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Before understanding the term fiscal cliff let us first try and understand what fiscal gap actually means. We know that government policies with regards to spending and taxation are known as fiscal policies. Fiscal gap arises whenever the income of the government that comes from taxation and other revenue receipts is less than the expenditure. Expenditure of government typically relates to defense spend, healthcare spend and subsidies, if any. Thus, a fiscal gap is a worry for any government as expenditure rises but there is no income to fund the same.
Right now, the US government is facing a huge fiscal deficit. If the government takes measures to overcome the same it may send a shock to the US economy. Basically, this catch 22 situation which the US economy is currently facing is known as fiscal cliff. Let us understand it in a bit more detail.
In order to eliminate the fiscal gap government will have to increase taxes and reduce spending. This would mean that various tax breaks that were available until now will vanish. It is believed that approximately 90% of the Americans will see their taxes rise. Government spending will also be slashed. That would mean some of the government benefits available until now will go away. These steps would reduce the deficit but affect growth. But this may also end up endangering the US economy.
However, if the government does not take any steps to curb the deficit its debt would grow. That's because it will not have sufficient income to fund the expenditure. So, it will have to borrow. However, excessive borrowing will put its sovereign rating at risk. It may also fall in a debt trap like Europe. Thus, the US is basically in catch 22 situation now. It is in a soup whether or not it takes steps to curb the deficit. But how did it land here?
It may be noted that in August 2011, the budget control act was passed in US. That raised the nation's debt limit, provided various tax breaks and other benefits to temporarily boost the economy. But these laws had a timeline attached to it during which none of them have yielded any material results. So, now they have to be rolled back. Or else the sovereign rating of US could come under threat. It seems that the US economy is in a complete cliff hanger. Only time will tell whether it can come out of this fiscal mess.