Economists are growing increasingly concerned that Congress and the Obama administration may fail to strike a deal on the fate of Bush-era tax cuts by the end of the year, a stalemate which threatens to cause significant damage to the US recovery.
Last week, lawmakers returned to their districts to campaign for the November midterm elections, deferring until after the polls any discussion about extending more than $3,000bn in tax cuts that expire on December 31.
“There is a good chance that they are not going to be able to work out a deal during the ‘lame-duck’ session,” said Andy Laperriere, head of policy research at ISI, the investment adviser.
The higher odds that a tax increase will take effect for all Americans in January have increased the “downside risk” for the economic outlook, since it would amount to a big fiscal tightening when any stimulus measures are unlikely, given fears about the high budget deficit. “If all the tax cuts and benefits expired at the end of the year then a recession would become pretty likely,” said Jan Hatzius, chief US economist at Goldman Sachs.
Goldman last month warned that allowing all tax provisions to expire at the end of the year would subtract nearly 10 percentage points from annualised disposable income growth in the first quarter of 2011, leading to a near 2 percentage-point drag on gross domestic product in the first half of the year.
If the tax cuts lapse, Tim Geithner, Treasury secretary, could try to mute the impact of the change by freezing the rate at which federal taxes are automatically deducted from people’s pay cheques until a new law is enacted. This would hold taxation at 2010 levels while Congress and the administration try to hammer out a deal, but it is unclear whether Mr Geithner would be willing to take such action. The Treasury declined to comment.
While the concern among economists is mainly focused on the potential impact of less spending power for Americans starting next year, some also worry that the US recovery could also be hurt in the current quarter by the uncertainty surrounding tax policy, as consumers hold back on shopping in anticipation of a tax rise.
“The longer it takes for Congress and the administration to come to some agreement, the bigger the drag on the economy,” says Michael Hanson, a US economist at Bank of America Merrill Lynch. He says the BofA forecast is for 1.5 per cent growth in the US economy both in the fourth quarter of this year and the first quarter of 2011, and “fiscal concerns weigh very heavily on that outlook”.
Conversely, the Congressional Budget Office has said that a permanent extension of all the Bush-era tax cuts would boost US output by somewhere between 0.5 per cent and 1.4 per cent next year, and between 0.6 per cent and 1.9 per cent in 2012. But Doug Elmendorf, CBO director, has warned that while extending the tax cuts would help the economy in the near term, the budgetary hole caused would lead to lower growth later.
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