Treasurer’s Topic of the Week: The Fiscal Cliff

Many news outlets have stories discussing the impending “fiscal cliff” that if not fixed, is said to bring doom for our economy on January 1, 2013. But before you stock up on canned goods we should take a moment to make sure we all understand what this all means.

On January 1, 2013, two major economic changes are set to take place:

  1. 120 different income tax credits and rate reductions will expire
  2. $984 billion dollars will be cut from the Federal Government Budget over 9 years

The combined effect of tax increases and spending cuts are intended to reduce the Federal Government’s annual budget deficit by approximately $500 billion dollars in 2013 and continue to shrink the deficit for several years going forward.

According to the Congressional Budget Office, however, the sharp spending reductions and tax increases will likely cause the economy to fall into a recession and unemployment will rise for at least the next year.

How did we get such a large budget deficit?

In 2000, the Federal Government ran a budget surplus of about $86 billion dollars. From 2001 – 2010, major tax and spending policies were implemented that reduced revenue and increased spending including:

  • 2001/2003 Tax cuts reduced revenue by $1.8 trillion dollars.
  • Iraq and Afghanistan wars increased spending by $1.4 trillion dollars
  • Response to the financial crisis from 2007-2010 increased spending by $2.1 trillion dollars

By 2009, the Federal Government had a budget deficit of $1.4 trillion dollars.

How did we get to the “fiscal cliff”?

When the government has a budget deficit they must borrow money to cover the difference. The U.S. government does this by issuing Treasury bonds. The cost of borrowing money is based on the interest rate. Just like any loan, if the people lending money are not very confident that they will be paid back they will charge a higher interest rate and vice-versa.

If the interest rate on Treasury Bonds increases, three main things would happen:

  1. The Government would have to spend more money to borrow money and,
  2. Interest rates on all other types of loans would increase
  3. Economic growth would slow

In 2010, many people in Congress began to worry that the interest rate on Treasury Bonds would increase if the Government continued to borrow more and more money. As a result, they would not allow the Government to borrow any more money unless it dramatically reduced spending.

The President and the Congressional leadership agreed to a deficit-reduction process that required a bi-partisan committee to agree on spending cuts by a specified time. If it did not, the tax increases and spending cuts known as the “fiscal cliff” would automatically go into effect.

What is happening now?

Congress and the President are attempting to negotiate an alternative to the “fiscal cliff” that would reduce the deficit without hurting the economy. The primary disagreement is about the best approach to increasing tax revenues.