I don’t know that we needed another analysis of the effect of the expiration of the payroll tax cut, but JPMorgan Chase provided that yesterday. They estimate a cut to GDP of 0.6% next year from canceling the payroll tax cut, which will suck $125 billion out of the economy.

As mentioned above, we no longer expect the 2%-pt reduction in payroll tax rates to be extended at year-end—a change that will increase payroll taxes and reduce household disposable income by around $125 billion next year. This tax holiday was initially agreed to in late 2010 as a one-year stimulus measure, partly to replace the expiring Making Work Pay tax credit and partly as a sweetener to get the Democrats in Congress and the White House to go along with a two-year extension of the Bush tax cuts. Last year, as the economy foundered, the Administration pushed for the payroll tax break to be extended another year. After a little resistance, Congressional Republicans agreed to this request.

Our expectation earlier this year was that the economy would remain sluggish and the Administration would once again push for an extension of the payroll tax credit, in order to avoid adding fiscal tightening to an already tepid recovery. The economy has indeed remained sluggish, and yet the Administration has shown little desire to push for an extension of the payroll tax holiday. In this sense, the change in our view
wasn’t because of something that happened, but rather what didn’t happen: few in the political establishment came forward to push an extension of this tax break. As such, we are now incoporating a 2%-pt increase in payroll taxes early next year into our forecast.

So you’ll get your paycheck in January, and at a minimum it will be 2% less than it was in December. Given that we’re still in the midst of deleveraging, and that households have a high propensity to spend any windfall in money delivered to them, JPMorgan believes that the spending multiplier is significant. Their prediction of an 0.6% reduction in GDP is roughly in line with other estimates. And it’s a bigger drag on growth than from other elements of the fiscal cliff. I don’t think Matt Yglesias is quite right here that there’s a supply-side effect to the expiration – the payroll tax cut is all on the employee side, not the employer side, and I don’t see how it impacts labor costs at all – but there’s no doubt that it creates a big headwind for the economy.

But nobody in Washington wants to extend it. Maybe they feel they can get away with this kind of fiscal drag. I don’t really see why, but maybe they think the economy has reached “escape velocity.” More likely, Democrats want to avoid the perceived threat to the Social Security trust fund, and Republicans aren’t too enthused about it either. That can be avoided simply by tweaking the design of the tax cut, and separating it from the Social Security situation through a different mechanism. But that kind of thinking doesn’t fly in Washington, I guess. So we’ll create this unnecessary headwind for the economy at precisely the time when the recovery needs the support.

David Dayen

David Dayen