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  • December 14, 2012

    • The fiscal cliff refers to a significant and legislated tightening of U.S. fiscal policy—federal tax increases and spending cuts—that will take place starting in January 2013 if Congress and the president do not act to stop it.
    • The tax increases will stem largely from the expiration of the marginal income tax cuts that were passed into law in 2001 and 2003 and were originally scheduled to expire at the end of 2010. These "Bush-era tax cuts" were extended by Congress and President Obama for two years at the end of 2010 as part of a bipartisan compromise to support U.S. growth.
    • Other tax increases include the expiration of the 2% payroll tax holiday and broader reach of the alternative minimum tax (AMT), which is not indexed to inflation but has been "patched" by Congress in recent years to keep it from affecting a larger number of taxpayers. In addition, the estate tax is scheduled to increase, as are dividend and capital gains tax rates.
    • The bulk of the spending cuts will stem from a $1.2 trillion sequester—forced cuts—authorized by the Budget Control Act of 2011 that are scheduled to take place over a 10-year period starting in January 2013. This is due to the failure in November 2011 of a bipartisan congressional "super committee" to agree on any long-term budget cuts.
    • If Congress and the president do not agree to delay or lessen the tax increases and spending cuts that are scheduled to take place, T. Rowe Price's economists, Jared Franz and Alan Levenson, calculate that U.S. gross domestic product (GDP) will be considerably weaker in 2013 than it otherwise would have been. Opinions vary, however, as to whether this by itself would send the U.S. economy back into a recession. At present, Franz and Levenson believe the odds of a U.S. recession next year are low.
    • Franz and Levenson believe that a compromise between Republicans and Democrats to avoid the fiscal cliff will be reached before the end of December. If no compromise is reached by year-end but lawmakers appear close to cutting a deal, the impact of tax increases and spending cuts on the U.S. economy would not be instantaneous. For example, the executive branch has the authority to freeze marginal tax rates at current levels, while sequestration could be delayed as lawmakers finalize a deal.
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