What Is the Fiscal Cliff and How Will It Affect You?

Libby Kane

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.

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.

  • Rockstar_chick87

    My guess is we will hit a double dip recession that’s worse than before. But I would not say we are post recession. Unemployment is still high. And gas is still high. Housing market still sucks. Those who voted for Obama will have it comin to them. Good luck living your life now.

    • LeAnne

       Unfortunately, most of the people who voted for Obama will have it coming to them, and by “it,” I mean benefits.  It’s those who realized that all of Obama’s altruistic intents would cost more money than the American people can afford will likely shoulder the cost.

      • PLRGPR

        Right on again! The people who are dependent on big government don’t realize that right now they are trading freedom for a different form of slavery. We’re creating a “benevolent master,” who in reality is unrealistically dependent on the hard work of those he (the government) oversees. The Founding Fathers fought for FREEDOM, and we are voting it away. We will still have a country, but not the glorious creation envisioned by the Declaration of Independence and the Constitution. We are blowing the greatest opportunity mankind has ever won.

      • Livin the life

        You have such a limited view of life.

  • Young_in_America

    The fiscal cliff could have such potentially devastating effects on our economy.  Starting out as a young person in this economy has already been challenging.  My now husband and I graduated from our Masters and from Law School and were very lucky to get jobs just as the economy was hit in 2008, but it’s still been very difficult.  We were never given money from our parents, and are blessed because of our jobs that we’ve always been able to be financially independent.  We have been trying to save up to buy a house for 3 years now, but we have significant student loans, and cost of living in NYC is very expensive.  We live a modest lifestyle, budget constantly, and keep each other in check with spending.  We are already being taxed, after everything is said and done (fed, state, city, etc…), at over 40% and can’t take deductions on student loans or anything because we’re considered “rich”.  I’m not looking for a pity party, but I would like people to stop saying we’re not paying our fair share.  We work very hard, and we’re finding it difficult to find a way to buy a home or even start a family at any point in the near future.  With increasing taxes, what used to be the American dream seems farther and farther away…

    • LeAnne

       You are paying more than you fair share. 

    • Sam G

      The problem with “fair share” is that it can not be defined.  It is an ambiguous term that can mean whatever the politician wants it to mean.  Basically, what it really means is, if you try to work and make a living, you are going to be paying your “fair share” until it hurts.  If you seriously want to understand what is happening, just read the book “The Communist Manifesto” by Karl Marx, and then read “Capitalism and Freedom” by Milton Friedman.

  • LeAnne

    FINALLY!  A LearnVest article that mentions how Obama’s intentions make hard work less appealing.  Like Ezra Klein in the article, I know the sting of having worked harder to get less. 

    The overspending of the government is ridiculous.  At no point in my career do I anticipate being able to go approach my employer and say, “I spent more money than I received in my last paycheck, you have to give me a raise.”  Why is the government allowed to force Americans to pay more just because they can’t budget properly?

    • PLRGPR

      You are so right. I have been asking the same question for years! If a guy on the street took my money just because he had squandered all of his, it would be called ROBBERY! It is stil robbery, even if the guy is named BIG GOVERNMENT!

    • http://twitter.com/shoegirlinbr Kacie

      A huge part of the problem is that the Senate hasn’t passed a budget in THREE years. Which means there is no red line or stop sign…they can tax and spend until the American worker is completely drained. I hope those who voted Obama are happy – the rest of us are paying for your freebies and government dole. Our forefathers are rolling over in their graves.

      “I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretense of taking care of them.” -Thomas Jefferson

  • Cc11782n

    I read a great piece in Fortune magazine suggesting ways to “fix” the economy that was co-written by a staunch Democrat and a staunch Republican, who had to agree and come up with a proposal. In its simplest terms, we overspent. On what or why is irrelevant now. What is important for the government is what is important for your own personal finances – if you’re in debt, it doesn’t matter why – but you need to get out of it as quickly as possible. Sometimes that means cuts in discretionary expenses so that you can pay your bills and your debt. It stinks to have to do that – even more so on a large scale such as the government which could tip the country back into a recession, but what people need to realize is that once the budget is balanced again, and we cut our debt out, those measures will be lifted. I sympathize with people all across the spectrum – from the college student who can barely afford to pay all of their bills because their student loans are so high, to the displaced worker who just cant find work whether they’re lacking in technical skills or education. I thought the piece you guys did on the Welfare mom was an excellent example of how not everyone is looking for a hand out as much as a hand up. We’re in this mess together, as crappy as it is, because we elected representatives who allowed this to happen – not just a president or vice president is to blame here.

    Unfortunately, when we talk about what to do to help get out of debt, that’s where the division happens, and it basically comes down to having to decide how much the Federal government should be spending and what programs they should be spending on, as opposed to what the state governments should be doing and what we personally should be doing.

    Also, I hate to say it, but the baby boomers who are aging and living longer and longer are the ones putting a huge strain on the healthcare/social security/medicare system. Those systems just werent designed with todays life expectancy in mind. We can’t turn away our grandparents or parents from having essential care, but similarly, we can’t expect to keep this up for much longer and have it be fair either – since it’s impacting our retirement savings.

    Its a big mess, and Washington, and all of us, need to cut out the partisanship and make some tough decisions that are as fair as possible to the biggest majority as possible.

    • Kmal9er

      Excellent post. What was the title of the Fortune article?

  • Sam G

    The cliff means, for anyone that tries to make a living and not live off the efforts of others… “Bend over, comrades! We’re all going to be paying “our fair share” until we squeal!”

  • jthebear

    It is amazing the stories of hardships and resentments. I voted for Obama and do not want taxes more than others. I’ve worked hard for the past 44 years and I expect to work several more. But I am going to be honest. The system is screwed up. The economic system is based on unsustainable material consumption. Our consumption of energy is wasteful and destructive. Our values are distorted. It is not a question of providing maintenance for people on welfare. We must end welfare. Not by starving people. But by raising them up, giving them dignity, and allowing them too participate productively. I do not believe anyone deserves extreme wealth. It can only be accumulated massively through some form of exploitation. We will always have the rich and the poor among us. But it should not be extreme. Those people that complain with such bitterness are peeing in their own bathtub.

    • Welcom Santa Claus

       Both parties are a mess. But I am/was a conservative American, no party as both are evil. But we have given in to Santa Claus.Told my kids this week who are in college go out get on welfare, food stamps, obama care and grants. I am not going to send them any more money to help them. They need to use the system and  take all that you can while it lasts. I guess just like Darth Vader we have given in to the dark side. Work less, play and live off the government as much as possible is our new family attitude. We have restructured out family business to take advantage of Obama Care freebies 7k in Tax Credit assume. Merry Christmas..

    • Guest

      What do you mean wealth can only be accumulated massively through some form of exploitation? That’s preposterous! How do you explain the wealth of James Dyson, Oprah, Dave Ramsey and TONS of others? Why do you think you’re allowed to decide what people are allowed to have? These people are extraordinary in their giving and are STILL able to live well. It’s because they  offer products and services that people purchase en mass because they’re AMAZING, not because they’re evil or exploit people. Living below your means and being ambitious and smart with your money doesn’t make you a bad person. These people are taxed on their income, taxed on capital gains, taxed on their businesses, and taxed MASSIVELY on their estate that they’ve built to pass down to their children AFTER THEY ALREADY PAID TAXES at ridiculous marginal rates when they earned that money. I think you need to reevaluate what it means to be an American. If you limit opportunity and earning potential because you just don’t think people should have that much, then that’s not freedom, ma’am.

  • Guest

    When did the depression end??
    You could have fooled US!