What is the Fiscal Cliff and Why Should I Care?

By now you have probably heard on the news about the impending “Fiscal Cliff.”  Economists are talking about it, politicians are talking about it, and even your friends may casually mention it when you are out and about.  Like a lot of political and economic news it often goes in one ear and out another.  You may have heard about it, often most likely, but you really do not know what it is.  The short version: the cliff is the impending budget deficit cuts and tax “increases”.  While on the surface it seems that reducing the deficit is a good thing, too many cuts all at once can have damaging effects on the economy.  There are three main components to the cliff that need to be dealt with by January 1^st.  At that time we will go over the fiscal cliff, and most economists agree it will send us into another recession.

Expiration of Bush Tax Cuts

In 2001 and 2003 then President Bush signed into law two acts that helped to lower people’s taxes.  While the actual process and how these provisions affected how you will pay taxes are quite complicated (you can follow the link to learn more about them), the bottom line is they will be expiring at the end of 2012.  This means next year most people will see an increase in the amount of taxes they have to pay, unless the cuts are extended another time.

Expiration of payroll tax cuts

In 2010 President Obama signed a law that not only extended the Bush Tax Cuts for two years, but also cut the FICA payroll taxes by 2% (as well as many other provisions to help get America’s economy back on track).  The cuts are only supposed to last for 2 years, and by the end of 2012 they will expire.  If they do, we can all expect to see our taxes increase by 2% (to a maximum of an extra $2,200 since FICA tax is not imposed on earnings over $110,000).

Decrease in Government Spending

If you remember, last summer there was a big debate about how much money the US Government was allowed to owe.  As the national debt was approaching the debt ceiling, congress had to get together and figure out how to either stop the debt from growing, or raise the ceiling.  As a provision of raising debt the ceiling, there was an agreement that starting in 2013, and continuing for the next ten years, government spending would be cut by a total of $2.4 trillion or more (the same amount the ceiling was raised).

While nobody likes paying more taxes, they are an important part of keeping our country running.  Taxes go toward paying for everything from our emergency workers to subsidizing our food.  Without taxes, the US simply would not be able to function.  Unfortunately, many people have the idea that the government is not very wise with money, so rather than pay more in taxes, we would rather pay less (personally if I knew the government could be trusted to use money wisely, I would gladly pay more taxes).  Reducing government spending is always a good thing, since most people feel the government is too big as it is and less spending would be better.  However, when you take 2 tax increases and a spending cut, and put them all into place at the same time, you have a recipe for knocking an economy back down.  So unless congress figures out what to do before the end of the year (and most experts feel they will), we can expect to head over this fiscal cliff come January.

So what does that mean for you the individual?  There really is nothing you should, or even can, be doing.  Your portfolio should be properly allocated if you have taken the time to do so.  Changing your investments would mean you are acting on emotion rather than logic.  The best you can do is to use your talents to earn more money now, vote for the “right” politician in the upcoming elections, and hope they can get things figured out before it is too late.  The bottom line is that most likely your taxes will increase next year; it is an inevitable part of recovering from a recession.

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