How Cliff-Jumping Could Play Out for the Economy

Catherine Hollander

With Washington deadlocked over the mix of automatic tax hikes known as the "fiscal cliff," worries are rising about the impact on the economy. But many economic forecasters say a brief slide off the fiscal cliff might not be catastrophic. The cliff is more like a slope, those experts say, and the most damaging effects won't be felt immediately—though they would be felt quickly. The slope only gets steeper as the early days of 2013 tick away with no deal in sight.

Few expect the nonpartisan Congressional Budget Office’s worst-case scenario—a plunge over the cliff that leaves its provisions intact for all of 2013—will come to pass. In that situation, the CBO warned that the country would return to recession in the first half of the year and that unemployment would rise to 9.1 percent by year-end.

More likely is that a deal to sidestep the full impact of the cliff's sharp tax hikes and spending cuts is reached early next year. How early matters a lot. The slope “can really start to get steep if you don’t take action,” said Chad Stone, chief economist at the Center on Budget and Policy Priorities. What follows are the economic milestones the U.S. doesn’t want to hit in the New Year, the points where the slope starts looking a whole lot more like a precipice. The longer Congress goes without a deal, the more likely each of the below events become.

1. Tax season uncertainty hits spending. The alternative minimum tax, which hits wealthy and, increasingly, middle-class Americans, is usually “patched” every year or two to exempt large swaths of people from paying it. It wasn’t patched in 2012, however, and with tax filing season getting under way in early 2013, the longer Congress goes without patching it, the more uncertainty and harm it will inflict on the economy. The AMT is unique in this regard; other tax provisions that make up the cliff don’t kick in until the 2013 tax filing season.

The IRS has warned that up to 100 million Americans could wind up filing their 2012 taxes late if no AMT patch is passed. “It’s a big mess, because you don’t know the tax policy for the year in which you’re filing taxes,” said Chris Lafakis, senior economist at Moody’s Analytics. The IRS may need to rewrite its software and forms to accommodate a deal. People who filed their taxes early might have to resubmit their returns. And late filing means late spending of tax refunds, starting the year on a weaker note.

As uncertainty over the fate of the AMT mounts, so will the economic damage. “If you are maybe an upper-income household, or even a middle-class household, and you are uncertain as to how the AMT is going to affect you, and all of a sudden you have the prospect of having to pay out a lot more money to the federal government when you file taxes this year, then you might not spend as much of your money as you otherwise would,” said Lafakis. Reduced sales could lead to reduced business investment and production and fewer workers.

2. A debt limit showdown. The Treasury Department says the U.S. will once again reach its borrowing limit on Dec. 31. Then, Treasury will begin taking “extraordinary measures” to delay the day when the country can no longer meet its obligations. It’s unclear exactly when those measures will be exhausted, but most expect the debt ceiling will need to be raised no later than February.

If the debt limit isn’t raised as part of a fiscal cliff deal before the February deadline is reached, things could get ugly. “In a worst-case scenario, Republicans could block (or significantly delay) a debt ceiling increase in retaliation for a lack of compromise from the Democrats regarding tax rate increases,” economists at Deutsche Bank wrote in a research note last week. Confidence could take a hit. Another showdown over the debt limit would be a bad outcome for the economy. Failure to raise it would be even worse. The country could see another credit rating downgrade, a government shutdown, and delayed payments of government contracts, wages, and social benefits, the Deutsche economists warned.

3. U.S. credit rating downgraded ... again. You don’t need a debt ceiling standoff to get a credit rating downgrade; deadlocked fiscal cliff negotiations could lead to such an outcome. “We might see further downgrades by the ratings agencies that are just saying that this government is not functioning, therefore we have no confidence in their ability to, you know, to get the deficit under control,” said Nigel Gault, chief U.S. economist at IHS Global Insight. “I’m not sure how long their patience will last. It’s their judgment on whether they see something emerging or whether it’s just complete gridlock,” he said.

4. Markets think there’s no possibility of a deal. Markets have been volatile as the Dec. 31 deadline approaches. But they haven’t tanked--yet. A sharp drop is likely to come when progress on a deal appears to hit a standstill. Ironically, that could be the impetus to get a deal. “I sort of wonder whether it may take the markets to simply give up on a deal before they actually drop sufficiently to put enough pressure on the politicians to make them do a deal,” said Gault.It’s not clear how far past the end-of-year deadline that moment would come; it would likely depend more on the mood than the timeline.

Another perspective: A short-term dive would inflict immediate pain on the economy. Some economists warn against even the briefest of cliff dives. “I don’t buy the idea that a short-term descent off the fiscal cliff would be not costly. I think it would be costly and, in fact, we’re already seeing costs,” Federal Reserve Chairman Ben Bernanke said at the central bank’s most recent press conference. Indeed, business investment has dropped and consumer confidence fell in December, developments widely attributed to concerns over the cliff.

But with days to go before the end-of-year deadline, a dive of some duration seems increasingly likely.