Sailing over the fiscal cliff … Would it really be the end?

Man standing on edge of cliff made of dollar bill

If you’ve tuned into the financial news lately, there’s a good chance you’ve heard lawmakers and experts talking in somber tones about the “fiscal cliff” looming for the federal government at the end of the year.

Much of the talk has been downright scary — earlier, they were calling the cliff “taxmaggedon.” But before grabbing the canned goods and heading into the cellar, it’s worth taking a look at what the fiscal cliff really is, and what it’s likely to mean to you.

To start, despite the hysteria, the cliff is unlikely to send the country plunging to its financial doom.

“It’s not really a cliff. It’s more like a slope,” says William Gale, codirector of the Urban Institute-Brookings Institution’s Tax Policy Center and one of several experts who believe going over the cliff isn’t the worst thing that could happen. “The language can get a bit hyperbolic.”

Second, the hard truth is it may take teetering on the cliff’s edge — or even plummeting a bit — to spur our deadlocked political system back into action on the budget.

OK, you say, but what is it?

The fiscal cliff refers to big changes in federal taxes and spending that will happen around Jan. 1, 2013, if Congress and President Obama are unable to reach a new deal.

It’s the result of fundamental disagreements over how to reduce the federal deficit that have largely paralyzed Capitol Hill since Republicans regained control of the House in 2010.

In August 2011, the two parties engaged in a battle over raising the federal debt ceiling that rattled world financial markets and caused the credit rating of the United States to be downgraded for the first time in history.

The Republicans wanted raising the ceiling tied to big spending cuts but no tax increases. Democrats wanted any budget solution to include higher taxes on the wealthy, something almost all congressional Republicans have said they won’t accept.

In the end, the two sides essentially decided to kick the problem down the road. But to put greater pressure on themselves to reach a real budget deal, they agreed that both tax increases and spending cuts would occur if they couldn’t work out an agreement by 2013.

In other words, the fiscal cliff was supposed to function as a sword hanging over lawmakers’ heads, an approach so severe it would force compromise. But further bipartisan negotiations collapsed, and here we are — again.

If nothing is done beforehand, reaching the cliff means all the tax cuts enacted more than a decade ago under President George W. Bush will expire, along with temporary tax relief measures passed later to boost the economic recovery.

For most Americans, the most noticeable change could be a jump in payroll taxes. Social Security will move from 4.2% back up to 6.2% on income up to $110,000.

But capital gains and income tax rates would also climb, and several tax breaks, including the child credit, would shrink. One way or another, almost all taxpayers would find themselves shelling out more to Uncle Sam.

At the same time, the first round of $1.2 trillion in budget cuts, spread out in equal amounts from 2013 to 2021, will go into effect.

Going over the cliff would cut most domestic discretionary spending by 8.4% and reduce the defense budget by around 7.4%. Social Security, Medicare and other social insurance programs are largely exempt.

The combination of tax hikes and spending cuts would take a meaningful bite out of the U.S. budget deficit over the longer term. The problem is they would also strike hard at the feeble economic recovery.

The U.S. economy is now growing at slightly less than 2% annually. The Congressional Budget Office estimates that going over the cliff would result in the economy shrinking at an annual rate of 2.9% in the first half of next year, before returning feebly to the black. The result, in other words, would be a brief but sharp recession.

“Basically, you’ve got this perfect storm coming up. You’ve got both tax increases and spending cuts, which in their current form wouldn’t be beneficial to the economy at all,” says Greg Womack, a financial planner in Edmond, Okla., who has been advising clients on the impact of the changes. (Click here to read Womak’s advice on how to prepare for the fiscal cliff.)

Sliding back into recession, especially when, for much of the country, it feels like we still haven't recovered from the last downturn, could be disastrous for uncounted Americans struggling to make do. The possibility is already causing anxiety in the financial markets and putting more pressure on political leaders to return to the negotiating table and find a better approach.

Many congressional observers believe they’re still likely to succeed.

“There’s now a real cost to inaction,” says Marc Goldwein, policy director for the Committee for a Responsible Federal Budget, a bipartisan group pushing for a compromise. “Ironically, it’s this horrible thing that’s going to happen that’s likely to make us act.”

Goldwein says he’s optimistic that, to get past the cliff, “we’ll get the beginnings of a grand bargain” that will put the nation’s finances on a much stronger path.

But even without a deal, Goldwein believes facing the cliff is better than simply pushing the problem down the road again by extending current spending and tax rates.

“Going over the cliff would be a problem for a while,” he says, “but continuing to add to the debt is a problem we would feel for decades.”

Neither Goldwein nor Gale dismiss the seriousness of a second recession so close on the heels of the last one.

But given the logjam on Capitol Hill, Gale believes the fiscal cliff may be necessary to get the combination of revenue increases and spending cuts that will set the deficit and the budget on the right path.

“I think the only way to get a solution that the American people want — 70% of them want taxes as part of the solution — is to go over the cliff,” he says.

He is quick to add, however, that it should be coupled with a new short-term stimulus package to ease the impact.

Other analysts believe higher tax rates, particularly on upper-income earners, will more permanently crimp growth. But the higher taxes will largely mark a return to what rates were under President Clinton, when the federal budget had a surplus and the economy was booming.

And while the federal spending cuts would definitely pinch, in many cases they’re not as apocalyptic as portrayed.

Potential defense cuts, for example, have caused much gnashing of teeth. But even with a cut of a little more than 7%, the U.S. military budget would still be larger than those of the next nine biggest-spending nations combined.

Should China, Russia, the United Kingdom, France, Germany, Japan, India, Brazil and Saudi Arabia join forces and decide to attack, we’d still have them outgunned — or at least outspent.

Cuts in some spending programs would certainly hurt. For example, America needs to be spending more on its roads, bridges and other public works, not less. But cuts wouldn’t mean the imminent collapse of the Republic.

Hopefully, our political leaders won’t figure that out until they’ve hammered out a better deal. Automatic, across-the-board budget cuts are no way to run a country. And tax increases should be carefully weighed and selective, not the result of political paralysis.

But should we reach the fiscal cliff, we may find that taking the tumble is worth it, if it shakes our political system back to life.