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Fiscal Cliff

Updated on January 29, 2024
Article byNanditha Saravanakumar
Reviewed byDheeraj Vaidya, CFA, FRM

Fiscal Cliff Meaning 

The fiscal cliff refers to a situation favoring and indicating the occurrence of economic contraction and recession due to the combined effect of tax cuts nearing expiration and reduced government spending. In short, it is an event where abrupt taxation and spending changes significantly and immediately impact a nation’s economy. Therefore, studying it helps policymakers to form effective economic policies.

Fiscal Cliff

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Events like the expiration of tax laws promoting tax cuts and government incentives like tax holidays and unemployment benefits reduce the spending from the consumer side, which subsequently discourages economic activity and growth when combined with reduced government spending. The fiscal cliff also portrays a scenario caused by the failure of certain fiscal policies.

Key Takeaways

  • A fiscal cliff definition can be referred to as a situation where the tax cuts expire, and a planned reduction in government spending and tax hikes occurs. 
  • The scenario can lead to economic recession. However, the situation can be averted by the government’s timely intervention.
  • The best example is the 2012 fiscal cliff in the United States, where the combined effect of the Bush-era tax cuts expired, and the Budget Control Act 2011 was expected to send the nation falling off the cliff. 

Fiscal Cliff Explained 

The fiscal cliff of 2012 was what many would remember as an interesting turn of events to save the economy. The origin of the term is still being determined. But it might be an accurate description. Two simultaneous events triggered the situation: the expiry of the tax cuts implemented in 2001 and 2003 by then-American President George Bush; and the planned expenditure cuts under the Budget Control Act 2011. These two events in the series were expected to severely impair the economy and send it ‘falling off the cliff’. 

The predicted results were rising unemployment, a fall in household income, decrease in investor confidence, among others. December 31, 2012, was filled with anxiety for most Americans. Their average taxes were set to increase by thousands of dollars. In addition, many tax deductions and tax credits were nearing expiry. However, the Senate decided to avert the cliff three hours before the New Year of 2013. They introduced the American Taxpayer Relief Act (ATRA) of 2012, which reduced the tax burden for lower and middle-income families.

Most measures employed by the Senate favored lower- and middle-income families. As a result, the tax burden of the people belonging to the top-income bracket needed to be fully alleviated. Also, the government postponed the public expenditure reduction for two months. However, on January 1, 2013, the US economy fell over the cliff. But only for a few hours. The government measures were proven successful.

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Examples 

Let’s discuss some examples of the fiscal cliff.

Example #1

In 2017, country A introduced 10% tax cuts for individuals in each tax bracket as the country was going through a economic recession. The tax cuts helped the country manage the situation and keep consumer spending constant. The tax cuts were set to expire in 2022. However, the same year, the government faced budget deficits and decided to cut down on spending.

As the year was about to end, many citizens were worried that it might lead the nation to a cliff. Therefore, the government decided to postpone the reduction in spending to 2024 and manage the costs with the additional tax collected (as the tax cuts were expiring).

Example #2

In July 2022, Houston’s budget watchdog warned that the city was heading toward a fiscal cliff. The warning came as the city was running out of stimulus money. The causes of this could be layoffs, and privatization of certain municipal services, which would help manage the annual budget.

Chris Brown, Houston’s elected controller, further stated that though the city’s fiscal situation as of July was healthy, it was because of the $350 billion aid received from the government in the aftermath of the COVID-19 pandemic. He said that the municipality should have used the aid to lower the operating costs of municipal assets. But rather, it used the money for employee pay raises. And this could be a problem in the long run when it has to cut its expenditure at some point.

Fiscal Cliff And Fiscal Drag

Before distinguishing between fiscal drag and cliff, let’s understand what fiscal drag means. It is the economic situation where an increase in individual or household taxable income moves people into higher tax brackets. As a result, it increases the tax payable, thereby reducing consumer spending.

In addition, an increase in public income contributes to inflation. Inflation and reduced disposable income decrease the demand for goods and services. Thus, the fiscal drag is a difficult situation for an economy, like a fiscal cliff. But there are some differences:

Fiscal CliffFiscal Drag
It happens due to an initial reduction in taxation. The problem arises when these tax cuts tend to expire.Fiscal drag occurs when the taxable income rises, thus increasing tax liability.
There will be an impending drop in government spending.Consumer spending will fall, reducing the aggregate demand.
Inflation may or may not accompany a cliff.Inflation is an important factor in fiscal drag.
 It is a difficult situation that can lead to recession and greatly impair the economy.Though an unfavorable situation, it is not as severe as a cliff.

Frequently Asked Questions (FAQs)

When is the next fiscal cliff?

It is difficult to predict when the next cliff will be. Such situations are not pre-planned. But they occur when tax cuts expire, and government spending falls simultaneously. Thus if this were to occur again, the economy would be nearing a cliff. Further, tax cut expiry doesn’t need to occur; even an increase in taxation can lead to a similar situation.

What is the fiscal cliff bill?

There is no official fiscal cliff bill. It can be confused with the decision made by the US Senate just 3 hours before midnight of January 1, 2013, to avoid the repercussions of the Bush-era tax cuts expiry and the reduction in government spending, which was passed through the Budget Control Act, 2011. Though an official decision was passed, there was no bill.

When was the United States fiscal cliff?

The US fiscal cliff took place on December 31, 2012. The country was facing a budget deficit scenario which triggered the sudden decision to cut spending and resort to tax hikes by January 2013.

This has been a guide to Fiscal Cliff and its meaning. We explain it with its examples, the event of 2012 in the US, and a comparison with fiscal drag. You can learn more about finance from the following articles –

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