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What is a 'Fiscal Cliff'

A fiscal cliff is a combination of expiring tax cuts and across-the-board government spending cuts scheduled to become effective Dec. 31, 2012. The idea behind the fiscal cliff was that if the federal government allowed these two events to proceed as planned, they would have a detrimental effect on an already shaky economy, perhaps sending it back into an official recession as it cut household incomes, increased unemployment rates and undermined consumer and investor confidence. At the same time, it was predicted that going over the fiscal cliff would significantly reduce the federal budget deficit.

BREAKING DOWN 'Fiscal Cliff'

Who actually first uttered the words "fiscal cliff" is not clear. Some believe that it was first used by Goldman Sachs economist, Alec Phillips. Others credit Federal Reserve Chairman Ben Bernanke for taking the phrase mainstream in his remarks in front of Congress. Others credit Safir Ahmed, a reporter for the St. Louis Post-Dispatch, who in 1989 wrote a story detailing the state's education funding and used the term "fiscal cliff."

If Congress and President Obama do not act to avert this perfect storm of legislative changes, America will, in the media's terms, "fall over the cliff." Among other things, it will mean a tax increase the size of which has not been seen by Americans in 60 years.

How Big Are We Talking?

The Tax Policy Center reports that middle-income families will pay an average of $2,000 more in taxes in 2013. Many itemized deductions will be subject to phase-out, and popular tax credits like the earned income credit, child tax credit, and American opportunity credits will be reduced. 401(k) and other retirement accounts will be subject to higher taxes.

Your marginal tax rate is the tax you pay on each additional dollar of income you earn. As your income rises, your marginal tax rate (better known as your tax bracket) rises. For 2012, the tax brackets are 10%, 15%, 25%, 28%, 33% and 35%. If Washington does not act, those rates will go up respectively to 15%, 28%, 31%, 36% and 39.6%.

In addition, the Congressional Budget Office estimates that 3.4 million or more people will lose their jobs. The October 2012 unemployment rate of 7.9% represents significant improvement over the October 2009 rate of 10%. The Congressional Budget Office believes that up to 3.4 million jobs would be lost, post fiscal cliff, due to a slowing economy with layoffs stemming from cuts in the defense budget and other things. This could result in an increasing unemployment rate up to 9.1% or more.

What Are the Bush Era Tax Cuts?

At the heart of the fiscal cliff are the Bush Era Tax cuts passed by Congress under President George W. Bush in 2001 and 2003. These include a lower tax rate and a reduction in dividend and capital gains taxes as the largest components. These are set to expire at the end of 2012 and represent the largest part of the fiscal cliff.

The potential expiration of the Bush-era tax cuts also affects tax rates on investments. The long-term capital gains tax rate will increase from 15 to 20%, and qualified dividend rates will increase to the individual's marginal tax rate up from a fixed 15% under the current plan. This not only affects Wall Street investors, but also retirees and retail investors, who are withdrawing funds from qualified retirement plans and brokerage accounts.

The current estate and gift tax exemption of $5.12 million will also drop, to $1 million. Currently, the tax on estates valued over $5.12 million is 35%. After the fiscal cliff, a 55% tax rate on estates over $1 million will apply.

Social Security Payroll Tax Rates Will Increase

In 2010, Congress approved a temporary reduction in the Social Security payroll tax. This 2% reduction took the tax from 6.2% down to 4.2% on the first $110,000 in earnings. This temporary rate is set to expire at the end of the year. This would cost somebody making $50,000 per year an additional $20 per week in taxes. However, that may not be the end of the impact of the fiscal cliff on Social Security. Social Security has a lot of moving parts, and lawmakers from both sides of the aisle believe that making changes to Social Security, in addition to the lapse of the payroll tax cut, could raise much-needed revenue.

Is There a Bright Side to This?

There are principally two bullish arguments regarding the fiscal cliff - first, that the Congress won't allow it to happen, and second, that maybe it wouldn't be so bad if it did.

Taking a very different track, there's also an argument that the cliff itself would be a long-term positive. Few argue that the U.S. has to tackle its deficits at some point, and this sort of "bitter medicine" would be a harsh, but definitive, step in that direction. Although the short-term impact could be severe (recession in 2013), the bullish argument would hold that the long-term gains (lower deficits, lower debt, better growth prospects, etc.,) would be worth the short-term pains.

According to the Congressional Budget Office, by 2022, the budget deficit would fall to $200 billion from its current level of $1.1 trillion. That would all be welcome news, but in order to get there, the nation would face almost certain financial turmoil.

How Do We Fix It?

Recently, lawmakers met at the White House over this issue. Both sides called the meeting productive, but neither side indicated that a deal was imminent. Democrats want to see more revenue (tax increases), especially from the nation's wealthy, as part of any deal. Republicans favor more spending cuts, especially to entitlements like Medicare. While both sides subscribe to different philosophies concerning taxation, each have indicated that they are willing to compromise on many of the more critical issues leading to Jan. 1.

Cliff or no cliff, deal or no deal, Americans will almost certainly pay more taxes, according to CNBC. It is just a matter of how much more. Therefore, any compromise will probably include tax increases, just not to the magnitude of those mandated by the fiscal cliff.

Will Fixing the Fiscal Cliff Solve the Economy's Current Woes?

Not at all. The Bush Era tax cuts and other stimulus measures have propped up the economy, as it continues to recover from the 2008 recession. Some investors believe that much of the most recent stock market decline has to do with the looming fiscal cliff. They believe that once a deal is announced, and economic uncertainty is removed, then the market may recover to near its recent highs. Others believe that if the deal includes another one-year extension (or something similar to the debt ceiling negotiations), investors will not be impressed.

The Bottom Line

When will a deal come? Nobody knows, but both sides of the aisle are admitting that fighting and bickering is not the answer. A more conciliatory political environment will give both parties a better chance at gaining control of Washington in 2016. Ultimately, when the deal comes, it will almost certainly result in some combination of tax rate increases and spending cuts. The willingness of both sides to compromise is crucial to any final agreement.

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