WASHINGTON: The “fiscal cliff” is a combination of dramatic spending cuts and tax increases mandated to take effect beginning January 2013 if Democratic and Republican US lawmakers cannot bridge their differences on how best to reduce the nation's budget deficit and debt.

What is it?

The Budget Control Act of 2011, set into law in a grudging political compromise in August that year, forces the government to slash spending by $1.2 trillion over 10 years from January 1, 2013. Next year's cuts, called “sequestration”, would be about $109 billion.

Also on that date, a package of tax reductions set or extended in 2010 to spur economic growth, as well as an extension of unemployment benefits, will expire, meaning taxes will rise significantly for most Americans.

Why will this happen?

Democrats and Republicans have long been deadlocked over whether to address a $1 trillion-plus annual budget gap with higher taxes or lower spending.

The BCA was a poison-pill deal designed to force them to find a less austere compromise, but neither side would budge before the November 6 election. Now that the vote has passed, they only have a few weeks to find a solution to beat the year-end deadline.

What happens if the cliff is not avoided?

Together the higher taxes paid and lowered spending could slice the $1.1 trillion deficit racked up in fiscal 2012 (ended September 30) by almost $500 billion next year, according to the Congressional Budget Office, vastly improving the government's financial picture.

But the CBO estimates the shock treatment would send the country back to recession and push the unemployment rate to 9.1 per cent.

Deep cuts would come to both defence and non-defence spending. Government suppliers and contractors would lose business, and temporary furloughs could be in store for tens of thousands of federal employees.

Taxes and automatic paycheck deductions would increase for most Americans, reducing the cash they have for spending, and taxes on capital gains and dividends would rise, hitting investors.