The Fiscal Cliff

The fiscal cliff refers to the effect the decisions made in the Budget Control Act of 2011 will have on the U.S. economy. A variety of tax increases and government spending cuts will go into effect as of January 1, 2013 unless Congress chooses to take action. There are several issues Congress must consider when making their decision including: the impact on businesses of increases in taxes they pay, debt and deficit issues, monetary policy, unemployment and inflation, and the mix of taxes and spending.

If the tax on businesses increase, there could be several different effects. These effects largely depend on the elasticity of demand of goods or services. If demand is elastic, most of the burden of the tax will be borne by the producer. To model this, imagine a graph with a relatively flat demand curve. An increase in price (due to a tax) will result in a shift of the supply curve to the left and a much larger decrease in demand. A producer will bear this additional cost to maintain sales. Internalizing these costs will mean they have less money for investment spending and may be unable to hire more employees. Some of these businesses may move their operations overseas to avoid taxes, or may go out of business, unable to compete with foreign companies. If demand is inelastic, consumers will bear a larger burden of the tax. Picture a demand curve with a steep slope. A shift in supply to the left (due to a tax) will result in only a slight decrease in quantity demanded. Producers will be able to sell goods and services at a higher price without experiencing a significant decrease in demand. There would not be a significantly negative impact on businesses if the goods or services they sell are inelastic, but taxes on businesses who sell goods or services with elastic demand would be extremely detrimental.

It is also important to consider debt and deficit issues. Debt and deficit differ in that debt is the sum of all past deficits, while deficit is the difference between how much the government is taking in (through taxes) and how much the government is spending (through transfer payments). Deficit is a yearly measure. Some argue that the government should reduce the federal budget deficit, as it is risky to continue accumulating so much debt. At the rate the U.S. is spending, we will reach the debt-ceiling, where we will have to start paying off our debts or raise the ceiling to allow for more government spending. If we cut spending and raise revenues through tax increases, the structural deficit could be eliminated (Manuel, n.d.). The structural deficit is a measurement of what the budget deficit would be if the economy were operating at full employment and is smaller than the actual deficit. Others disagree, stating that we should instead focus on job creation and economic growth and that reducing government spending now could keep us in a recession. Cutting government spending would result in a decrease in income, meaning higher