The US 'fiscal cliff' explained

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President Barack Obama and congressional leaders will meet on Friday for budget and tax talks aimed at preventing the US economy from falling back into recession. We look at the fiscal cliff, its origins and possible disastrous effects.

On January 1, Americans could face big tax increases coupled with draconian cuts in government spending if President Barack Obama and his Democrats are unable to hammer out a compromise with Republicans on fundamental changes in the way the country handles its finances.

There will be economic pain for virtually all Americans and political and ideological agony for politicians of both parties no matter how the looming "fiscal cliff" plays out. After years of government spending far more than what it collects in taxes, even the best solution for pulling back from the abyss will be nothing more than the least painful outcome.

Here is a look at the fiscal cliff, its origins and the possible solutions for avoiding its disastrous effects:

What is it the fiscal cliff?

The fiscal cliff is a convergence of mandatory spending cuts and the expiration of tax cuts, all scheduled to take effect January 1.

Unless Congress and Obama reach an agreement, $85bn in federal spending will be automatically eliminated - $32bn from military spending and $53bn in across-the-board cuts to education, health care, law enforcement and other social programs.

Democrats and Republicans agreed last year to schedule the automatic cuts, though neither side wants them and both hope they won't take place. It was a compromise worked out to end a dispute about the government's borrowing authority that threatened to send the US into default.

The cuts were seen as so politically untenable that they were expected to be an overwhelming incentive for both Republicans - who are deeply opposed to cuts for the Pentagon - and Democrats - who want to keep government social programs in place - to take more palatable action this year on the federal debt.

The expiration of tax cuts instituted during the 2001-2009 presidency of Republican George W. Bush would affect most working Americans. Again, neither party wants that to happen, but they can't work out their differences: Obama wants to keep the reduced tax rates for all but the wealthiest Americans; Republicans oppose any increase in tax rates.

Also expiring January 1 will be a 2pc reduction in payroll taxes that Americans pay into the federal Social Security pension system, temporary tax breaks for businesses and individuals, and extended unemployment benefits.

All together, the spending cuts, higher taxes and loss of extended unemployment benefits will mean that $671 billion would be sliced out of the American economy next year.

What are the consequences if no action is taken?

While the fiscal cliff would narrow the federal deficit that is now $1.1 trillion, it would mean Americans would have far less money to spend, devastating a US economy that has only weakly rebounded from the last recession.

The non-partisan Congressional Budget Office predicts there would be a return to recession and a spike to more than 9 percent in the already stubbornly high unemployment rate.

Without a deal, Americans would find their paychecks shrunken by higher taxes - less money to spend, especially for already strapped middle income families. Compounding that, people who depend on an array of social programs from education for their children to certain health care programs would find them spending more on that even as incomes are diminished by higher taxes. For the U.S. economy as a whole, going over the fiscal cliff might end up having similar effects to the deep austerity programs in Europe (Chicago Options: ^REURUSD - news) that have driven the countries using the Euro currency back into recession.

Since the United States remains the world's largest economy, the repercussions would be felt worldwide, compounding other problems, such as the weak European economy.

What are the politics behind the fiscal cliff?

Any resolution would have to be worked out by Obama and the outgoing Congress, which remains in office until the new legislature is sworn in early next year.

Obama and his primary antagonist, House Speaker John Boehner, the most powerful Republican in Washington, have already begun laying out their positions.

Obama, who has been accused of caving too readily to past Republican demands, is holding fast to his position that taxes go up for households earning more than $250,000 a year. He also says he is willing to see cuts in government spending, although he has not offered specifics.

Boehner and his Republicans - the low-tax, small-government tea party movement in particular - are equally adamant that tax rates not be raised for any income level and instead call for even deeper cuts in spending, although the targets of those reductions are unknown.

What are prospects for a resolution?

Obama meets on Friday with top congressional leaders for the first time since his re-election. He finds himself with increased political standing given his victory. Republicans, meanwhile, lost seats in both chambers of Congress, though they still hold a substantial majority in the House.

Both sides are talking about compromise even as they hold fast to their longstanding positions. A poll finds that Americans are not optimistic. The survey by the Pew Research Center for the People & the Press and The Washington Post (NYSE: WPO - news) , found that 51pc of those questioned believed no compromise would be reached. Of those surveyed, 53pc said blame would lie with Republicans in Congress, while 26pc said with Obama.

Boehner has shown interest in raising more money without increasing tax rates by revamping tax policies. A possible compromise, ironically, may grow out of an idea Mitt Romney put forward in his failed campaign against Obama. He had proposed putting a cap on deductions Americans use to lower their taxable income - things like interest paid on home mortgages and state and local income taxes.

That could be constructed so that it has a greater effect on high-income Americans, meeting Obama's demand that the wealthy pay more, while satisfying Republican demands that tax rates not be increased.

Inevitably, any serious compromise that addresses the deficit would mean that at least some Americans would be paying more in taxes, and fewer services would be available.

Still possible, too, is some sort of short-term fix that would temporarily avoid the worst of the consequences of the fiscal cliff while requiring that the new Congress and the president find a long-term solution next year.