The Fiscal Cliff Explainer: What It Is, Where It's From, Who Will Pay, and Why It Matters

By Derek Thompson

Understanding the biggest story in Washington today

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In an ideal world, all cliffs are non-fiscal in nature/Wikimedia Commons

The end of the election means the most important story in politics is the Fiscal Cliff -- a sudden rise in taxes combined with spending cuts scheduled for January 1, 2013.

But before we get to the policy -- and the graphs -- let's talk about the term. "Cliff" is an imperfect analogy. It's really more a long, rolling hill. A fiscal slope.

In January, family income won't plunge into the watery depths and government spending won't collapse. Instead, higher tax rates would reduce family income throughout the year, and mandatory spending cuts would shrink the deficit. The federal government would have to cut programs, fire some people, and cancel some company contracts. It would be bad. It might turn out to be awful. But it wouldn't be sudden.

Whether you prefer cliffs or loping hillsides for your metaphor, topography is a good analogy for this crisis. It has been forming, as if tectonically, for many years. One could trace its origins all the way back to the 1960s and the creation of the perennially troublesome Alternative Minimum Tax. But the best place to begin is 2001, when President George W. Bush signed the first of two tax cuts which were scheduled to expire under the next president. That next president, Barack Obama, twice extended the tax cuts and added his own, including a huge break on payroll taxes. Then, in 2011, after Republicans insisted on trillions in spending cuts in exchange for raising the debt ceiling, the Budget Control Act. This law scheduled $1.2 trillion in cuts divided between defense and other parts of government.

Now all of these things -- the Alternative Minimum Tax, the undoing of Bush/Obama tax cuts, and the Budget Control Act -- are about to hit in seven weeks. What will that look like? How will it feel? How could we avoid it?

To the graphs, my friends.

What Does the Fiscal Cliff Look Like?

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Here is an at-a-glance look at the $500 billion in government savings that will take place in 2013. Taxes are in BLUE. Spending is in RED.

The pie, as you can see, is almost all blue. This is a tax cliff. Or a taxy knoll. Whatever.

Half of the savings come from the expiration of the Bush tax cuts, the Obama tax credits, and the payroll tax cut. Another quarter comes from the alternative minimum tax kicking in and walloping upper-middle-class and rich families.

As for the Budget Control Act, it's a $1.2 trillion machete chop to government spending. But that's a 10-year figure. Only 5% of that cut -- about $65 billion -- would actually take place in 2013, according to the Committee for a Responsible Federal Budget. That's a big deal for defense contractors and doctors and federal government employees.

But most Americans wouldn't feel it. They'd just feel the tax hike.

How Much Would the Fiscal Cliff Cost You?

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You pay more. That's the three word summary of the fiscal cliff's impact on your taxes.

If your household makes a typical salary -- say, $50,000 -- you should expect to pay $2,000 more in taxes next year. If your household makes an atypical salary -- say, $500,000 -- you should expect to take a $50,000 hit. The richer you are, the bigger the hit you face as a share of income. The top 0.1% would see an average tax hike of $600,000.

Where do the tax increases come from? To answer that question, here's another great chart via TPC that shows which policies would raise your taxes and by how much.

Change in Average Federal Tax Rate by Cash Income Percentile 2013

The poorest Americans, few of whom pay federal income taxes, would be hurt mostly by higher payroll taxes and expired credits from the Obama stimulus. The typical household would be hit equally by higher payroll taxes and the expiration of the Bush tax cuts. The hit to the richest 1% would come mostly from the expiration of the Bush tax cuts, alone. Payroll taxes and stimulus credits barely affect them.

What Will the Fiscal Cliff Do to the Economy?

The double whammy of spending cuts and tax changes will push the U.S. economy into a recession in the first six months of 2013, according to the Congressional Budget Office. Unemployment would rise to 9%. Real GDP would decline by about 3% in the first half of 2013. That's a certain double-dip.

But don't confuse certain for immediate. If we wake up on January 1 with no deal, we won't be in a recession. Stocks might get jittery. Cable news will get super-jittery. Corporate leaders will sign more letters. But the deadline for avoiding the recession isn't hard, and it's not December 31, 2012.

Republicans know that, and Democrats know that, so you should, too. Since the fiscal cliff is really more like a loping hillside that dips below water sometime next year, neither side has any macroeconomic reason to reach a hasty bad deal.

Should We Avoid the Fiscal Cliff?

Nobody wants a recession. But you know what's worse than a short-term recession? A bad long-term deal. That's why some liberals are asking the president to dig in and not make a compromise with Republicans that would change Social Security and Medicare, or give up on higher tax rates on the richest 2%. 

Screen Shot 2012-11-09 at 10.50.09 AM.pngThe CBO has projected that making a deal to avoid the fiscal cliff entirely would improve GDP growth by an astounding 2.9% by the fourth quarter of next year (see left). To put that in perspective, we're expected to grow by 1.5% in the fourth quarter of this year. About two-thirds of this growth would come from keeping taxes down. The rest would come from keeping spending up.

To fully appreciate this graph, don't think of the fiscal cliff like a cliff. Think of it like weights in a backpack when you run. The U.S. has promised itself that it will try to run with four weights on our back next year: Higher payroll taxes, higher income taxes, lower defense spending, and lower non-defense spending. Each weight slows us down. Taking any of them out makes the bag lighter and helps us run faster.

Eventually, the U.S. will have to learn to run with a little more weight on its back. But the weights we've promised to carry in 2013? They'll probably make the economy fall on its face.

This article available online at:

http://www.theatlantic.com/business/archive/2012/11/the-fiscal-cliff-explainer-what-it-is-where-its-from-who-will-pay-and-why-it-matters/264990/