Fiscal cliff: What is it and what it means for Canada

The 'fiscal cliff' is the most threatening hazard facing the Canadian economy in the year ahead. If we're pulled over its abyss it would cripple growth here in the near-term, and almost certainly plummet us into a recession, our own finance minister Jim Flaherty has warned.

The only salvation is that it's not going to happen, or at least, not with anything near the severity that many fear.

The cliff in question here is the combination of US$7 trillion in tax hikes and deep spending cuts that will come into effect in the U.S. on Jan. 1 unless Congress can agree on a deal.  If no resolution, Jan.2 will look like this:

  • Bush-era tax cuts will expire, which see hikes in income tax, capital gains tax, dividend tax, etc.
  • The payroll tax break will end
  • Extended unemployment benefits will dry up
  • $55 billion cut from defense spending
  • $55 billion in non-defense spending cuts will come into effect, including cuts to education, food inspection and air travel safety, to name a few

The problem is that Congress is staunchly divided between the Republicans, who oppose any tax increases, and the Democrats, who are equally adamant that there be no spending cuts, particularly to social programs. The Republicans control the House of Representatives. The Democrats run the Senate. Both houses must sign off on a deal here, and there have been few signs that either are prepared to budge on this one.

The issue has rocketed to the forefront this week as the recent election changed none of the key players, nor sent any a message that a new direction was necessary. Both sides' constituencies came out in full force, in almost equal measure, and they agreed to disagree. The fiercely partisan posturing, and resulting logjam, that has thwarted countless legislative initiatives over the past four years -- i.e. the debt ceiling crisis -- remains firmly in place. If anything, it's even more antagonistic, stoked as it's been by months of hostile campaigning.

However, there remains reason for hope. Not the least of which is that Republicans have nothing to gain by destroying the economy to spite Obama. He's not running again. They can try to ruin his place in the history books but they can't cut short his rule. He won. He's in.

More importantly, though, the cliff won't be careened over because the stakes are too high. If withdrawing US$600 billion in spending doesn't completely wipe out any stimulus and hope of growth in the U.S. economy, slapping on significant tax hikes at the same time would certainly do it. The result could be catastrophic, and would almost certainly result in the loss of millions of jobs, only further derailing the country.

Neither party would escape blame, nor would the politicians involved, who unlike the President, will most likely be seeking re-election in the years ahead. Indeed, there are already clear signs from both parties that calamity needs to be avoided.  Republican House of Representatives speaker John Boehner spoke on Wednesday of his willingness to accept tax hikes providing certain code reforms were part of the deal.  In turn, Democratic Senator Harry Reid said he was prepared to negotiate in the same spirit.

Both sides can seek solace in the fact that any compromises made no matter how horrific to their base, is better than a complete economic meltdown; plus they all have at least two years now before they have to face the voters.

Fiscal cliff poses risks to Canada's economy

What does this all mean for us, a country with so much at stake yet no say in the matter? Unfortunately it will likely mean a few weeks of nervousness followed by a rocky road in the New Year, as our neighbours grudgingly inch towards the least worst fate.

A repeal of the Bush-era tax cuts alone would have a dramatic effect on consumer spending in the U.S., which could cripple Canada's export industry -- an area of the economy already under strain.  The U.S. is not only Canada's largest trading partner, but the country's largest economic partner, meaning our economies are intrinsically linked.

"It would also be felt through broader confidence effects, including business investment," Bank of Canada Governor Mark Carney said in a press conference earlier this week.

"One of the things that appears to be happening already, and obviously would be reenforced if they went over this cliff,  is the level of policy uncertainty in the United States -- in particular the uncertainly around this issue -- is impacting business investment in the United States. They transparently fumbled this issue," he went on to say.

In layman's terms: If investment dollars dry up in the U.S., we could expect a similar effect north of the border. Couple that with a weakened export industry, which would see broad implications for our commodity sector, and Canada is poised for a world of hurt.

What Are the Odds of Falling Off the Fiscal Cliff?Maury Harris, UBS Investment Research, and Alan Gayle, RidgeWorth Capital Management, discuss the impact of the looming fiscal cliff on the markets and economy.

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