The U.S. “Fiscal Cliff” and Its Threat to the Domestic Economy

Bloomberg:  U.S. Fiscal Cliff Endangers World Economy, Lagarde Tells APEC

BusinessWeek:  Face It: 2013 Is Gonna Be a Bummer

CBO:  Fiscal Tightening in 2013 and Its Economic Consequences - Infographic

Reuters:  U.S. Recovery at Risk From Fiscal Cliff-Bernanke

WSJ:  Federal Budget Cuts Detailed

Fiscal deficits have gained recent worldwide attention—mainly due to the struggles in the European Union—and rightly so, as deficits restrict governments’ ability to use spending and tax policies to respond to economic crises, as well as pose challenges to economic growth since deficits raise interest rates and discourage investment. To address the fiscal deficit in the United States—which has run above $1 trillion for the past 4 years, or approximately 8% of annual gross domestic product (GDP)—the White House and Congress plan to cut government spending and increase taxes at the start of 2013. However, this plan—popularly known as the “fiscal cliff”—poses grave concerns for the domestic economy.

The first half of the “fiscal cliff”—spending cuts—originates from an agreement between the White House and Congress to cut $1.2 trillion from the federal deficit between 2013 and 2021. In 2013 alone, the government would cut about $109 billion. About half of the planned spending cuts would come from the U.S. defense operations, such as army expenses and navy aircraft. Other top sources of spending cuts include the National Park Service, salaries to employees of the Securities Exchange Commission, salaries of food-safety workers, rural rental assistance, and health-care exchanges.

The second half of the “fiscal cliff”—tax increases—arises because the Bush-era tax cuts (temporary tax cuts that applied to every tax bracket when President Bush was in office) expire at the end of 2012. If Congress does not extend these tax cuts, tax rates will return to higher pre-Bush-era levels, which are approximately 3% higher for most income levels. Observers are uncertain as to how this issue will be resolved because of the November 2012 presidential election. Democratic candidate President Obama wants to extend tax cuts for Americans making under $250,000, while Republican candidate Mitt Romney wants to extend tax cuts for all Americans. Moreover, since the new president will be sworn into office at the beginning of 2013, the new president will have little to no time to address both the spending cut and the tax rate issues.

The “fiscal cliff” threatens the U.S. economy because it would trigger another significant recession and wipe out approximately 2 million jobs. According to the Congressional Budget Office (CBO), a nonpartisan analyst for the U.S. Congress, the “fiscal cliff” would cut almost four percentage points off the U.S. growth rate in 2013, leading to a 0.5% contraction in the economy, and would also increase the unemployment rate to 9.1%. Moreover, the Federal Reserve—the central banking system of the U.S.—warned that if the “fiscal cliff” throws the U.S. economy into another recession, the Federal Reserve might not have sufficient tools to offset the fiscal shock. Therefore, to avoid the threat of a significant recession, the Federal Reserve recommended that the White House and Congress create an alternative fiscal plan to prohibit spending cuts and maintain the lower tax rates. The CBO predicted that this alternative fiscal plan, unlike the “fiscal cliff,” would allow the U.S. economy to continue to grow—1.7% growth rate in 2013—and to maintain a lower unemployment rate—8.0% in 2013.

The “fiscal cliff” is not only a threat to the U.S. domestic economy, but also one of the top risks to the global economy. Due to the United States’ significant global economic presence, the potential U.S. recession could have a global impact, as it could disrupt other economies and adversely affect investors’ confidence levels in financial markets. This would, in turn, plunge the United States into an even deeper recession.