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What is the Fiscal Cliff?

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Even now, after it's been solved (or at least postponed to some extent) some Americans are still confused when they hear the words “Fiscal Cliff.” What exactly does it mean? Commentators have been tossing it around for months now.

In short, the fiscal cliff is a package of government spending cuts and tax increases. For a variety of reasons, on January 1, 2013, tax rates on nearly all Americans were set to increase. Meanwhile, the budgets of many government agencies would be slashed.

The term “cliff” was used so as to denote a dramatic drop.

Imagine the economy as a person, walking steadily through a flat clearing. Then, all of a sudden, this person comes to a cliff -- a straight drop down 1000 feet. No warning in the land; no sudden sloping, just a harsh jagged edge and a tremendous fall.

Likewise, the American economy has been walking along steadily -- consistent low tax rates combined with fairly large government budgets. Then, until two days ago, tax rates were set to jump while government budgets would be slashed -- leading to a dramatic drop, like falling off a cliff.

The term has become popular in the media because of the economic fears surrounding it.

With the economy still struggling to recover from the financial crisis of late 2008, raising taxes while cutting government spending could deal a fatal blow to the economic recovery.

In fact, the non-partisan Congressional Budget Office said that “going over the fiscal cliff” would send the economy back into recession. Likewise, the Federal Reserve's Chairman Ben Bernanke warned that if Congress failed to prevent the cliff, he would be powerless to protect the economy from the slump that would likely ensue.

Has the fiscal cliff been avoided?

Technically, yes.

On Wednesday, Congress passed a bill that would prevent taxes from going up on most Americans, while delaying cuts in government spending.

Still, taxes on households making over $450,000 per year will increase. At the same time, even those making less than $450,000 will see their take home pay decline to some extent. The payroll tax -- the tax directly on employment itself -- is set to increase two percent. But, what remains unresolved is the spending portion of the cliff.

The problem is that the U.S. government spends more than it takes in, which means it has to borrow money to finance itself on a daily basis.

However, in order to limit government spending, Congress created a “debt ceiling” almost 100 years ago. When the government gets to the debt ceiling, Congress either must pass a bill to increase it, or the government will be unable to fund itself.

The U.S. hit the debt ceiling on Monday.

Treasury Secretary Tim Geithner said that he can pull a variety of tricks to work around the borrowing limit until February 28. At that point, the government will face a true spending crisis if the debt ceiling has not been raised.

Like the debate over the fiscal cliff resolution, the debate on raising the debt ceiling could be just as intense. Congressional Republicans largely believe that the government needs to reduce its expenditure and will not agree to raising the debt ceiling without corresponding spending cuts.

At the same time, Democrats don't want to cut spending. In fact, many Democrats want to increase it, as a way to support the economy.

Unfortunately, this conflict ensures that talk of the fiscal cliff will continue to dominate the headlines for at least a few more weeks.

Posted-In: News Global Economics General Best of Benzinga

 

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