Fiscal Cliff

With the election behind us, financial media has now shifted all of their focus to the upcoming “fiscal cliff”. So what exactly is this fiscal cliff, why do you keep hearing about it on the news and what does it mean for you?

The United States fiscal cliff refers to the effect of a series of tax cuts and recent laws that, if left unchanged, will result in substantial tax increases and spending cuts that would begin in 2013. While these tax increases would create a corresponding reduction in the budget deficit, they would be very destructive to the economy as a whole. The largest of these tax cuts were put in place in 2001 and 2003 and had been set to expire in 2010. At that time, President Obama put a two year extension on these tax acts since the markets were in the early stages of recovery from the big downturns in 2008/2009. It was widely agreed that allowing them to expire would have very negative effects on the economic recovery.

Fast forward two years and we find ourselves facing the new expiry date and the same struggles of the global economy. If they were allowed to be implemented, the projected effects of these changes would create a far greater risk of the US slipping into a full blown recession.

Fortunately, both sides of the political system agree that something must be done to avoid this fiscal cliff and both parties are eager to extend at least some parts of these tax acts. Unfortunately, in the typical fashion of politicians, many are using this important negotiation as a means to further their own interests on outside issues. The past few weeks have been difficult for stock markets as many wary investors are nervous about an agreement being made before the January 1st deadline. The reality is that an agreement will be made but it will almost surely be pushed to the last possible moment. It was widely expected that no changes would be agreed upon until after the elections on Nov 6th but this now leaves policy makers with a short window to come up with their solution.

Since the upcoming changes are due to legislation expiring, US Congress would have to pass new legislation (and have the president sign it) to avoid the forthcoming cliff. The president has stood firm in his vow to veto any legislation that does not include expiration of tax cuts for the wealthy. While most people think that this sounds like a great idea, many analysts argue that this could propel more wealthy individuals to shelter larger amounts of their assets offshore. Additionally, these changes would force substantial cuts to programs like Medicare and the unemployment rate would see a significant jump as benefits are reduced.

As we await a solution to this issue, we will most likely see extra caution creep in and some additional volatility in the markets. It’s my confident prediction that the fiscal cliff will be averted in some form or another but we won’t see a solution reached until at least Christmas time and possibly later. Congress can act to change laws retroactively after the deadline so it’s possible some changes won’t be agreed upon until the start of the new year. Until then, let’s hope the media doesn’t work too hard to create unnecessary fear of a situation that will be resolved and rational negotiations are able to take place in the halls of Congress.

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