What is the Fiscal Cliff?

It is a term used to describe the tax increases and spending cuts that will automatically take effect in the United States at the end of the year.  “Fiscal” refers to the fact that we are dealing with government and not central bank policy, while “cliff” attempts to illustrate what will happen to the U.S. economy if these tax increases and spending cuts are allowed to occur at the same time.

The general idea is that if the American people see their incomes decline while the government removes investment or stimulus from the economy, consumption and economic growth will suffer.

At the end of the year:

1.      Income tax cuts implemented by President George W. Bush over ten years ago will expire, without extension.  If they are not extended, taxes will increase back to levels of the Clinton presidency.

2.      A payroll tax reduction that came into effect January 2011 will expire.

3.      The Affordable Care Act will see Medicare payroll taxes increase and the implementation of a new investment income surtax of 3.8% on dividends and capital gains for high-income earners.

4.      $1.2 trillion of budget “sequestration” will be implemented over the next 10 years.  This is just a fancy way of saying budget cuts. 

5.      The unemployment insurance benefit extension for 2012 will expire.

6.      Various other tax provisions will expire and spending cuts will occur.

This list is not totally complete, but it hits all the major issues.  Bottom line, a reduction in disposable income for consumers and a reduction of investment by the government will hurt what has been a painfully slow economic recovery in the United States.

Should we panic if we don’t see a deal by the end of the year?

No.  The fiscal cliff is an important issue because not only does it focus attention on America’s increasing deficit, it involves trillions of dollars, and the consequences would have a very negative impact on the U.S. economy.  But because the impact would be severe, it is hard to believe the politicians could be foolish enough to actually let it happen.

Admittedly, U.S. politicians have made questionable moves in the past.  However, even when they do the wrong thing, they usually fix it once they see the negative consequences of their actions.  So a deal could be reached before the end of the year, but it could also be reached early 2013.  Either way, they will make a deal because quite simply; failing to do so would be unacceptable and both Democrats and Republicans are fully aware of this.

Furthermore, if the U.S. “went over the cliff,” the impact of the tax increases and spending cuts would not necessarily hurt the economy immediately; the politicians know this, so they know they will have more time to work with, even as the end of the year rapidly approaches. 

So, investors shouldn’t panic.  In fact, any short-term downward pressure on the markets will provide us with a window of attractive buying opportunities.

Wishing you and your family all the best for the New Year!

Cheers,

 

Tracey

Source:  Original article by Gareth Watson, published on Advisor.ca Dec. 21/12