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How the Fiscal Cliff Works

Economic Effects of the Fiscal Cliff

In an election year when Republicans and Democrats agree on very little, both sides warn that allowing the economy to run off the fiscal cliff would be ruinous. The Congressional Budget Office concurs, calculating that a combination of large tax increases and deep budget cuts would raise unemployment levels higher than 9 percent and sink the economy into another recession [source: O'Keefe].

The fiscal cliff will be so damaging to the U.S. economy because it slows down two critical engines of the economy: consumer spending and government spending.

Consumer spending will decrease because a greater chunk of Americans' paychecks will go to taxes. In 2010, President Obama extended the Bush-era tax cuts through 2012. If allowed to expire, 90 percent of Americans would see their tax rates go up by an average of $3,500 per family [source: Montgomery]. That amounts to cutting 6 percent from each paycheck. With less money in their pockets, consumers will buy less stuff. When companies sell less, they cut jobs, investors back off and the economy shrinks. Bad news all around.

Then there are the budget cuts. Unless Congress comes up with an alternative deficit-reduction plan, it will have to make deep budget cuts to federal programs in January 2013. These cuts, amounting to $109 billion a year from 2013 to 2021, will affect federal programs across the board, but defense spending will take the biggest hit [source: Khimm]. Defense programs will see a 9.4 percent reduction in spending, or roughly $55 billion a year [source: Grant]. Non-defense programs will also be cut by an average of 8.2 percent, including popular programs like special education and Medicare [source: Weisman].

When the government spends less money, the economy suffers. Defense contractors that make the planes and ships for the military will see their orders drop. Hospitals that rely on Medicare payments will have to cut staff, as will public schools that count on government-funded special education programs. This is why the CBO expects unemployment to surge past 9 percent if budget cuts are allowed to proceed as planned.

The only economic upside of the fiscal cliff is that it would significantly lower the federal budget deficit. The projected deficit for 2013 would drop to $641 billion if America runs off the fiscal cliff. If the U.S. avoids the cliff, it will be $1 trillion. This could translate to a debt-to-GDP ratio of 58 percent in 2022 as opposed to one of 90 percent without the cliff [source: Kurtzleben].

In a perfect political world, Congress would pass legislation that trims the deficit without inflicting so much pain on the economy. But we live in the real world. On the next page, we'll look at a few different scenarios for steering clear of the fiscal cliff.