Budget Accord Seen Crimping U.S. Expansion

Elimination of payroll tax cut will limit first-quarter growth to 1%.

The U.S. economic expansion probably will be crimped without being halted by the budget deal that won approval by the House of Representatives last night after being forged by the Senate and White House.

The agreement permanently reinstates the income tax cuts for most workers that ended Dec. 31, continues expanded unemployment benefits and delays automatic spending cuts for two months. It would let a two-percentage-point payroll tax cut expire.

The elimination of the payroll tax cut, coupled with higher income taxes on the wealthy, will help clip growth in the first quarter to 1 percent, from 3.1 percent in 2012’s third quarter, the latest data available, according to economists at JPMorgan Chase & Co. and Bank of America Corp. The expansion will strengthen later in the year as the housing market continues to rebound, they forecast.

“It’s going to definitely present a headwind for the economy,” Michael Feroli, chief U.S. economist for JPMorgan Chase in New York, said. “We’re looking for a downdraft in growth in the first half of the year, with the economy coming back in the second.”

The package isn’t the grand bargain on deficit reduction that lawmakers wanted when they created the tax-and-spending deadlines over the past three years. Instead, it would avert most of the immediate pain and postpone Congress’ fiscal feud for two months -- until a February fight over raising the $16.4 trillion debt limit.

The biggest hit to the economy from the fiscal package probably will come from the expiration of the payroll tax cut, Feroli said. Designed as a temporary measure to boost the economy in 2011, the reduction was extended through 2012. He reckons that its elimination will slow growth by just over a half percentage point this year by taking $125 billion out of consumers’ pockets.

Payroll taxes would rise, to 6.2 percent from 4.2 percent last year, ending transfers from the general fund to Social Security to cover its cost. That will make paychecks smaller in 2013; someone earning $50,000 and being paid twice a month will lose $41.67 per paycheck.

It “would have a meaningful impact because it hits everybody,” said Michael Gapen, a New York-based senior economist at Barclays Plc. “You’d see it in the first quarter, and consumption would ratchet down.” Higher taxes on the wealthy won’t have as much of an effect because top earners tend to save more of their income rather than spend it, he added.


Limited Progress

The first-half slowdown will mean that the U.S. will make limited progress in reducing unemployment in 2013, according to projections by Ethan Harris, co-head of global economic research for Bank of America in New York. He sees the jobless rate falling to 7.5 percent in the fourth quarter of 2013 from 7.7 percent in November 2012.

Regardless of how Congress dealt with the fiscal accord, “we’re probably going to see a slower economy in early 2013,” said Guy Berger, an economist at RBS Securities Inc. in Stamford, Connecticut. “Growth is going to be soft though not negative in the early part of the year, with the economy gradually picking up in the second half of the year.”

The agreement, initially forged by Vice President Joe Biden and Senate Minority Leader Mitch McConnell, a Kentucky Republican, averts the more than $600 billion in automatic tax increases and spending cuts slated to take effect this year, known as the fiscal cliff.

Households making less than $450,000 per year would be spared an income tax rate increase. The wealthy would see a rise in their top rate, to 39.6 percent, from 35 percent.

Asian stocks climbed, extending last year’s 13 percent global rally. The MSCI Asia Pacific excluding Japan Index climbed 1.7 percent as of 12:55 p.m. in Hong Kong, heading for its highest close since August 2011. Equity markets in Japan and mainland China are closed today and tomorrow for public holidays.

U.S. stocks rose Dec. 31 as lawmakers looked increasingly likely to reach agreement on the budget. The Standard & Poor’s 500 Index climbed 1.7 percent to 1,426.19 at 4 p.m. in New York, bringing the gain for the year to 13 percent.

Still ahead is an agreement on the U.S. debt ceiling. The U.S. on Dec. 31 hit its $16.4 trillion debt limit, forcing the Treasury Department to start taking what it called “extraordinary measures” to keep funding the government.


Exhaust Measures

The Treasury probably will exhaust such measures by late February or early March, setting up another confrontation between President Barack Obama and congressional Republicans, according Andrew Laperriere, senior managing director for ISI Group in Washington, said in a Dec. 31 report to clients. Laperriere spent eight years working on Capitol Hill before joining ISI in 1999.

Obama said Tuesday night while he is “very open to compromise” with Congress to reduce the deficit, including tackling rising Medicare costs, he won’t have another debate on whether to raise the debt ceiling.

“We can’t not pay bills that we’ve already incurred,” he said. “If Congress refuses to give the United States government the ability to pay these bills on time, the consequences for the entire global economy would be catastrophic, far worse than the impact of a fiscal cliff.”

When Congress threatened to default in August, 2011, “our entire recovery was put at risk,” Obama said. “Consumer confidence plunged, business investment plunged, growth dropped. We can’t go down that path again.”

He said he will work with Congress to reduce spending, “but we can’t simply cut our way to prosperity.”

The economy should prove resilient in the face of government belt-tightening because of the progress that the private sector has made in rebounding from the 2007-2009 recession, said Bank of America’s Harris.

“Both the housing market and the banking sector have healed significantly,” he said.

Residential real estate, which collapsed and helped trigger the 18-month economic downturn that ended in June 2009, is picking up. Existing homes sold at their strongest pace in more than two years in November and building permits reached a four- year high. Companies including Toll Brothers Inc. and KB Home are competing for buildable lots and raising prices.

“We’ve seen a virtuous cycle building in housing,” said Terry Sheehan, an economic analyst at Stone & McCarthy Research in Princeton, New Jersey.


Bouncing Back

Banks are bouncing back as well, with profits in the third quarter the highest in six years, according to the Federal Deposit Insurance Corp. in Washington.

The number of lenders on the FDIC’s confidential list of so-called problem banks -- those deemed to be at greater risk of collapse -- fell from 732 in the second quarter to 694 in the third, the smallest number since a peak of 888 after the financial crisis.

Another encouraging sign: The job market has held up even in the face of concerns about the possibility of higher taxes and government spending cuts in 2013. Payroll gains this year through November averaged about 151,000 a month compared with 147,000 in the same period of 2011.

Labor Department figures due Jan. 4 may show employers added 150,000 jobs in December, about the same pace as the prior month, according to the median forecast of economists surveyed by Bloomberg.

“Underneath the fiscal drama is an improving economy,” said Ryan Sweet, a senior economist at Moody’s Analytics. “The fiscal drag will take some wind out of it but once there is more clarity, we can expect stronger growth.”


Bloomberg News

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