Payroll Tax Cut: The Good And Bad News

by: Russ Koesterich, CFA

Now that Congress has finally come to an agreement on extending the payroll tax holiday and unemployment benefits through the end of 2012, a number of investors are asking me what this means for them.

The good news is that the extensions remove a near-term source of risk for both the U.S. and global economies.

If an agreement hadn’t been reached, disposable income in the United States would have taken an approximately $160 billion hit at a time when there is little organic real-income growth. This would have significantly impacted both the U.S. and global economies as the U.S. consumer accounts for roughly 25% of global consumption.

With the risk of that income hit removed, the chance that the United States and global economy will experience a recession in 2012 is now modestly lower than the 35% I predicted in January.

But the bad news is that significant risks remain for the U.S. and global economies. In the near term, Europe is still struggling to contain the risk of contagion from a potential Greek default.

Meanwhile, U.S. politicians have yet to address a far bigger and longer-term issue - the pending tax hikes and spending cuts scheduled to take effect in January 2013. In the absence of a policy change on this issue, which is unlikely ahead of the presidential election, the U.S. will face a fiscal drag of approximately 4% of GDP. The tax hikes and spending cuts, assuming they occur on schedule, would significantly lower U.S. growth in 2013, slow the global economic recovery and endanger the recent improvement in financial markets.

Still, agreement on payroll tax and unemployment benefit extensions was one of the signs I suggested investors watch for to confirm that slow, but positive growth is the likely economic scenario for in 2012. In my 2012 outlook piece, you can see the investments I advocate for three potential 2012 scenarios, including slow but positive growth.

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