How to Prepare for the 'Fiscal Cliff'

Congress could help salvage the economy—or wreck it.

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The so-called "fiscal cliff" is the topic of conversation between President Obama and labor leaders this week.

It's tempting to tune out politics and the 2012 elections. Your time might be better spent getting a jump on holiday shopping. Or knitting a new sweater. Or watching Jersey Shore reruns.

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But there's one bit of political theater people should be paying attention to: The so-called "fiscal cliff." This is the big set of tax hikes and spending cuts that are set to go into effect at the end of the year, unless Congress intervenes. Like much of what goes on in Washington, the drama is unnecessary and perhaps even absurd. But the outcome could zap many Americans in the wallet.

A lot of political experts feel that Congress will come up with some kind of last-second deal that averts the worst-case scenario, which would be to do nothing and let all of those tax and spending provisions go into effect at once. That would lop as much as five percent off of GDP and promptly cause a recession. But there's no easy way around the decisions that need to be made, and Congress will probably enact at least a few of the measures set to go into effect. Here's what ordinary Americans ought to be preparing for:

A modest tax hike. The expiration of the Bush-era tax cuts, which comes at the end of this year, would represent a huge tax hike on working Americans, so Congress will probably put that off. But another temporary tax cut will probably be allowed to expire on schedule, which means most workers will experience a de facto tax hike starting January 1.

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The payroll tax cut went into effect (in a slightly different form) in 2009, and it's already been extended for one year beyond its original expiration date. Basically, it cut the amount deducted from a typical paycheck to fund Social Security from 6.2 percent to 4.2 percent. That saved the typical worker about $85 per month, or $1,000 per year. The maximum savings for higher earners was about $2,000 per year. That money will once again be deducted from paychecks if the tax cut lapses, a change that will reduce the take-home pay of about 160 million Americans.

Reduced unemployment benefits. Another program that's set to expire—and probably will—is the federal extension of unemployment benefits. This temporary stimulus measure extended the unemployed benefits offered by the states—which typically last for 26 weeks—to as many as 99 weeks. The program is already winding down, and if the federal benefits aren't renewed, people who get laid off in 2013 will qualify only for the basic state program.

Skittish employers. CEOs are losing confidence in Washington's ability to handle basic challenges, and they're concerned that Congress could end up hurting the economy rather than helping it. A recent survey of CEOs by the Business Roundtable showed that confidence in the economy has fallen markedly in recent months. Just 58 percent of CEOs expect sales to pick up over the next six months, compared with 81 percent who felt that way earlier this year. And just 29 percent expect their companies to be hiring, down from 42 percent.

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That means hiring through the end of the year could be even weaker than it has been lately. When hiring is weak, raises tend to be scarce as well. And consumers worried about their paychecks spend less, so it's shaping up as another bleak holiday season for retailers and the workers who depend on them.

Federal job and benefit cuts. A few weeks ago, the White House issued a detailed report on where the spending cuts will hit if they go into effect as currently planned. The biggest losers would be defense agencies and contractors, but most federal agencies would face budget cuts of 8 percent or so. The same goes for civic, nonprofit or private programs funded by the government. Those cuts might end up being smaller, or going into effect later, but either way, it seems likely that a lot of people dependent on a government check will have to deal with cutbacks.

Pronounced volatility. Wall Street analysts think the time around the end of the year could be similar to August, 2011, which was when a big, needless fight over extending the nation's borrowing limit led to the first-ever downgrade of the U.S. credit rating by Standard & Poor's. The stock market fell by 7 percent and took six months to recover its losses.

This time around, even a good outcome could have damaging consequences. Economists and CEOs might be relieved if Congress delays the tax hikes and spending cuts set to go into effect, but Moody's has said it will join S&P in cutting the U.S. credit rating if Washington makes no progress later this year in cutting its annual deficits. Financial markets might yawn, or they might convulse. It would be wise to prepare for both scenarios. 

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.