What is the “fiscal cliff”？

The fiscal cliff is the large spending cuts and tax increases that are scheduled to be automatically enacted at the start of 2013 unless Congress takes action. Bush-era income-tax cuts will expire for tens of millions of Americans， and billions of dollars of spending cuts will go into effect because Congress couldn’t reach a deal last year to reduce the deficit by at least $1.2 trillion. Democrats want a combination of spending cuts and tax increases， while Republicans want to cut spending， but don’t want to raise taxes. Both would like to avoid the fiscal cliff， because it forces severe cuts， particularly in defense.

What taxes and spending are affected？

A payroll-tax holiday ends， which means a tax increase for workers of as much as 2% of wages. Income-tax rates revert to pre-George W. Bush levels， rising not only for the rich but for nearly all taxpayers. Across-the-board cuts in domestic and， particularly， defense spending are triggered.

What is the immediate cost to the economy？

The sudden rise in taxes and cuts in spending are seen having a harsh impact. In all， according to an analysis by J.P. Morgan economist Michael Feroli， $280 billion would be pulled out of the economy by the sunsetting of the Bush tax cuts； $125 million from the expiration of the Obama payroll-tax holiday； $40 million from the expiration of emergency unemployment benefits； and $98 billion from Budget Control Act spending cuts. In all， the tax increases and spending cuts make up about 3.5% of GDP， with the Bush tax cuts making up about half of that， according to the J.P. Morgan report.

How would this impact growth？

If no agreement is reached to extend the tax cuts and block the spending curbs， the nonpartisan Congressional Budget Office projected the economy would contract 1.3% in the first six months of 2013 if certain tax increases and spending cuts are allowed to take effect next year， with the economy stabilizing in the second half and eventually achieving an annual growth rate of 0.5%. The agency didn’t provide new projections of the unemployment rate if the tax increases and spending cuts went into effect. Earlier this year， CBO estimated joblessness would rise to 9.2% at the end of 2013 if Congress didn’t act. The unemployment rate in April was 8.1%.

How worried is the Fed？

Federal Reserve Chairman Ben Bernanke has warned lawmakers about the potential effect of the “fiscal cliff，” adding that “there is absolutely no chance that the Federal Reserve would be able to have the ability whatsoever to offset that effect on the economy.” The Fed， in the minutes of its April meeting released Wednesday， said that if lawmakers don’t reach agreement on a plan for the federal budget， “a sharp fiscal tightening could occur at the start of 2013.” That uncertainty “could lead businesses to defer hiring and investment” and weigh on economic sentiment， officials worried at the meeting. Agreement on a long-term plan could alleviate some of that uncertainty.

What is the state of play in Congress currently， and what are some possible scenarios？

No final action is likely until the end of the year， when hitting the fiscal cliff is imminent， because of partisan divisions in Congress and the political risk of taking tough votes on taxes and spending ahead of the November elections. In the short term， House leaders plan a vote to extend Bush-era tax levels for all taxpayers temporarily， possibly for one year， to give the next Congress time to work on overhauling the tax system to make it more competitive with other countries. That pre-election vote likely will include a fast-track mechanism so the eventual tax overhaul will get an expedited vote next year， and won’t get hung up by parliamentary maneuvering. The badly divided Senate doesn’t appear likely to take a vote on basic tax rates until after the election. A big question is whether and how lawmakers in a lame-duck session will seek to soften the blow of scheduled spending cuts.