What You Need to Know About the Fiscal Cliff

Have you heard about the fiscal cliff? If not, it's time for a quick explanation. It's big, it's important, and you need to know about it.

If everything goes according to plan, Jan. 1 will cause one of the biggest shocks to the economy since the financial crisis four years ago.

How can we be so sure? Because on that day, policy changes will cause federal spending to fall, and federal taxes to rise, by a combined $607 billion in 2013 alone. The magnitude and abruptness of the changes gave rise to the name "fiscal cliff."

This isn't the result of new laws. The impending changes reflect how existing laws, some passed more than a decade ago, were designed to play out. Dozens of policy changes await, the big ones being:

1. Expiration of the Bush-era tax cuts
Congress and President Bush signed tax cuts into law in 2001 and 2003. The legislation was championed as tax reform but came with a distinct limitation: Rather than being made permanent, each round of cuts was designed to expire at the end of 2010 to conform to budget rules. In late 2010, Congress and President Obama extended the tax cuts for two years to avoid the looming expiration. Now both are set to expire again on Jan. 1. If they do, federal taxes will increase by $221 billion next year, according to the Congressional Budget Office.

2. Expiration of the payroll tax cut
A one-year payroll tax cut was passed in Dec. 2010, reducing taxes on the majority of working Americans by 2%. The cut was extended for an additional year last December and expires again on Jan. 1. It will raise taxes by $95 billion next year.

3. Budget-deal spending cuts
As part of last summer's deal to raise the debt ceiling, both parties agreed to form a bipartisan "supercommittee" tasked with cutting $1.2 trillion in spending over a decade. If the committee failed that task, $1.2 trillion in automatic spending sequestration would take effect over nine years. The sequestration slashes indiscriminately across government programs in an attempt to prod legislators into action. Alas, it didn't work. The supercommittee didn't reach a deal, so sequestration begins Jan. 1. The White House estimates it will reduce federal spending by $109 billion in 2013.

On top of those, an expiration of extended unemployment benefits, a big cut to Medicare providers, and a laundry list of expiring tax deductions are set to hit Jan. 1. Add it all up, and we're talking policy changes equal to about 4% of the economy. This is quite literally one of the biggest alterations to how the federal government operates in modern history. And it starts in about 90 days.

Regardless of ideology, virtually all economists agree that going over the fiscal cliff will tip us back into recession. The CBO predicts it would cause the economy to contract 0.5% in 2013, pushing the unemployment rate above 9%. That's particularly dangerous right now, as millions of Americans in precarious financial conditions from the last recession have little or no buffer against bad times. It's not even a smart way to fix our debt problem. Another recession and higher unemployment mean shrinking the taxpayer base, offsetting a big chunk of the deficit reduction.

Now, almost no one wants the fiscal cliff to happen, particularly in its entirety. There's something in it for everyone to hate: tax hikes if you're conservative and spending cuts if you're left-leaning. Both parties have voiced their desire to avoid the cliff by making a deal to extend current policies, if only in parts. Odds are that will happen with a last-minute deal hammered out just like last summer's debt-ceiling deal. Goldman Sachs puts the odds that a deal won't be made at just 35%. Moody's puts the odds of failure at 15%. Even if Jan. 1 rolls around without a deal, one could be made soon after, even retroactively. It's in neither party's interest to so flagrantly cause another recession.

But everyone knows striking a deal will be messy. It will be loud, insulting, and at times terrifying. What's so dangerous about the fiscal cliff is that it will happen if Congress does nothing. And doing nothing is the one thing they excel at.

What should investors be doing in the meantime? Probably nothing. If you're contemplating making big changes to your portfolio ahead of the fiscal cliff, stop. There's a good chance you're driven more by emotion than reason. If you were happy with your investment strategy three months ago, you should be happy with it three months from now. Smart investing is about long-term businesses, not short-term politics.

If the fiscal cliff isn't fixed and we do fall back into recession, the ones who will look smart in hindsight will be those who keep their heads on straight, take a long-term view, and even purchase some of their favorite companies at bargain prices. All recessions turn out that way. Those who attempt to protect themselves by selling stocks often expose themselves to bigger risks and miss out on the biggest rebounds. Dysfunctional politics is no excuse for dysfunctional investing.

I'm still optimistic the fiscal cliff will be avoided, but you can count on months of threats, bickering, and nonsense. "You can always count on Americans to do the right thing," Winston Churchill said, "after they've tried everything else."

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

The article What You Need to Know About the Fiscal Cliff originally appeared on Fool.com.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel.The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.