Economists split on impact of allowing tax cut to expire in January

Economists are divided on whether the expiration of the payroll tax cut and unemployment benefits on Jan. 1 would hurt the economy.

The standoff between House Republicans and Senate Democrats on legislation that would extend both programs for two months has made it likely that the payroll tax rate will rise from 4.2 percent to 6.2 percent in January. 

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House Republicans argue the two-month extension of the tax cut would create uncertainty for business, while Democrats and President Obama say it is imperative to keep taxes from rising as the economy recovers. Democrats also say conservatives have never liked the payroll tax cut and are just using it as leverage for policy riders. 

Analysts at firms such as Moody’s Analytics, Goldman Sachs and Macroeconomic Advisers say the economic impact of failing to extend the tax cut and unemployment benefits would starve the economy of $140 billion in stimulus, reducing GDP by between 0.5 percentage points and 0.9 percentage points in 2012. 

Economists at those firms said that the biggest hit to the economy would come in the first quarter of 2012, when people start to receive smaller paychecks.

Moody’s Analytics economist Marc Zandi said if the policies are not extended quickly, the economy would be  “very close” to a double-dip recession in the first quarter. 

“The economy will be very vulnerable at that point to Europe and to the housing price declines,” he said. “If anything else goes wrong, we could be in a recession.”

Conservative economists at the American Enterprise Institute and The Tax Foundation, on the other hand, say the payroll tax cut has never provided much stimulus to the economy and worry an extension of jobless benefits will prolong unemployment.  

“Just in terms of straight economics, the effects are not large,” said Alex Brill of the American Enterprise Institute. 

Brill said the payroll tax holiday is similar to the tax rebates passed in 2001 and 2008 in that consumers mostly save the extra money rather than spending it, providing little boost to the economy. He said the uncertainty created by the brinkmanship in Congress is likely hurting the economy, however.  

The division among economists underlines the political divide in Washington over tax policy. 

Obama and other Democrats are arguing from the Keynesian perspective that the woes in the economy are due to a lack of demand that can be alleviated by putting more money in the pockets of consumers.  

Some Keynsians say the payroll tax cut works well because the extra money arrives steadily in a bi-weekly paycheck. Extra money in the paycheck is more likely to be spent because many earners spend everything that comes into their checking accounts, they argue.

“That is how I manage my checking account,” Zandi said.

Conservative economists are much more skeptical of stimulus and argue the right way to increase growth is to lower income taxes on high earners. They argue that cutting taxes stimulates investment.

Will McBride of The Tax Foundation argues that when the disruptive costs to human resource companies and payroll processors is taken into account, a payroll tax holiday does little to stimulate the economy in the short run and actually harms it in the long run.

McBride said Organization for Economic Cooperation and Development data suggests that in the long-term stimulus that encourages consumption over savings and investment harms growth. The right policy is to flatten the tax code, he said.

Among supporters of the payroll tax cut, there is some division over how harmful it would be if Congress waits and implements the tax cut and jobless benefits retroactively. 

Zandi said there would be little effect if Congress retroactively implements the policies.

A family making $50,000 would lose close to $40 from each paycheck, according to White House figures. So delaying the extension until mid-January would have a fraction of the effect of not extending the policy at all.

“A couple of weeks is not a significant event,” Alec Phillips of Goldman Sachs said. “If the policies are extended in the middle of the month, this something that doesn’t have long-term effect.” 

Joel Prakken of Macroeconomic Advisers said consumer expectations matter more and argued a lapse in the tax cut could quickly make people gun-shy about spending money. 

“If there is ironclad certainty that the holiday will be extended later on and retroactively, then the delay has very little effect,” he said. “However, the delay causes uncertainty over the final outcome, and that uncertainty reduces spending by reducing the expectation of future income.”

Professor Mark Thoma of the University of Oregon said predicting exactly how earners would react is still the subject of academic debate, but now is not the time to test out the theories of economists. 

“It is the wrong time to do anything that would potentially disrupt the recovery,” Thoma said. “Letting both of those things expire could send the recovery in the wrong direction.” 

One opponent of the payroll tax holiday agreed that it will be disruptive but said 2012 is the time to take the medicine. 

Jason Fichtner at George Mason University said the payroll tax cut should be allowed to expire because it reduces the flow of money to the Social Security trust fund, making the program more dependent on the general treasury, which is propped up by deficit spending. At some point, he said, the economy needs to be weaned from the tax holiday, and 2012 is as good a time as any. 

Analysts are generally in agreement that shoppers are not paying enough attention to the tax issue to dial back their Christmas shopping, which is up this year over 2010. They also do not expect much impact on the stock market. 

Brain Gardner of Keefe, Bruyette & Woods said that Wall Street did not go into a tailspin after the August debt downgrade and had likely “already priced in” low expectations that Congress can do anything for the economy.

“If there was some sort of pristine view of Congress, then this might shatter that,” Brill said. “My view at the moment is that there are pretty low expectations of Congress.”