Payroll tax deal could boost U.S. economy

President Barack Obama speaks about the "Community College to Career Fund" and his 2013 budget at Monday, Feb. 13, 2012, Northern Virginia Community College in Annandale, Va. (AP Photo/Charles Dharapak) Charles Dharapak

A congressional deal to extend both a payroll tax cut and jobless benefits through year-end is unlikely to provide a major jolt to the U.S. economy, but it should help support the recent upturn in growth.

Under the agreement, which lawmakers were expected to announce as early as Wednesday, employees' share of the Social Security tax on earnings would remain at 4.2 percent, rather than the usual rate of 6.2 percent. That will result in lower taxes for 160 million Americans, providing a tax cut of roughly $960 for a typical worker making $50,000 a year and more than $1,900 for anyone with annual income of $100,000.

Despite the fierce partisan conflict in Washington over the payroll tax extension, many experts say the cut will help stimulate the economy even as it temporarily shrinks federal revenue. A 2011 report by Moody's Analytics estimated that every $1 decrease in revenue from reducing the payroll tax for workers expands the economy by $1.27. Reducing payroll taxes is also a more effective way of boosting growth than most other fiscal measures, including offering housing tax credits, an employer-side payroll tax cut, and even an across-the-board tax cut, according to the research firm. 

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By contrast, failing to extend the payroll tax cut and unemployment benefits, which President Obama and Congress passed in 2010 as part of a broader tax-relief package, could stifle growth just as the economy is gaining steam. "If they are not extended, real GDP growth will be nearly a percentage point slower in 2012 and there will be approximately one million fewer jobs by year's end," warned Mark Zandi, chief economist at Moody's Analytics, in the report.

The Center for Budget and Policy Analysis estimates that allowing the payroll tax cut to revert to its previous rate would add nearly $400 to the 2012 taxes for a worker earning roughly $20,000 a year, $790 for those making $40,000, and more than $2,200 for employees with annual income of $123,000. "Failure to extend the payroll tax cut would harm workers in nearly every job and income category," researchers at the Washington think-tank said in a recent report. 

The benefit of the tax cut is fairly straightforward: Handed a little more money in their paycheck every two weeks, people tend to spend it. That boosts demand. Although the tentative deal in Washington only cuts the average employee's tax bill by about $20 a week, that could help spur spending at a time the economy is picking up speed. The nation's gross domestic product rose 2.8 percent in the fourth quarter, up from 1.8 percent in the previous period and the fastest pace since the second quarter of 2010. The unemployment rate also declined sharply in January to 8.3 percent, a three-year low. Other signs of life in recent months include resilient consumer spending, growth in factory output, and rising home construction.

Allowing jobless workers to continue collecting unemployment insurance benefits could benefit the economy even more than holding the line on payroll tax cuts. The Congressional Budget Office ranked it first last year among fiscal measures as a way to stimulate economic growth.

Although these measures will help shore up the economy as it continues to heal, they are unlikely to kick it into overdrive. Economists estimate the deal over payroll taxes only maintains the two percentage-point decrease that prevailed in 2011, when the economy struggled for much of the year. It also remains to be seen whether other steps the Obama administration has taken of late to speed the recovery, such as a $25 billion pact with big banks to settle foreclosure abuses and offer mortgage relief to homeowners, will do much to boost growth.

Economic prospects for the millions of unemployed Americans also remains grim. Under the payroll tax-cut deal, negotiators agreed to reduce the number of weeks of benefits that workers would be eligible to receive if they lose their jobs. The maximum number of weeks of benefits in states with the highest jobless rates would be cut from 99 weeks to 73 weeks by the end of the year.

Whatever the ultimate economic benefits of the payroll tax deal, all signs point to it being one of the only forms of economic stimulus likely to prove politically palatable in Washington.

"Payroll tax cuts are not the best way to stimulate the economy, but unlike other policies, such as increased infrastructure spending or a jobs bill, they have the advantage of being politically feasible," University of Oregon economist Mark Thoma said in an email. "And payroll tax cuts certainly have enough of an impact to help the recovery, [and] enough to create worry that the recovery would be slowed if they were to be eliminated. The time will come when we will be able to reverse short-term stimulus measures, but the recovery is just beginning and we aren't there yet."

For Obama, who earlier this week exhorted Republicans to extend the payroll tax cut in presenting his fiscal-year 2013 budget, the agreement would help the White House dodge an economic bullet just as the election season gears up. "Congress needs to stop taxes from going up on 160 million Americans by the end of this month," he said Monday. "And if they don't act, that's exactly what will happen. Congress needs to pass an extension of the payroll tax cut and unemployment insurance without drama, and without delay, and without linking it to some other ideological side issues."

  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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