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What Is The 'Fiscal Cliff?'

U.S. President Barack Obama has cut short his Christmas vacation to return to Washington and bring together Republican and Democratic Congressional leaders in a last-minute bid to, at least, strike a short-term compromise.
The end of the year is the deadline for Republicans and Democrats to agree on reducing the U.S. budget deficit in order to prevent the United States from going over the so-called fiscal cliff.

What is the "fiscal cliff"?

In a nutshell, the so-called fiscal cliff is a combination of automatic tax increases and U.S. government spending cuts that will take effect on New Year's Day unless the White House and Congress agree on how to reduce the budget deficit during the next decade.

The tax increases would take effect because temporary tax cuts of the George W. Bush presidency, approved in 2001 and 2003, are due to expire on December 31, 2012.

Meanwhile, $1.2 trillion in government spending cuts during the next decade would be triggered automatically under legislation from 2011.

Why would government spending cuts come into force automatically?

Spending cuts would come into effect automatically under the Budget Control Act, which averted the U.S. debt-ceiling crisis in the summer of 2011.

It was a compromise between Republicans and Democrats that prevented a default on U.S. government debt in August 2011.

The legislation temporarily raised the limit of debt the U.S. government was allowed to accumulate so that it could repay funds it had borrowed.

But the Budget Control Act also contained a variety of spending cuts aimed at reducing the U.S. budget deficit by $2.1 trillion during the next decade.

It included $917 billion in immediate spending cuts. It also specified that $1.2 trillion in further automatic cuts would be triggered at the start of 2013 unless a bipartisan committee could agree on how to reduce the deficit by another $1.5 trillion.

Those automatic spending cuts would be applied equally across defense programs and nondefense programs.

What do economic experts think the impact on the U.S. and world economy if Republicans and Democrats can't agree on further deficit reductions and the United States goes over the fiscal cliff?

Christopher Lockwood, U.S. editor of "The Economist," explained the impact of political deadlock in a video posted online by the magazine earlier this month.

"If the Republicans and the Democrats fail to reach agreement, the U.S. economy will be hit with a devastating fiscal sledgehammer, which could be equivalent in a full year to 5 percent of GDP," Lockwood says in the video.

"If America does go over the fiscal cliff, businesses could respond by sharply curtailing business investment. That will return America to recession and, perhaps, deepen recession all across the world."

Most economists agree, saying higher taxes would hit all income earners in the United States -- giving them less money to spend and damaging the economy's growth prospects.

At the same time, the elimination of government spending would mean less money to stimulate growth, and also would probably result in a higher unemployment rate.

Many analysts say there are already signs that the political deadlock in Washington is negatively affecting the U.S. economy by damaging investor confidence and impeding economic recovery.

Why are the parties deadlocked?

President Barack Obama and the Democrats want the wealthiest Americans to pay more in taxes by restoring the tax rates for the richest to the levels where they had been during the 1990s under President Bill Clinton.

They would do that by extending the Bush-era tax cuts for everyone except the highest income earners.

A bill proposed in the U.S. Senate, which is controlled by the Democrats, calls for tax-rate increases on incomes that are more than $250,000 a year for married couples or individuals.

The Republicans, who control a majority in the House of Representatives, have agreed that tax revenues need to be increased. But the Republicans have opposed an increase in the tax rate for the wealthiest -- arguing that revenues should be raised by closing tax loopholes instead.

The Republicans also want the Democrats to reduce spending on so-called entitlement programs -- such as Medicare and Social Security. But Democratic leaders have made it clear they will not support those kinds of spending cuts.

Obama has cut short his Christmas vacation to return to Washington and bring together Republican and Democratic Congressional leaders in a last-minute bid to, at least, strike a short-term compromise.

But economists say a short-term deal would only delay the problem of a growing deficit crisis instead of solving the problems in the long term.

With reporting by Reuters, AP, "The New York Times," U.S. Congressional Research Service, and "The Economist"