It involves the combination of temporary tax cuts expiring at the same time as government spending is scheduled to be cut. Politicians in the United States – where the economy is still fragile following the 2007 global financial crisis – will decide how to manage the situation.
The term “fiscal cliff” has been in the news headlines, is the topic of numerous research papers and has featured in other high-profile publications. We examine – in simple terms – what it means.
Temporary tax cuts expiring at the same time as government spending is scheduled to be cut is such an economic challenge because both play a significant role in growth – or gross domestic product (GDP). And growth is the key to keeping out of a technical recession.
Tax cuts tend to stimulate growth because people have more money to spend – which, in turn, can lead to more demand for goods and services and more jobs. The end of temporary tax cuts could see disposable incomes fall and spending follow suit.
Likewise, government spending increases demand for goods and services and typically increases jobs. So when governments cut spending, demand and jobs and growth can all be hit.
Watch out: cliffs can be dangerous
By itself, the term "fiscal" typically refers to government tax and spending. Adding the term “cliff” gives the sense that a sharp – and potentially dangerous – drop is looming.
The term “fiscal cliff” has been so high-profile in the US in 2012 that it may well enter the economic lexicon and be used if similar situations arise – perhaps in other countries – in years to come.
A Peterson Institute for International Economics policy brief details the planned tax and spending changes scheduled for the end of 2012. It also outlines several scenarios US politicians have open as they try to balance public finances.
The policy brief explains Congressional Budget Office (CBO) estimates suggest driving over the fiscal cliff would likely turn US GDP negative in the first half of 2013.
Decisions on exactly how the challenge will be met are delayed until after the November US Presidential election– but it is unlikely to be as simple as completely halting the planned changes to tax and spending because pressure to reduce government debt remains.
Where the cliff came from
On Project Syndicate, Mohamed El- Erian, the CEO of investment company PIMCO, writes that the situation in the US arose from compromises set up in mid-2011 to solve immediate problems of the US government breaching its debt ceiling. The debt ceiling was also detailed in an earlier eZonomics update video.
El-Erian notes how game theory can help explain why politicians have not yet been able to agree on an appropriate course of action and how the current position could lead to a further downgrade in the credit rating of US government debt.