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'Fiscal Cliff': CNBC Explains

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The "fiscal cliff" may sound like the name of an exercise retreat on a mountain top in Southern California, but the reality is not so pretty.

What "fiscal cliff" actually refers to is the potentially dire economic situation the U.S. faced at the end of 2012.

The now infamous phrase was coined by Federal Reserve Chairman Ben Bernanke in February 2012, during one of his required appearances before Congress on the state of the U.S. economy. He described ... "a massive fiscal cliff of large spending cuts and tax increases" on Jan. 1, 2013.

Since then, "fiscal cliff" has taken on legendary status as a harbinger of economic gloom and doom.

So what would have the "fiscal cliff" triggerd for the economy and how bad would it have been? (A compromise was reached, as you'll see below.) Here's a look.

How would the fiscal cliff come about?

At midnight on Dec. 31, 2012, a major provision of the Budget Control Act of 2011 (BCA) was scheduled to go into effect. This was the deal signed by President Obama in August 2011 to end the Congressional battle over raising the government debt ceiling.

The Act was a compromise between Democrats and Republicans on economic policies while temporarily increasing the debt ceiling — the amount of money the government could borrow from itself to pay its bills.

The crucial part of the Act provided for a Joint Select Committee of Congressional Democrats and Republicans — the so called Supercommittee — to produce bipartisan legislation by late November 2012 that would decrease the U.S. deficit by $1.2 trillion over the next 10 years.

To do so, the committee agreed to implement by law — if no other deal was reached before Dec. 31 — massive government spending cuts as well as tax increases or a return to tax levels from previous years. These are the elements that make up the "fiscal cliff."

What laws from the Budget Control Act would go into place?

Among them were the end of 2011's temporary payroll tax cuts — the result of which would be a 2 percent tax increase for most workers.

There would also be an end to several tax breaks for businesses, and changes in the alternative minimum tax (AMT) that could result in more people having to pay — the income range is currently between $45,000 and $200,000 — and higher tax payments for those who do.

Several of these existing tax breaks came from the George W. Bush tax cut bill of 2001, which were extended under President Obama until the end of 2012.

There would also be tax increases for higher income individuals to help pay for the Affordable Health Care Act (so-called ObamaCare).

At the same time, spending cuts would take place in more than 1,000 government programs, including cuts in the defense budget as well as social programs like Medicare, through 2022.

But some programs are exempt from the BCA. Those are Social Security, federal pensions and veterans' benefits.

What would be the impact of the tax increases and budget cuts?

While higher taxes and spending cuts would reduce the U.S. budget deficit by an estimated $560 billion, the Congressional Budget Office (CBO) predicted that the policies from the BCA would cut gross domestic product by four percentage points in 2013. Many analysts say that would likely have sent the still-struggling U.S. economy into a recession, if not a depression, as the financial markets would likely go into a tailspin while businesses and consumers both cut back on spending.

As a result of the economic slowdown from the stilted GDP growth, the CBO predicted unemployment would rise by almost a full percentage point, with a loss of about two million jobs.

What was done to prevent the fiscal cliff from happening?

The major problem was getting Republicans and Democrats in Congress and the White House to agree on budgetary policy for the future. Republicans pushed for cuts in government spending to reduce the country's deficit without raising taxes. For their part, Democrats said they want spending cuts with certain taxes raised.

But at the eleventh hour-- just before midnight of Dec. 31, 2012--Congress and President Obama reached a deal to address the fiscal cliff. The deal focused on tax revenue and included a number of changes to the tax code, including a permanent extension of the Bush-era tax cuts on income below $450,000 for families and below $400,000 for individuals.

But the deal left major issues unresolved, including the debt ceiling, the automatic spending cuts known as sequestration, and a final version of a budget to fund the federal government in the current fiscal year.

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