Fiscal cliff decoded

Kamala Aithal

A terminology/situation currently gripping the market is "fiscal cliff". Suddenly Eurozone's debt crisis and China's slowing growth are on back burner for the market watchers. What is both important and urgent is resolution to fiscal cliff by the US lawmakers.

What is fiscal cliff?

Fiscal cliff is a term that describes an economic situation which is a combination of tax increase and spending cuts scheduled to kick in on 1st January 2013, if existing laws are not changed before end of 2012. For all practical purposes, the year ends in a week and a resolve is nowhere in sight. Hence all the sturm und drang (turmoil)!

What caused this?

Bush tax cuts expires by end 2012 and spending cut (under the Budget Control Act of 2011) takes effect from 2013; these are two main contributors to fiscal cliff. There are also other laws such as those governing temporary pay roll tax cuts and federal unemployment benefits amongst others expiring end of this year, worsening the situation.

What are the possible scenarios and effect?

Going ahead with original plan is scenario 1. With increase in tax revenues and spending cuts, this will considerably reduce deficit as a % of GDP. On the flip side this would bring down GDP significantly and push the economy into recession. An alternate fiscal scenario could be arrived at by changing some of the laws. While this would result in not so steep tax increases and spending cuts, it would result in higher deficit.

What is holding up a resolve?

Simply put - the political divide. Republicans have proposed that Bush tax-cuts be extended in its entirety. Democrats want more targeted approach where tax cuts would end for people in high income bracket and would continue for others. Neither of these has gotten through, creating a logjam. Negotiations are on, now with a tough timeline.

Can the congress buy more time? 

Yes, laws could be changed retrospectively, if a consensus is reached after the deadline. So, fiscal cliff need not necessarily be an impediment to growth if a mid-path is agreed even as late as early next year. However, the cost of indecision will affect spending pattern of individuals and corporations in anticipation of changes taking effect. The longer it takes to resolve, higher will be the impact on GDP. 

Hope the market receives a timely Christmas gift!!

Kamala Aithal is the founder of a consulting firm that assists corporates develop Risk Management Framework and a regular contributor to Wisonomics column. The views and opinions expressed in this article are those of the author and does not reflect the views or position of

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