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Economist: Failure to extend tax cut will slow recovery

COMMENTARY Congress has not been able to agree on extending the payroll tax cut, and as it stands, payroll taxes will increase in January. What impact will this gridlock have on the economy? What about the expiration of unemployment benefits, another effect of the failure to produce legislation on the payroll tax cut?

The payroll tax cut amounts to around $1,000 per year for the typical household, which adds up to a around $120 billion per year in additional purchasing power for the total workforce. If the payroll tax cut is not extended when Congress reconvenes, losing that much purchasing power would make an already slow recovery even slower.

However, if the tax cut is reinstated at some point and only lapses for, say, the month of January, then the impact will be much smaller. It would be inconvenient for workers to have their pay cut just as Christmas bills are arriving in the mail, but so long as the tax cut is reinstated relatively soon the economic effects shouldn't be too large. But if the tax cut is not extended at all (something I don't expect given how much the GOP seems to be losing politically over this move. But who knows -- I didn't expect it would go this far), then the impact would be more significant.
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To give some idea of the size of the impact, the approximately 800 billion dollar stimulus package was spread over two years, and this would be more than a quarter of the per-year stimulus. There is some question about the effectiveness of a payroll tax cut in stimulating the economy, but the initial stimulus package was also not designed as well as it could be, and was nearly 40 percent tax cuts, so the comparison probably isn't too far off.

The expiration of unemployment insurance is also worrisome. This has both a short-run and a long-run impact. In the short-run, it takes purchasing power away from unemployed workers, and the resulting fall in demand won't help the economy or the unemployed. It also promotes less efficient matching between workers and jobs, which has negative effects on economic growth in the longer run.

The issue is whether unemployment insurance should be extended beyond the 99 week limit at which point benefits usually expire. With the ratio of job seekers to job openings as high as it is, jobs remain very hard to find and there is no certainty that a diligent search for a job will be successful within the usual 99 week limit. For this reason, the benefits have been extended in the past, but even though labor market conditions remain dismal, the GOP is blocking a further extension.

If the Republicans succeed, 2 million people will stop getting checks, which average about $296 a week, in January. Another 5 million will lose benefits over the course of the year. All told, that would be a loss in purchasing power of $44 billion according to the CBO, and would put yet another drag on the economy.

The economy remains on shaky legs, and the combined impact of an increase in payroll taxes, a reduction in unemployment benefits, and the coming austerity measures as we begin dealing with the long-term debt issue could put a substantial drag on the already too slow recovery. We need to get the economy back on solid footing first, then tackle our long-run debt problem. But getting the order wrong and imposing austerity measures before the economy is ready is, as Europe is learning the hard way, counterproductive.

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