What Is the "Fiscal Cliff"?

The 'fiscal cliff' may sound like the name of an exercise retreat on a mountain top in Southern California, but the reality is not so pretty.

What 'fiscal cliff' actually refers to is the potentially dire economic situation the U.S. faces at the end of 2012. 

The now infamous phrase was coined by Federal Reserve Chairman Ben Bernanke in February 2012, during one of his required appearances before Congress on the state of the U.S. economy. He described ... "a massive fiscal cliff of large spending cuts and tax increases" on Jan. 1, 2013. 

Since then, 'fiscal cliff' has taken on legendary status as a harbinger of economic gloom and doom. (Read More: Why "Rise Above?')

So what does the 'fiscal cliff' trigger for the economy and how bad can it be? Here's a look.

At midnight on Dec. 31, 2012, a major provision of the Budget Control Act of 2011 (BCA) is scheduled to go into effect. This was the deal signed by President Obama in August 2011 to end the Congressional battle over raising the government debt ceiling.

The Act was a compromise between Democrats and Republicans on economic policies while temporarily increasing the debt ceiling — the amount of money the government could borrow from itself to pay its bills.

The crucial part of the Act provided for a Joint Select Committee of Congressional Democrats and Republicans — the so called 'Supercommittee '— to produce bipartisan legislation by late November 2012 that would decrease the U.S. deficit by $1.2 trillion over the next 10 years.

To do so, the committee agreed to implement by law — if no other deal was reached before Dec. 31 — massive government spending cuts as well as tax increases or a return to tax levels from previous years. These are the elements that make up the 'fiscal cliff.'

What laws from the Budget Control Act will go into place?

Among them are the end of 2011's temporary payroll tax cuts — the result of which will be a 2 percent tax increase for most workers.

There will also be an end to several tax breaks for businesses, and changes in the alternative minimum tax (AMT) that could result in more people having to pay — the income range is currently between $45,000 and $200,000 — and  higher tax payments for those who do.

Several of these existing tax breaks came from the George W. Bush tax cut bill of 2001, which were extended under President Obama until the end of 2012.

There will also be tax increases for higher income individuals to help pay for the Affordable Health Care Act (so-called ObamaCare).

At the same time, spending cuts will take place in more than 1,000 government programs, including cuts in the defense budget as well as social programs like Medicare, through 2022.

But some programs are exempt from the BCA. Those are Social Security, federal pensions and veterans' benefits.

What is the impact of the tax increases and budget cuts?

While higher taxes and spending cuts would reduce the U.S. budget deficit by an estimated $560 billion, the Congressional Budget Office (CBO) predicts that the policies from the BCA would cut gross domestic product by four percentage points in 2013. Many analysts say that would likely send the still-struggling U.S. economy into a recession, if not a depression, as the financial markets would likely go into a tailspin while businesses and consumers both cut back on spending.

As a result of the economic slowdown from the stilted GDP growth, the CBO also predicts unemployment would rise by almost a full percentage point, with a loss of about two million jobs.

Can anything be done to prevent the 'Fiscal Cliff' from happening?

The major problem has been getting Republicans and Democrats in Congress and the White House to agree on budgetary policy for the future. Republicans say they want cuts in government spending to reduce the country's deficit without raising taxes. For their part, Democrats say they want spending cuts with certain taxes raised.

There have been calls to extend some or all of the tax cuts and to replace the massive cutbacks in government spending with more targeted reductions. Some proposals include repealing the BCA altogether and just keeping what exists now until another agreement can be reached.

But so far, there is no consensus on what to do, and some analysts say nothing might happen to avoid the 'fiscal cliff' until the last week in December.

There is one ace in the hole, so to speak. Even if the BCA deadline comes and nothing is done, Congress can still act to change laws retroactively if it chooses.