Meaning, History, How It Was Fixed

What Is a Fiscal Cliff?

Fiscal cliff is a term coined to describe a rare combination of expiring tax cuts and government spending cuts that was perceived as threatening U.S. economic stability at the end of 2012. There were fears that the situation would cause an economic crisis.

Fear over the fiscal cliff was exacerbated by the already shaky state of the economy. If no action was taken, there were concerns that the economy would spiral into recession, cutting household incomes, increasing unemployment, and undermining consumer and investor confidence.

Others argued that going over the fiscal cliff would significantly reduce the federal budget deficit.

Fiscal Cliff Explained

Who first uttered the words “fiscal cliff” is not clear. Some believe that it was first used by Goldman Sachs economist Alec Phillips. Others credit Federal Reserve Chair Ben Bernanke for taking the phrase mainstream in his remarks before Congress. Others credit Safir Ahmed, a reporter for the St. Louis Post-Dispatch, who, in 1989, wrote a story detailing Missouri’s education funding shortfall and describing it as a “fiscal cliff.” One source cites an editorial going back to 1975 that described New York City’s financial crisis.

In any case, in 2012, many argued that If Congress and President Obama did not act to avert this perfect storm of legislative changes, America would “fall over the cliff.”

Not incidentally, it would have led to the biggest income tax increase seen by Americans in 60 years.

How High Was the Cliff?

The Tax Policy Center reported that middle-income families would pay an average of $2,000 more in taxes in 2013.

Phaseouts were added to many itemized deductions and popular tax credits like the earned income credit (EITC), child tax credit, and American opportunity credits (AOTC) were to be reduced. Even 401(k) and other retirement accounts were to be subject to higher taxes.

The tax brackets also were to rise significantly. In 2012, the tax brackets were 10%, 15%, 25%, 28%, 33%, and 35%. If Washington did not act, the rates would have gone up to 15%, 28%, 31%, 36%, and 39.6%. (Note that the 2024 and 2025 tax brackets are 10%, 12%, 22%, 25%, 32%, 35%, and 37%).

In addition, the Congressional Budget Office estimated that 3.4 million or more people would lose their jobs. The October 2012 unemployment rate of 7.9% represented a significant improvement over the October 2009 rate of 10%. (The unemployment rate as of October 2024 was 4.1%.)

The Congressional Budget Office believed that up to 3.4 million jobs would be lost post-fiscal cliff, due to layoffs stemming from cuts in the defense budget and other programs. This could have resulted in an unemployment rate of up to 9.1% or more.

What Were the Bush Era Tax Cuts?

At the heart of the fiscal cliff were the Bush Era Tax cuts passed by Congress under President George W. Bush in 2001 and 2003. The largest components of this legislation were lower tax rates and a reduction in dividend and capital gains taxes. These were set to expire at the end of 2012 and represented the largest part of the fiscal cliff.

If the Bush-era tax cuts expired, the long-term capital gains tax rate would increase from 15 to 20%, and qualified dividend rates would increase to the individual’s marginal tax rate, up from a fixed 15%. This would have affected Wall Street investors, retirees, and retail investors.

The estate and gift tax exemption of $5.12 million was also scheduled to drop to $1 million. At the time, the tax on estates valued over $5.12 million was 35%. After the fiscal cliff, a 55% tax rate on estates over $1 million would have applied.

Social Security Payroll Tax Rates Would Have Increased

In 2010, Congress approved a temporary reduction in the Social Security payroll tax. This 2% reduction took the tax from 6.2% down to 4.2% on the first $110,000 in earnings.

This temporary rate was set to expire at the end of 2012, which would cost an individual making $50,000 per year another $20 per week in taxes.

Was There a Bright Side to the Fiscal Cliff?

There were principally two bullish arguments regarding the fiscal cliff. First, that Congress would not allow it to happen, and second, that maybe it wouldn’t be so bad if it did happen.

There was an argument that the cliff would be a long-term positive. To mix metaphors, it was seen as “bitter medicine” that would finally bring the federal deficit under control.

According to the Congressional Budget Office, by 2022 the budget deficit would fall to $200 billion from its then level of $1.1 trillion.

How Was the Fiscal Cliff Avoided?

Three hours before the midnight deadline of Jan. 1, 2013, the Senate agreed on a deal to avert the fiscal cliff. The key elements included an increase in the payroll tax by two percentage points to 6.2% for income up to $113,700 and a reversal of the Bush tax cuts for individuals making more than $400,000 and couples making over $450,000.

Investment income was also affected, with an increase in the tax on investment income from 15% to 23.8% for taxpayers in the top income bracket and a 3.8% surtax on investment income for individuals earning more than $200,000 and couples making more than $250,000.

The deal also gave U.S. taxpayers greater certainty regarding the alternative minimum tax (AMT). Some popular tax breaks such as the exemption for interest on municipal bonds remained in place.

The Bottom Line

The term fiscal cliff is used to describe a situation that is part real and part rhetoric. It’s a looming crisis that could seriously disrupt the U.S. economy, sending it into recession and damaging the well-being of many Americans. The rhetoric is an inevitable factor, since action can be taken in Washington to avert the crisis or at least soften the landing.