What is the Fiscal Cliff?
The Fiscal Cliff Explained
“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.
Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect. According to Barron’s, over 1,000 government programs – including the defense budget and Medicare are in line for “deep, automatic cuts.”
In dealing with the fiscal cliff, U.S. lawmakers have a choice among three options, none of which are particularly attractive:
- They can let the current policy scheduled for the beginning of 2013 – which features a number of tax increases and spending cuts that are expected to weigh heavily on growth and possibly drive the economy back into a recession – go into effect. The plus side: the deficit, as a percentage of GDP, would be cut in half.
- They can cancel some or all of the scheduled tax increases and spending cuts, which would add to the deficit and increase the odds that the United States could face a crisis similar to that which is occurring in Europe. The flip side of this, of course, is that the United States’ debt will continue to grow.
- They could take a middle course, opting for an approach that would address the budget issues to a limited extent, but that would have a more modest impact on growth.
Can a Compromise be Reached?
The oncoming fiscal cliff is a concern for investors since the highly partisan nature of the current political environment could make a compromise difficult to reach. This problem isn’t new, after all: lawmakers have had three years to address this issue, but Congress – mired in political gridlock – has largely put off the search for a solution rather than seeking to solve the problem directly. Republicans want to cut spending and avoid raising taxes, while Democrats are looking for a combination of spending cuts and tax increases. Although both parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve – particularly in an election year. There’s a strong possibility that Congress won’t act until the eleventh hour. Another potential obstacle is that the next Congress won’t be sworn in until January 3, after the deadline.
The most likely outcome is another set of stop-gap measures that would delay a more permanent policy change until 2013 or later. Still, the non-partisan Congressional Budget Office (CBO) estimates that if Congress takes the middle ground – extending the Bush-era tax cuts but cancelling the automatic spending cuts – the result, in the short term, would be modest growth but no major economic hit.
Possible Effects of the Fiscal Cliff
If the current laws slated for 2013 go into effect, the impact on the economy could be dramatic. While the combination of higher taxes and spending cuts would reduce the deficit by an estimated $560 billion, the CBO estimates that the policies set to go into effect would cut gross domestic product (GDP) by four percentage points in 2013, sending the economy into a recession (i.e., negative growth). At the same time, it predicts unemployment would rise by almost a full percentage point, with a loss of about two million jobs. A Wall St. Journal article from May 16, 2012 estimates the following impact in dollar terms: “In all, according to an analysis by J.P. Morgan economist Michael Feroli, $280 billion would be pulled out of the economy by the sunsetting of the Bush tax cuts; $125 billion from the expiration of the Obama payroll-tax holiday; $40 billion from the expiration of emergency unemployment benefits; and $98 billion from Budget Control Act spending cuts. In all, the tax increases and spending cuts make up about 3.5% of GDP, with the Bush tax cuts making up about half of that, according to the J.P. Morgan report.” Amid an already-fragile recovery and elevated unemployment, the economy is not in a position to avoid this type of shock.
The cost of indecision is likely to have an effect on the economy before 2013 even begins. The CBO anticipates that a lack of resolution will cause households and businesses to begin changing their spending in anticipation of the changes, possible reducing GDP before 2012 is even over.
Having said this, it’s important to keep in mind that while the term “cliff” indicates an immediate disaster at the beginning of 2013, the impact of the changes – while destructive over a full year – will be gradual at first. What’s more, Congress can act to change laws retroactively after the deadline. As a result, the fiscal cliff won’t necessarily be an impediment to growth even if Congress doesn’t address the issue until after 2013 has already begun.
The Next Crisis
Unfortunately, the fiscal cliff isn’t the only problem facing the United States right now. At some point in the first quarter, the country will again hit the “debt ceiling” – the same issue that roiled the markets in the summer of 2011 and prompted the automatic spending cuts that make up a portion of the fiscal cliff.
What is the debt ceiling exactly? It’s a legalcap set by Congress on the amount of money the federal government can borrow. The ceiling applies to debt owed to the public (i.e., anyone who buys U.S. bonds) plus debt owed to federal government trust funds such as those for Social Security and Medicare.
The first limit, established in 1917, was set at $11.5 billion, according to the Committee for a Responsible Federal Budget. By setting a limit, Congress gave the Treasury Department authority to borrow money as needed. Congress had to sign off every time the federal government issued debt.
How high is the debt limit right now? The ceiling is currently set at $16.394 trillion. The country’s accrued debt subject to the limit as of Friday was $15.670 trillion. (Here’s where the Treasury posts daily updates of the number.)
When will we hit it? Treasury Secretary Tim Geithner has said he estimates that U.S. borrowing could hit the debt ceiling by the end of 2012.
But by taking “extraordinary measures” — such as suspending investments in federal retirement funds — Geithner might be able to buy enough time to keep borrowing below the legal limit until early 2013.
How is the ceiling determined? They never admit it, but every time lawmakers vote to hike spending or cut taxes and not pay for them, they’re tacitly acknowledging that the debt ceiling will need to raised in the future.
So arguing over the debt ceiling after the fact is essentially arguing over whether to pay the bills the country has already incurred and which Congress has already approved.
How many times has the ceiling been raised? Since March 1962, debt ceiling increases have been enacted 76 times, according to the Congressional Research Service. Congress has voted to raise the ceiling 11 of those times since 2001.
Expect more of the same over the next decade. Barring major changes to spending and tax policies, “Congress would repeatedly face demands to raise the debt limit,” CRS wrote.
Why does Congress even bother to set a debt limit? In theory, the limit is supposed to help Congress control spending. In reality, it doesn’t.
Every time the debt limit needs to be raised, lawmakers and the president are forced to take stock of the country’s fiscal direction, which in theory isn’t a bad thing.
But the decision about how high to set the ceiling is usually a political one — depending on how quickly the minority party wants to raise the issue again for political gain or to extract concessions.
In any case, the vote usually comes after lawmakers have already passed the spending hikes and tax cuts that necessitate an increase in the first place.
What happens if Congress doesn’t raise the debt ceiling? Treasury would not be able to borrow any more money.
That means the government would fall short of what it needs to pay all its bills in full, which include funding government operations and paying creditors and contractors.
During last year’s debate, Geithner’s critics said he could prevent default by simply paying the interest due to bondholders.
But since average spending — minus interest — outpaces revenue by about $115 billion a month, Geithner would have to pick and choose whom to pay and whom to put off every day.
And there’s no guarantee that paying interest while shirking other legal obligations will protect the country from the perception of default.
Geithner said it would be akin to a homeowner who pays his mortgage but puts off his car loan and credit cards. Translation: the homeowner’s credit could still be damaged.
Ultimately, if lawmakers fail to raise the ceiling, they will have two choices, both awful.
They could immediately enact massive spending cuts or tax increases. Or they could acknowledge that the country would be unable to pay what it owes in full and the United States could effectively default on some of its obligations.
The first option is impossible to execute without serious economic repercussions. And the second option could cripple the economy and send world markets into a tailspin.
“Not only the default but efforts to resolve it would arguably have negative repercussions on both domestic and international financial markets and economies,” according to the CRS.
Will reaching the debt ceiling cause a government shutdown? Technically, no.
A government shutdown occurs if lawmakers fail to appropriate money for federal agencies and programs.
By contrast, if the debt ceiling is breached, Uncle Sam would still have revenue coming in that could be used to fund the government, noted Rudolph Penner, a former Congressional Budget Office director.
But if Geithner is coming up short by $115 billion on average every month, and lawmakers just decide to cut spending by that amount, that could effectively mean a partial government shutdown.
So what happened last year? The 2011 debt ceiling showdown resulted in a three-part increase to the debt ceiling in exchange for, among other things, at least $2.1 trillion in debt reduction over 10 years.
The debt ceiling deal — known as the Budget Control Act — also empowered a so-called super committee of lawmakers from both parties to negotiate how to achieve at least $1.2 trillion of that debt reduction.
That committee failed, however, thereby triggering a sequester of nearly $1 trillion in automatic spending cuts, mostly across defense and nondefense discretionary spending. That latter category pays for many common and popular governmental functions, from food inspections to the operation of national parks.Those cuts are set to start taking effect in January 2013.
Many lawmakers hate those cuts– but apparently not enough yet to negotiate a bipartisan deal to replace them.
The debt ceiling showdown of 2011 also created a lot of bad blood between the parties and between Republicans and the White House.
And it sparked the first-ever downgrade of the U.S. credit rating by Standard & Poor’s, which cited political brinksmanship as the chief cause.
That, in turn, caused one of the most volatile weeks in world markets and left Americans and investors with the sense that Congress can’t handle even the most elemental tasks without a lot of destructive drama.
An Overview of the United States National Debt
$16,245,318,820,569.34
Last Updated: Saturday, November 10th, 2012
Every man, woman and child in the United States currently owes $53,469 for their share of the U.S. public debt
Public Debt: $11,421,836,402,771.01
Intragovernmental Holdings: $4,823,482,417,798.33
Total U.S. National Debt: $16,245,318,820,569.34
Question: Who owns the public debt?
Answer: Mutual funds, pension funds, foreign governments, foreign investors, American investors, etc.
Which Foreign governments own the most U.S. debt?
Answer: Here is the Top 10 (as of Aug/2012)
1. China, Mainland, $1153.6 billion dollars
2. Japan, $1121.5 billion dollars
3. Oil Exporters*, $263.0 billion dollars
4. Carib Bnkng Ctrs**, $256.9 billion dollars
5. Brazil, $253.9 billion dollars
6. All Other, $226.8 billion dollars
7. Switzerland, $202.2 billion dollars
8. Taiwan, $198.0 billion dollars
9. United Kingdom, $153.6 billion dollars
10. Russia, $153.3 billion dollars
*Includes oil exporting countries such as Saudi Arabia and Iran
**includes countries such as Bermuda and the Cayman Islands
Of the $5.1 trillion dollars of US debt that is owned by foreign governments, China and Japan own nearly half, as evidenced by this chart:
Growth of US Debt Over Past 50 Years
Current: $16,245,318,820,569.34
2010: $13,178,317,356,215.73
2004: $7,379,052,696,330.32
1999: $5,656,270,901,615.43
1994: $4,692,749,910,013.32
1989: $2,857,430,960,187.32
1984: $1,572,266,000,000.00
1979: $826,519,000,000.00
1974: $475,059,815,731.55
1969: $353,720,253,841.41
1964: $311,712,899,257.30
1959: $284,705,907,078.22
Commonly Asked Questions:
How much Money does the United States Owe China?
A: $1.15 Trillion (Aug/2012)
How much Money does the United States Owe Japan?
A: $1.12 Trillion (Aug/2012)
How much Money does the United States Owe Russia?
A: $153.3 Billion (Aug/2012)
How much Money does the United States Owe the United Kingdom?
A: $153.6 Billion (Aug/2012)
How much Money does the United States Owe Germany?
A: $64 Billion (Aug/2012)
How much Money does the United States Owe Canada?
A: $57 Billion (Aug/2012)
Fact: Corporations move our jobs overseas to take advantage of slave labor wages, lax environmental laws and no taxes. Yes, no taxes! “Free trade” allows giant multinational corporations to pay zero taxes overseas and zero taxes in America. In 2010, corporate giant GE made a profit of $14.2 billion but it paid not a penny in taxes because the bulk of those profits, some $9 billion, were offshore. In fact, GE got a $3.2 billion tax benefit.
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