. It will cost households with incomes up to $500,000 $633 per year, and households with incomes over $1 million $11,242. This isn't always considered part of the cliff because it isn't a temporary measure like the others, but is another tax increase that will add to the burden in 2013.
The rest of the $7 trillion will come from a combination of smaller cuts in spending and increases in taxes and their compounded effect over the next ten years.
How the Cliff's Impact Could Be Lessened
President Obama has a few ways he could deal with the cliff: One option is to let the policies expire and begin as expected, which will have the benefit of reducing our national debt by the largest amount in over 30 years. The problem with this, though, is that it runs the risk of plunging the United States back into a recession when it abruptly takes $500 billion out of the economy by stopping funding and limiting the amount of money spent by middle-class families, who traditionally buy the most goods and services.
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Another option is to postpone or cancel the deadlines for the policies, which would push us away from recession but add to our national budget deficit, which could lead to something akin to the European debt crisis. Canceling the deadline would extend tax cuts without reining in spending, and the deficit would rise.
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A third option, and the most amorphous, is to find some magic combination of cuts and increases that will reduce our debt and keep our economy growing. It is expected this strategy will be the winner, but not easily instituted because different parties control the House and Senate.
President Obama hasn't embraced the idea of going through with all of the spending cuts, but has also resisted the idea of simply revoking them. Instead, he will likely extend the Bush tax cuts for people earning under $250,000 per year and has indicated that he expects to make major financial policy changes in the first six months of his second term.
What the Cliff Means for Your Money
It's estimated that the fiscal cliff will affect 88% of taxpayers, most of whom will see a tax increase of 5% if the tax cuts do expire and spending cuts kick in as planned. The Tax Policy Center estimates that if the cliff policies continue as planned, it will cost middle-income families about $775 a year. The top 20% of earners would end up with a tax increase of 5.8%, the bottom 20% of earners would face an increase of 3.7% and the middle bracket's taxes will rise 3.8%. The cuts in government spending would also eliminate around two million jobs.
But Ezra Klein of The Washington Post, digging into the Tax Policy Center numbers a bit deeper, points out that this tax increase will raise marginal tax rates (the taxes you pay according to your income bracket) a lot more than the average tax increases imply. As he puts it, "If I’m deciding whether to work overtime and get $1,000 more on my paycheck, I don’t care about what tax I’m paying on all my income. I care what tax I’d have to pay on that $1,000. High marginal tax rates thus function as a work disincentive. If I get to keep less of each additional dollar I earn, I’m not going to be as inclined to earn additional dollars." And what does he find? The marginal tax rates most severely impact people at either end of the spectrum: the richest and poorest of us. People with middle incomes, however, will see the least change.
It's all very dramatic and we're bracing ourselves for the fall, but some experts think the cliff will be more like a steep hill, or possibly even a convenient rope bridge across the valley. It's expected that that the current AMT will be extended to keep over 25 million households from an average tax increase of $2,800.
But the thing is, no one really knows what will happen and how it will affect the economy. While we could follow the buffalo off the cliff and hit another recession fueled by our increased tax payments, things are likely to change in the next few months--hopefully, in a way that's good for both our own wallets and the economy.