What is the 'Fiscal Cliff'? Barack Obama faces his first big challenge

Nov 7, 2012

The re-elected president faces an economic enemy that could tip America back into recession in 2013

Having defeated Mitt Romney by a commanding margin in the presidential election last night, Barack Obama will scarcely have time to get his feet back under his White House desk before he must tackle a massive threat to American prosperity - the 'Fiscal Cliff'.

On 1 January 2013 a raft of Bush-era tax cuts which were extended in 2010 will end, boosting federal tax revenues by almost a fifth but threatening “to tack $3,700, on average, onto taxpayers’ bills for the current tax year", the Washington Post reports.

More than 26 million US households will be affected when the Alternative Minimum Tax (AMT) is levied on their tax returns for the 2012 tax year.

The first $175,000 above the exemption rates - which will be topped at $45,000 - is to be taxed at 26 per cent, and anything above that will face a levy of 28 per cent.

At the same time, spending cuts brought in by the Budget Control Act of 2011 will kick in through a process called budget sequestration, where the federal government will cut its budget across the board.

This is likely to shave a quarter per cent off Washington's spending bill, with the money likely to come from federal agencies and cabinet departments, such as defence.

According to The Daily Telegraph, "the Congressional Budget Office, a leading independent forecaster in Washington, has warned that if all the tax increases and reductions in government spending are allowed to happen, the world's largest economy will be back in recession within months".

The spending cuts will amount to $110bn and, coming alongside families finding themselves out of pocket to the tune of almost $500bn across the country, the fiscal squeeze could amount to four per cent of the American economy.

Some analysts fear that such a move could see the unemployment rate, which edged under eight per cent before the election, jumping to ten per cent of the workforce.

The Washington Post says that the newly re-elected president could actually turn the potential disaster into a great legacy of his second term.

"If Obama can engineer a compromise to avert the cliff with the freshly re-elected Republican House, he could set the stage for progress on other second-term priorities, including immigration reform, climate change and investments in education and manufacturing.

"Such a compromise could also infuse fresh energy into an economic recovery that has suffered from uncertainty over the future of federal budget policies," the paper reports.

However, the reason that America finds itself in this situation is because of the stalemate that has developed between a Democratic president and a Republican-led House of Representatives.

In keeping with his campaign promises, Obama doesn't want to see any tax cuts for families earning more than $250,000, while the Republicans won't accept any deal that will lead to cuts in the military budget.

"Mr Obama’s victory clearly hands him some leverage in his effort to force Republicans to accept higher taxes on the rich as one of the solutions to both the short-term fiscal cliff and America’s longer term deficit problems," reports the Financial Times.

"But the reaction from House Speaker John Boehner and his rank-and-file members will be key, since it is unclear whether House Republicans will be in any mood to cave on allowing Bush-era tax cuts for Americans earning more than $250,000 to lapse as Mr Obama proposes."

In the wake of a chastening defeat which could lead to civil war within the party, Republicans may demand that the president makes all the running on resolving the issue.

But equally the party could see that the partisan squabbles over the 'fiscal cliff' of the last two years have damaged their standing in the eyes of the electorate and decide to work with the president.

Whatever happens, it must be dealt with quickly - there are just over 50 days to fix the problem.

Sign up for our daily newsletter

Read more: