Allowing payroll tax cuts to expire could harm economic recovery

December 21, 2011

If Congress does not reach agreement on extending payroll tax cuts and unemployment insurance benefits that are set to expire at the end of the year, the fragile U.S. economic recovery will be at risk, economists say.

In the absence of Without a deal, most American workers would receive less money in their first paycheck of 2012, with a typical earner getting about $20 per week less after taxes in their after-tax income. Also, jobless benefits would be cut off for about 3.5 million people who have been unemployed for long periods — up to 99 weeks— would see their jobless benefits halt abruptly.

The economy is in a delicate spot, barely growing fast enough to keep the unemployment rate from rising. A tax increase in 2012 could slow economic growth enough to make the jobless rate rise again. At the least, the tax increase could make the economy more vulnerable to outside shocks, such as last year’s spike in oil prices or new financial turmoil in Europe.

“We’re right on the knife’s edge, and when you’re operating this close to the edge, the last thing you need is a wind to come along and push you over,” said Stuart Hoffman, chief economist at PNC Financial Group. “The risk is that if payroll taxes go up, it takes an economy that is comfortably in moderate growth territory and slips back.”

The policies that Congress is looking to extend — there is bipartisan agreement on taking the actions, but not on how to pay for them — would pump about $140 billion extra into the U.S. economy in over the course of 2012, increasing the amount of money Americans have to spend by that much.

What that would mean for the economy depends in part on one’s assumptions about how the $140 billion would be spent and circulated around the economy. Many forecasting firms say that not extending a failure to extend the tax policies would reduce growth by about 1 percent to 1.5 percent. That slower growth would mean perhaps 500,000 to 750,000 fewer jobs created.

Even with the tax cuts and extended benefits, most forecasters are projecting that U.S. economic growth next year would be about 2 percent to 3 percent. Below 2 percent growth, the unemployment rate probably would get stuck at a high level or even begin rising again.

There’s a real danger that even a modest sign of to economic growth could tip the economy from a virtuous cycle of rising incomes and falling unemployment rates to a vicious one. Many economists fear that if growth slowed to about 1 percent, it would be a “stall speed” that eventually would result in another recessionat which another recession eventually results.

After the temporary payroll tax cut was enacted a year ago, it provided enough of a lift in the first few months of 2011 to buffer the U.S. economy against the effect of higher oil prices and supply disruptions caused by the earthquake in Japan. Economic growth averaged less than 1 percent in the first six months of the year but could have contracted without the temporary tax cuts.

Political observers say Congress might allow the policies to expire at the end of December but move quickly in January — amid popular anger over tax increases — to renew them. Economists said that scenario probably would not do any lasting economic damage.

“The upshot is that if reinstated by mid-January, the effects on disposable income from a lapse in the payroll tax cut . . . could be mostly reversed before the end of the month,” Alec Phillips, an economist at Goldman Sachs, said in a research note. A lapse in the emergency jobless benefits would have even less effect on the overall economy but “would be more disruptive for the limited number of individuals affected.”

Although the unemployment insurance benefits are less important than the payroll tax for the overall U.S. economy, the insurance money represents a major factor in certain state economiesthe economy of certain states.

There is another set of risks: The sheer uncertainty surrounding tax policy — and particularly the haphazard last-minute nature of the political system — may be damaging for business and consumer confidence.

“This is just ridiculous,” said Diane Swonk, chief economist at Mesirow Financial. “I never thought as an economist I would have to spend so much time doing political analysis. It's hard to plan ahead when every policy decision waits until the last possible minute.”

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