---
title: "Stocks and the Fiscal Cliff"
description: "What happens to stocks if we fall off the fiscal cliff? What might happen in the market if the US defaults on its debt."
canonical_url: https://trendshare.org/how-to-invest/stocks-and-the-fiscal-cliff
markdown_url: https://trendshare.org/ai/stocks-and-the-fiscal-cliff.md
published: 2012-12-01
last_updated: 2017-04-17
content_license: https://trendshare.org/about/disclaimer
---
# Stocks and the Fiscal Cliff

Source: https://trendshare.org/how-to-invest/stocks-and-the-fiscal-cliff
Updated: 2017-04-17
In late 2012, the US federal government had a difficult decision to make.
How would it react to the deadline Congress placed on itself to handle the 2013
budget? These were tough questions, given the size of the federal debt, the
lingering effects of the 2008 recession, and the perpetual questions about who
should pay what tax rate and why.

Back in those days, everyone talked about something called "the fiscal
cliff".

## What is the Fiscal Cliff?

As part of earlier negotiations to improve the budget process, reduce the
federal deficit, and attempt to pay down the federal debt, a committee of
members of Congress agreed to a failsafe: if they could not agree on a plan, an
automatic series of cuts to spending and expirations of tax rates would occur.
See the [Budget Control Act of 2011](http://www.legisworks.org/congress/112/publaw-25.html) for gory and boring details.

As you might expect, they did not agree.

The fiscal cliff was a manufactured crisis that no one wanted to happen:
those spending cuts and effective tax increases. There's still time to reach a
deal, but as 2013 approached, uncertainty increases. Almost everyone would like
to find a compromise to avert the automatic cuts and increases.

If you want to get precisely technical about things, the US *did* go
over the fiscal cliff on January 1, 2013. The sky didn't fall and Congress went
on to pass the [American Taxpayer Relief Act of 2012](http://www.gpo.gov/fdsys/pkg/BILLS-112hr8eas/pdf/BILLS-112hr8eas.pdf) by noon on January 1, 2013.

What did this mean for you? What might happen if this negotiation happened
again? Consider a couple of hypotheticals, as if it were December 2012.

## What Happens if Nothing Happens?

If there's no deal, federal taxes will go up—not just income taxes,
but also payroll taxes. In effect, everyone who works and has money deducted
from a paycheck will see less money in every paycheck. As well, federal money
spent on various government programs will diminish.

Because the current economic malaise is a demand-side problem (there aren't
enough people willing to spend money in places where it matters), and because
the most effective way to stimulate the economy is for the federal government
to distribute money to the people most likely to spend it (the poor and
especially the working poor), it's likely that a second recession will
occur.

Almost no one wants that.

Yet if this does happen, the effect on the stock market will likely reflect
the weakening economy: prices will tend to go down. If you're waiting for [stocks to go on sale](https://trendshare.org/how-to-invest/when-stocks-go-on-sale), this is an opportunity
to buy, but who knows how long the weakness in the economy will linger in the
stock market?

## What if Taxes Go Up?

If Congress finds a compromise, it's likely that some taxes will increase
(in that temporary tax rates are likely to expire). If Congress manages to
leave the payroll tax cuts in place for the near future, the economy will have
a chance to improve (or at least not get any worse), as more money will be
available for the people who most need to spend it to spend.

It's plausible that the tax rate on things like dividend income and capital
gains will increase. This will affect you in two ways. First, you'll have to
get better returns from your investments to make the same amount of
money—if you pay more in taxes, you'll realize smaller gains when you
sell. (This is a good reason to practice [value investing](https://trendshare.org/how-to-invest/what-is-value-investing), which minimizes the number
of times you buy or sell and, consequently, spends less of your money in taxes
because you take larger profits less often.)

Second, [companies which pay dividends](https://trendshare.org/how-to-invest/should-you-invest-in-the-highest-dividend-paying-stocks) will probably pay fewer dividends. If shareholders have to
pay more in taxes, dividends will be less attractive. (Companies that pay
really big dividends will probably continue to do so, but expect other
companies to use that money to [buy back more shares](https://trendshare.org/how-to-invest/why-do-companies-perform-stock-buybacks)
instead, which should push up stock prices.)

If your taxes go up (whether through rate cuts expiring or removal of
deductions), it's more important than ever to practice wise investing through
[buy and hold investing](/how-to-invest/buy-and-hold) and [choosing great companies to invest in](/how-to-invest/how-to-pick-good-stocks).

## What if Taxes Stand Still?

This is probably the best case scenario. If tax rates stay the same,
dividends will remain historically cheap and stocks which pay dividends will be
attractive. You won't have to work any harder to beat the market's returns
after taxes if your tax rates stay the same.

## The Stock Market and the Fiscal Cliff

What did the stock market do?

Throughout December, the stock market wavered a bit. For every dip in
prices, commentators were quick to blame "The fiscal cliff is eroding investor
confidence." (No one was much surprised [the media covers stocks so lazily](https://trendshare.org/how-to-invest/why-does-the-media-cover-the-stock-market-so-poorly).) Yet stocks rose in general from November through
December.

With the announcement of the "resolution" of the fiscal cliff issue through
the American Taxpayer Relief act enacted on January 1, 2013, the market jumped.
In 2013, the [S&P 500 index](https://trendshare.org/how-to-invest/buy-the-s&p-index-fund) gained
almost 30%. It increased just over 11% for 2014. Good investors found some
bargains and made some money.

No one can predict [what the stock market will do in any given day](https://trendshare.org/how-to-invest/what-happened-in-the-stock-market-today), but because [stock prices have a connection to expected earnings](https://trendshare.org/how-to-invest/earnings-matter-most), any suggestion that the economy will slow down again tends to
drive prices lower, at least for the market as a whole.

This can be depressing, but it can be very profitable to find [good stocks at bargain prices](https://trendshare.org/how-to-invest/when-stocks-go-on-sale). If you have
great investments, stay the course. If you're looking for new investments, keep
in mind that daily, weekly, or monthly fluctuations in prices are merely bumps
in the road to success.

No matter what happens with a future fiscal cliff, budget negotiations, tax
rates, or any other federal economic policy, investment success still depends
on your ability and willingness to find great stocks, buy them at good prices,
and wait patiently for the market to reward your diligence and hard work.