Economists fear withdrawal symptoms if payroll-tax cut vanishes

It was the tax cut that nobody noticed when Congress enacted it a year ago. Now the question is, can anyone live without it?

The $120 billion payroll-tax cut, which was extended for two months until March just before Congress left town last week, turned out to be an addictive fix for consumers this year, providing an extra $20 to $30 in extra cash in every paycheck that - while nothing to write home about in any given week - provided a cumulative boost to consumer spending over the course of the year.

At first, surveys showed that most Americans hadn’t even noticed that they received a tax cut increasing their take-home pay. For the early part of the year, the tax cut served primarily to offset the fast-rising costs of food and fuel as gasoline prices approached record levels near $4 a gallon.

But the added spending power and support for consumers ended up paying off at a critical time around midyear, when the economy seemed in danger of falling into a double-dip recession. As the year progressed, the tax cut helped fuel a more convincing return to the shopping malls by consumers that is still providing a bit of oomph to the economy in the Christmas season.

“U.S. economy is accelerating,” thanks to the unleashing of a fresh wave of consumer demand this fall, said Alan James, an analyst at Barclays Capital. “The extension of the payroll-tax cut is important to maintaining the momentum.”

Black Friday, the day after Thanksgiving, was the best shopping day in years, and the prime Christmas sales season from Dec. 1 to Dec. 24 clocked in with sales 4.7 percent higher than last year, research firm ShopperTrak reported Wednesday. The day after Christmas also appears to have been one of the busiest shopping days of the season, the firm added.

While the consumer mood brightened considerably thanks in part to the tax cut, economists remain concerned that Congress extended it only temporarily and did the same with emergency unemployment benefits. The two parties remain at loggerheads over how to pay for a full-year extension that all sides say they want to enact early next year.

“The consequences of not extending these measures through the remainder of 2012 would be dramatic,” said Gregory Daco, an economist at IHS Global Insight.

Expiration of the tax cut would shave 1 percentage point or more off the economic growth rate for the year, and growth likely would disappear altogether in the first quarter after it is withdrawn, analysts estimate.

While the tax cut remains in place for now, observers of Washington’s long-running political impasse are not entirely confident that the parties will be able to overcome their entrenched differences in the next two months and extend programs that have a cumulative cost of $200 billion.

“The ongoing political feud could still turn into a breakdown of the political apparatus, and a lapse in the payroll-tax cut and emergency unemployment benefits payments,” Mr. Daco said.

While the loss of the tax cut would affect the most people, an estimated 160 million households, the loss of unemployment benefits would cause the most hardship for an estimated 4 million to 5 million households that depend on the payments for such basic needs as food and housing, he said.

“It would be disastrous for families reliant on unemployment benefits” who have few other financial options, Mr. Daco said.
Allowing the tax cuts to lapse “would have a tangible negative impact on the economy” and cause “a major strain on household incomes,” said Harm Bandholz, an economist at Unicredit Markets.

Consumers also would experience a blow to confidence from another failure of the political parties in Washington to agree on essential matters affecting the economy, he said.

A principal reason many economists are concerned about the tax cut expiring is the slow growth this year of wages, which normally fuel consumer spending.

At less than 2 percent, wage growth did not keep up with the 3.5 percent inflation rate in the past year, so typical workers who rely almost exclusively on wages for income would have lost considerable purchasing power without the tax cut.

The Council on Foreign Relations estimates that consumer spending fueled 91 percent of economic growth this year, but less than half of that spending was driven by the usual source - increased incomes. About a third of the spending was paid for by consumers dipping into their savings, and about a fifth was driven by the payroll-tax cut, the group estimated.

“U.S. consumers are maintaining surprisingly brisk personal consumption and retail spending despite low real wage growth,” said iShares Global Chief Investment Strategist Russ Koesterich. “While consumers can maintain spending by reducing saving for a while longer, it is not sustainable over the long term.”

With wages growing at the slowest rate since February 2004, Americans also have become heavily dependent on government transfer programs such as Social Security and unemployment benefits for their income, he said, including the benefits for the long-term unemployed that Congress coupled with the temporary tax-cut extension.

“Such transfer payments have accounted for approximately 60 percent of all income growth over the past 45 months and now constitute 20 percent of disposable income,” Mr. Koesterich said. “Any cutbacks in transfer payments could have a significant and immediate impact on consumers’ ability to sustain their relatively brisk spending.”