What it means
Governments sometimes pass temporary tax cuts or spending programmes with fixed end dates. If lawmakers do not agree on a replacement before the deadline, taxes rise and spending falls automatically.
The size and speed of the change is what makes it a cliff and not a gentle slope. The phrase became widely known in the United States around the end of 2012, when several tax cuts were due to expire alongside automatic spending reductions.
Commentators used the cliff image to warn that the economy could fall sharply if nothing was done. Similar situations have been described in other countries when temporary measures or budget deadlines collided.
The economic worry is simple. When taxes rise, households have less to spend, and when government spending falls, there are fewer contracts, wages and benefit payments flowing into the economy.
Together these changes reduce demand, which can lead to lower sales, job losses and falling confidence. Businesses watch these events closely because they create uncertainty.
Companies may delay hiring, postpone investment or build up cash until the outcome is clear, and markets can become volatile as deadlines approach. Governments, for their part, often negotiate a last-minute deal that delays or softens the changes.
Not every cliff turns out to be as steep as predicted. Deals may phase in the changes, or one part may be postponed while another goes ahead.
For a manager, the practical response is scenario planning, which means preparing a budget for the worst case, the most likely case and the case where a deal is reached.
In practice
Real-world examples.
Example
A homebuilder reviews its order book as a tax relief for house buyers is due to end in six months. It brings forward some projects and plans a cautious budget in case demand falls once the relief ends. Its sales director warns the board that enquiries may dry up in the months straight after the deadline.
Example
A defence supplier sees that automatic cuts to government spending could hit its contracts. Its finance director models revenue with and without the cuts and arranges a larger overdraft in case payments slow. He also asks his largest suppliers whether they could extend payment terms if needed.
Example
A retailer expects customers to have less spending money if tax rates rise next quarter. It trims stock orders for non-essential goods and runs a smaller promotion programme than the previous year.
Formula
Calculation
Analysts size a cliff by comparing the total fiscal tightening to the economy.
Fiscal tightening = Tax increases + Spending cuts
Fiscal drag (% of GDP) = Fiscal tightening divided by GDP x 100
Worked example: a fictional economy has a GDP of $20,000 billion. Scheduled tax increases are $300 billion and automatic spending cuts are $200 billion.
Fiscal tightening = $300 billion + $200 billion = $500 billion
Fiscal drag = $500 billion divided by $20,000 billion = 0.025, or 2.5% of GDP
If the economy would otherwise grow by 2% in the year, a drag of 2.5% of GDP could in principle push it into contraction, although the exact effect depends on how households and businesses respond.Case study
Seen in the real world.
Calder Industrial Supplies is a fictional distributor whose customers include government agencies and small manufacturers. In the months before a fictional budget deadline, its finance director, Elena, noticed that customers were delaying orders and asking for longer payment terms.
In this illustrative case, Elena built three scenarios: a deal, a partial deal and a full cliff. She set aside a cash buffer equal to six weeks of costs and agreed a standby credit line with the bank. When a partial deal arrived at the last minute, the buffer was not needed, but the company had been ready. The story shows that planning for uncertainty is cheaper than reacting to it. The buffer cost a small amount in interest, which the board considered a fair price for the protection.
Watch out
Common mistakes.
- Assuming a cliff will definitely happen. Governments often reach last-minute agreements, so plans should include a no-cliff scenario as well as a worst case.
- Ignoring indirect effects. Even if your own customers are not directly affected, their customers may be, and the impact can flow along supply chains.
- Treating the effect as instantly visible. Spending and hiring decisions respond over several months, so the damage may arrive after the event itself.
Questions
People also ask.
What is the difference between a fiscal cliff and a debt ceiling crisis?
A fiscal cliff involves scheduled tax rises and spending cuts, while a debt ceiling dispute is about the legal limit on how much a government may borrow.
Who is most affected by a fiscal cliff?
Households facing higher taxes, businesses dependent on government contracts and sectors that rely on tax incentives are usually among the first affected.
How can a business prepare?
It can model several scenarios, hold extra cash, talk to its bank about spare credit lines and avoid taking on fixed commitments that depend on one outcome.
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