What Is The Fiscal Cliff?

Fiscal cliff is the shorthand to describe the point in January when several tax breaks end and public sector spending cuts hit the US economy. Among the changes are the cancellation of a 2% payroll tax cut introduced in last year that is the equivalent in the UK of putting 2% on employee national insurance (up from 4.2% to 6.2%). Tax breaks for businesses that George W Bush passed in 2003 allow big write-offs on new equipment. They will lapse. The Republicans seem most concerned about America's highest earners, or individuals making more than $388,350 (£243,000), who will see a 4.6 percentage point increase in income tax, going from 35% to 39.6%.

What about spending cuts?

About $108bn of cuts to departmental spending from defence to Medicare will kick in. Most of the heavy lifting on cuts has so far been carried by local government and individual states. Now it will be the turn of federal government.

What is the impact of the cuts?

There is little agreement on the immediate impact, though the financial effect tends to be overstated because they will be spread over the whole year. In that sense, the use of the word cliff is misplaced.

But the potential loss of confidence in the US economy and the Obama administration's reputation could be catastrophic if politicians fail to make progress over the next month. When the cumulative financial effects of the tax rises and spending cuts for 2013 are variously estimated as a drop in GDP of between 4% and 6%, wrangling over the government debt ceiling is not a good idea. For one thing, unemployment would rise by an estimated two percentage points from 8% to 10% resulting in an additional 2.8 million people out of work.

How has the market reacted?

From the moment the fiscal cliff became an issue the markets have dismissed its significance because traders cannot believe US politicians would kill the economy next year, even if action succeeded in halving the annual deficit at a stroke. Markets believe European politicians are capable of such a mistake, but think Congress will cobble together a deal, if only at the last minute.

Is a deal likely?

Republicans have defended the Bush tax breaks for the better off, but given the size of Barack Obama's re-election victory, are likely to concede ground if they can protect some business tax reliefs. Obama will want to limit the impact on workers from any rise in payroll tax.