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What is a 'Fiscal Cliff'

The fiscal cliff refers to a combination of expiring tax cuts and across-the-board government spending cuts that was scheduled to become effective December 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. Still, 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 did not act to avert this perfect storm of legislative changes, America would have, in the media's terms, "fall over the cliff." Among other things, it would have led to 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 reported that middle-income families will pay an average of $2,000 more in taxes in 2013. Many itemized deductions were subject to phase-out, and popular tax credits like the earned income credit, child tax credit, and American opportunity credits were to be reduced. 401(k) and other retirement accounts were to 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 were 10%, 15%, 25%, 28%, 33% and 35%. If Washington did not act, those rates would have gone up to 15%, 28%, 31%, 36% and 39.6%, respectively.

In addition, the Congressional Budget Office estimated that 3.4 million or more people would lose their jobs. The October 2012 unemployment rate of 7.9% represented significant improvement over the October 2009 rate of 10%. The Congressional Budget Office believed 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 have resulted 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 were the Bush Era Tax cuts passed by Congress under President George W. Bush in 2001 and 2003. These included a lower tax rate and a reduction in dividend and capital gains taxes as the largest components. These were set to expire at the end of 2012 and represented the largest part of the fiscal cliff.

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

The current estate and gift tax exemption of $5.12 million was also scheduled to drop to $1 million. At the time, the tax on estates valued over $5.12 million was 35%. After the fiscal cliff, a 55% tax rate on estates over $1 million would have applied.

Social Security Payroll Tax Rates Would Have Increased

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 was set to expire at the end of 2012, which would cost an individual making $50,000 per year an additional $20 per week in taxes. However, that may not have been 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 believed that making changes to Social Security, in addition to the lapse of the payroll tax cut, could raise much-needed revenue.

Was There a Bright Side to This?

There were 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 happen.

Taking a very different track, there was 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 Did We Fix It?

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 wanted to see more revenue (tax increases), especially from the nation's wealthy, as part of any deal. Republicans favored more spending cuts, especially to entitlements like Medicare. While both sides subscribed to different philosophies concerning taxation, each had indicated that they were willing to compromise on many of the more critical issues leading to Jan. 1.

Three hours before the midnight deadline on January 1, the Senate agreed on a deal to avert the fiscal cliff. The key elements of the deal included an increase in the payroll tax by two percentage points to 6.2% for income up to $113,700, and a reversal of the Bush tax cuts for individuals making more than $400,000 and couples making over $450,000 (which entailed the top rate reverting from 35% to 39.5%).

Investment income was also affected, with an increase in the tax on investment income from 15% to 23.8% for taxpayers in the top income bracket and a 3.8% surtax on investment income for individuals earning more than $200,000 and couples making more than $250,000. The deal also gave U.S. taxpayers greater certainty regarding the alternative minimum tax (AMT) and a number of popular tax breaks - such as the exemption for interest on municipal bonds - remain in place.

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