Forget the market rally. The fiscal cliff deal is still a drag on growth.

January 3, 2013

The stock market surged the day after Congress passed a fiscal cliff fix, with the Dow rallying more than 300 points on Wednesday. But economists point out that the deal will still cause some drag on the economy in 2013, and some analysts have released more pessimistic projections for growth this year.


No worries on Wall Street. (Scott Eells/BLOOMBERG)

By averting the cliff -- the series of sharp spending cuts and overall tax increases that were to take effect this week -- legislators avoided the biggest possible hit to the economy in 2013. But the deal they passed will also slow down economic growth in various significant ways. Most of that stems from the expiration of the payroll tax holiday, which legislators decided not to renew. It's the most far-reaching tax hike in the deal, affecting the vast majority of the middle class and working poor, and it will lower GDP growth by 0.6 percent as a result, according to JPMorgan's chief economist Michael Feroli. Likewise, IHS Global Insight estimates that it will knock 0.4 percent off GDP in 2013.

That's prompted analysts who had expected the White House and Congress to either extend or replace the payroll tax break to lower their forecasts for 2013. "We expect first-quarter growth to be no better than the fourth quarter, at 1.0 %, well below the 2.2 % pace that we projected last month," writes Nigel Gault, chief U.S. economist for IHS Global Insight. "The primary reason is the expiry of the payroll tax cut, which has reduced our first-quarter consumer spending growth projection to 1.4%, from 2.6%."


(Source: JPMorgan)

Altogether, JPMorgan estimates that the fiscal cliff deal will subtract about 1 percentage point from growth in 2013, according to its appraisal of the Senate version of the bill, which closely mirrors the final legislation. That's mostly attributable to the payroll tax hike, rather than to the agreement to raise taxes on the wealthiest earners, which both JPMorgan and IHS agree will have a very limited effect on growth this year. "The income tax increases at upper-income levels are worth only about 0.2% of GDP in 2013, and their impact on spending will likely be limited, cushioned by a drop in the saving rate," Gault explains. 

Economists warn that further threats to growth lie ahead, as the deal sets up a debt-ceiling fight between the administration and Congress in two months. And they point out that the threat of the nation defaulting on its debt is much greater than any scenario under the fiscal cliff. "Hitting the debt ceiling would have far more severe consequences than going off the fiscal cliff would have done," says Gault, who anticipates that "another damaging episode of brinkmanship" is on the horizon.

That said, there are some parts of the final deal that were more generous than some economists had expected. Macroeconomic Advisers, for example, had anticipated that various temporary business tax breaks—aka the "tax extenders"—would have been allowed to expire. Instead, the deal extends all of them for another year. The move has raised the firm's expectations for business spending in 2013, helping to nudge up its 2013 GDP forecast very slightly from 2.6 percent to 2.7 percent.

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Sarah Kliff · January 3, 2013