The biggest threat posed by the $7 trillion fiscal cliff is that it could throw the U.S. economy into recession next year.
But how exactly? The nonpartisan Congressional Budget Office on Thursday estimated the economic punch of different parts of the cliff -- a series of spending cuts and tax increases that starting taking effect in January.
They include reductions in both defense and non-defense spending; the expiration of the Bush tax cuts; the end of a payroll tax holiday and extended unemployment benefits; and the onset of reimbursement cuts to Medicare doctors.
The fiscal cliff as a whole, if it went into effect for all of next year, could result in a drop of 0.5% in real gross domestic product, according to the CBO. And that contraction could push unemployment to 9.1% by the end of 2013.
The report looks at the short-term impact of different policy decisions that Congress may make to avoid parts of the cliff.
For example, Congress could choose to protect 27 million taxpayers from paying the Alternative Minimum Tax and extend the Bush tax cuts along with other expiring tax cuts. Such a move could boost real growth by 1.4% and increase employment by 1.8 million by the end of 2013, while adding $330 billion to the deficit, CBO estimates.
If Congress chose to do the same thing but not extend the Bush tax cuts on income over $200,000 ($250,000 if married), as President Obama has proposed, that could boost output by 1.3% and add 1.6 million jobs. The deficit under such a scenario would be $288 billion higher.
Should lawmakers opt to cancel the non-defense spending cuts and avert the scheduled payment cuts to Medicare doctors, real GDP could be 0.4% higher and employment boosted by 400,000 by the end of 2013. Those policies would add $40 billion to next year's deficit.
If the fiscal cliff were averted altogether -- minus an extension of the payroll tax holiday and expanded unemployment benefits -- real GDP would be 2.2% higher and there would be 2.7 million more jobs next year. The deficit would increase by $395 billion.
At the same time, the country can't afford to put off fiscal tightening for too long. The growth in federal debt, which is already at its highest point since 1950, would continue to rise much faster than the economy -- and that would hurt growth.