Cliff-Diving: Here's What Will Happen


Despite the prospect of tumbling down the fiscal cliff being less than 14 hours away, stocks are up this morning, with the Dow Jones Industrial Average and the broader S&P 500 up by 0.03% and 0.25%, respectively, as of 10:15 a.m. EST.

Here are five questions and answers to get up to speed on what will happen.

What happens on Jan. 1?
A broad range of tax credits and tax rate cuts -- including cuts on individual income tax rates -- will expire on Jan. 1. In addition, as a result of the 2011 agreement to extend the federal debt ceiling, across-the-board government spending cuts and caps also go into effect. Finally, unemployment insurance that has been extended in the face of a slow recovery is also set to expire. All told, the Congressional Budget Office estimates that, under this scenario and with no countervailing action, U.S. GDP will shrink by 0.5% next year.

Without a deal, will the economy automatically tip into recession on Jan. 1?
No -- it doesn't work that way. The CBO's estimate of a decline in GDP assumes that lawmakers do nothing whatsoever to address the issue. In fact, lawmakers can produce an agreement early next year that would extend tax cuts retroactively and "normalize" government expenditures.

Will my tax rates go up?
It depends on your income bracket. Lawmakers will probably craft an agreement that extends the tax cuts for most Americans; however, top earners should expect their tax rates to rise. What is the income threshold? That has yet to be determined. President Obama has, at various times, floated $250,000 and $400,000 in annual income as the bar.

Will the stock market crash when it reopens on Wednesday?
If we assume the market is mostly efficient, there is little reason to believe stocks will decline by a substantial amount on Jan. 2. Investors already know we are going over the cliff -- or they should. Nevertheless, because I think too many investors are hoping against all odds for an 11th-hour deal tonight, I think the chances that the market will fall on Wednesday are slightly better than 50-50. Furthermore, the longer it takes for politicians to craft an agreement, the greater the odds of a significant market reaction in the days, weeks, or -- let's hope it doesn't get to this -- months to come as investors become increasingly concerned about the impact on the broader economy.

As we pass the Dec. 31 deadline, is there another milestone ahead?
There is another milestone, though it is unknown precisely when it will come: the day when the U.S. reaches its federal borrowing limit, which it is expected to do at some time in February or March. As we approach this date without an agreement, the negotiations on the debt ceiling may become intertwined with those on the fiscal cliff.

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Alex Dumortier, CFA has no positions in the stocks mentioned above; you can follow him @longrunreturns. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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