Correction: The article misquoted Joseph E. Gagnon, a senior fellow at the Peterson Institute for International Economics, as saying that “tax increases and spending increases hurt the economy.” He actually said that “tax increases and spending cuts hurt the economy.” This version has been corrected.
Even if Washington somehow finds a way to avoid the fiscal cliff — the automatic tax hikes and federal spending cuts that threaten to plunge the nation back into a recession — the economy could suffer a stiff blow next year from other looming changes in public policy.
A payroll tax cut benefiting 160 million workers is scheduled to expire at the end of the year, as are unemployment benefits for millions of people. Also on tap are new taxes on the wealthy and cuts in tens of billions of dollars in domestic and defense spending that will occur regardless of the fiscal cliff.
With the government putting less money into the economy and taking more out of people’s wallets, many economists estimate that these changes could reduce growth by at least one percentage point and leave at least 1 million more people jobless.
While economists and politicians have been warning about the dangers of the fiscal cliff, far less has been said about the more modest, yet serious, toll that these other government actions would take.
Of these, the biggest impact would come from the expiration of the temporary payroll tax cut, enacted in December 2010. Since then, the payroll tax that funds Social Security has been 4.2 percent, down from 6.2 percent, giving the average family an extra $1,000 to spend.
The disappearance of unemployment benefits would also hamper economic activity, especially because recipients usually spend most of the cash on food and other goods rather than saving the money.
Meanwhile, upper-income earners would see a slight increase in the taxes they pay under President Obama’s health-care law.
Finally, under an agreement forged last summer, the government is required to trim about $60 billion from domestic and defense spending next year.
Together, these changes could do at least as much to slow the economy as any other government action in the past half-century, according to Moody’s Analytics.
Coming out of the recent recession, it was inevitable that the government would eventually curtail policies that had been enacted to stimulate the economy. But some economists say it doesn’t make sense for the government to retrench while the economy remains fragile.
“The weakness of the economy means that 2013 is not a good year for any tax increase or spending cut,” said Joseph E. Gagnon, senior fellow at the Peterson Institute for International Economics and a former top official at the Federal Reserve. “Tax increases and spending cuts hurt the economy. So do them when the economy is healthy, not when it’s weak.”
Neither the White House nor leaders in Congress are calling for an extension of payroll tax cuts this year. Treasury Secretary Timothy F. Geithner said earlier in the year that they should not be renewed.
Still, the issue could be revisited after the election, when Congress will enter a period of furious fiscal negotiations. A White House official said the president wants the extension of unemployment insurance at the end of the year and would take a look at the payroll tax cut as part of a host of issues to be discussed after Nov. 6.
Congress may consider extending the payroll tax cut and other provisions then as part of the broader discussion of tax-and-spending policy, especially if the economy does not appear to be firming up.
There would be precedent. Despite gridlock, starting in late 2010, Congress and the White House have been able to inject hundreds of billions of dollars into the economy through payroll tax cuts and unemployment insurance extensions. This helped buffer the U.S economy from the European financial crisis, rising oil prices and the Japanese earthquake.
The economy is now growing at about the same pace as or more slowly than in previous years. It is facing fresh threats, too, including a historic drought and a global economic slowdown that is sapping U.S. manufacturing and exports, which had been fueling the recovery.
“This is not the right moment to repeal the payroll tax cut,” said Obama’s former top economic adviser, Lawrence Summers, in a speech Thursday. Even without an immediate way to make up the lost revenue, extending the payroll tax would be helpful, as long as the government eventually takes steps to control the federal debt, he said.
Alex Brill, an economist at the American Enterprise Institute and former top economist for the Republican-led House Committee on Ways and Means, said he would oppose another temporary payroll tax cut.
“I don’t think a one-sided approach where we make further commitments to unsustainable deficits is going to be an effective approach,” he said. “We need permanent tax policy and not to use the tax code as a turn-it-on, turn-it-off tool for managing the quarter-to-quarter performance of the economy.”
Mark Zandi, chief economist with Moody’s Analytics, said that it’s important for Congress to replace the severe tax increases and spending cuts of the fiscal cliff with a long-term plan that raises tax revenue and more gradually reduces spending. The cliff consists primarily of automatic $1.2 trillion of cuts in domestic and defense spending over the next decade, which Obama and lawmakers agreed to last summer if they could not reach another deal to trim the deficit. The cliff also includes the expiration of George W. Bush-era tax cuts.
But Zandi said the government should allow the other policies — such as the expiration of the payroll tax cut — to go ahead, even if it causes short-term pain.
“It’s a big drag and it’s very significant head wind to the economy, but I think that 1.5 percent drag is manageable,” he said. “The economy is going to struggle early next year, but we will avoid recession.”
There’s also another way the economy could suffer even if Washington finds a way to avoid the fiscal cliff. If policymakers decide, for instance, to delay the steep cuts and tax increases but fail to come up with an alternative to tackle the soaring federal deficit, growth could slow over the coming years. Concern about the fiscal health of the U.S. government could undermine business confidence and lead to higher borrowing costs for consumers, companies and the government itself.
Moody’s has warned that the failure to make any progress on long-term debt reduction would mean that the economy would grow much slower over the subsequent decade, with unemployment staying above 6 percent.
Moreover, credit-rating companies could further downgrade the U.S. rating if the White House and Congress fail to come up with a plan for putting the government’s finances on a sound footing.
Last summer, after the bruising fight between Democrats and Republicans over raising the federal debt limit, Standard & Poor’s downgraded the U.S. rating.
That has had a negligible impact on the nation’s borrowing ability so far. But a second downgrade by another agency might be more significant, because many types of investors, such as pension funds, cannot buy bonds if they do not carry the highest ratings of two agencies.