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Fiscal cliff explained

The possibility of the US economy teetering ever closer to the so-called fiscal cliff dominated financial headlines at the turn of the year. It is certainly an emotive term, conjuring a picture of markets sliding into complete disarray. But the reality, while altogether less dramatic, still reflects a fraught situation that caused no end of headaches for economists and politicians in the States.

The fiscal cliff and its effects on markets

Simply put, the fiscal cliff is a description of the financial dilemma faced by the US economy at the tail end of 2012 when the Budget Control Act of 2011 was due to be implemented.

Changes to tax

At midnight on New Year's Eve, one of the results of this legislation was to conclude the previous year's temporary tax cuts on payrolls. While this had provided considerable monetary leeway for workers right across the board, the new rules meant that everyone's tax would instantly be hiked by 2%.

Similarly, there would be an end of the tax breaks which had been in force for some businesses, as well as changes in the alternative minimum tax threshold. Effectively, this led to a rollback of the 'Bush tax cuts' that were implemented back in 2001-3, signalling that the upgraded tax regime required to pay for President Obama's health care revolution were about to start biting.

Spending cuts

At the same time as the tax rises, a series of spending cuts were due to be put into place. These had previously been agreed on during the 'debt ceiling deal' ironed out in 2011. This would affect well over a thousand government programs, from Medicare to the defence budget.

Of these two factors, the tax changes are regarded as the most significant. Countering the economic repercussions of hitting this fiscal cliff led to long hours of argument and bargaining between Democrat and Republican representatives as alternative strategies for coping with this sudden shock to the American economy were discussed.

How the fiscal cliff was countered

Three hours before midnight, the rival parties finally signed-off a deal to avert the fallout of the fiscal cliff. The Senate approved their version two hours after the deadline, while the House of Representatives followed suit the following day. While America had, for a short while, actually gone over the cliff, the recommendations were backdated to the start of the New Year.

The deal's key elements included a payroll tax increase to 6.2% for income to $113,700, and a reversal of the Bush tax cuts for individuals earning over $400,000 and couples over $450,000.

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