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10/12/2010 | Tax Deal Boosts U.S. Growth Prospects in 2011

Nigel Gault

The tax deal struck by President Obama and the Republican leadership would boost 2011 growth to around 3.0%, from the 2.4% projection in our December forecast.

 

The tax compromise agreed upon by the president and Republican congressional leaders (although not yet by congressional Democrats) carries a price tag of $900 billion, and injects meaningful extra stimulus into the economy. What does it mean for our forecast? The forecast implications are not driven by the headline size of the package, since many components were already embedded in our forecast assumptions. The forecast implications depend on the differences between what is in the tax compromise and what we had assumed would happen.

Tax Package Components That We Had Already Incorporated in Our December Forecast

  • There is to be a two-year extension of the Bush-era individual income tax cuts. We had included such an extension in our December forecast (before December, we had assumed that the upper-income tax cuts would only be extended for one year).
  • There is another temporary "fix" for the Alternative Minimum Tax, which would otherwise have hit millions more taxpayers starting with 2010. The fix covers 2010 and 2011. Our forecast already assumed such a fix (which we assume will be extended indefinitely).
  • The "Making Work Pay" tax credit, part of the original ARRA stimulus package, will expire on schedule at the end of 2010. This matches the assumption in our December forecast. Before December, we had assumed a one-year extension of Making Work Pay, but because we saw little political support for its extension, we removed it.
  • The R&D tax credit is extended, effective January 1, 2010. We had always assumed that the R&D credit would be extended.

Tax Package Components Not Included in our December Forecast

  • There is a one-year reduction in the employee Social Security tax rate of two percentage points, from 6.2% to 4.2%. This is worth $120 billion for 2011 (0.8% of GDP). The payroll cut replaces the Making Work Pay tax credit, but it is roughly twice as large. The Social Security tax cut is capped at a maximum of $2,136 per worker by the $106,800 earnings limit (above which Social Security tax is not levied), but it does not phase out, unlike the Making Work Pay credit. So, the payroll tax cut is less tilted towards lower incomes than the Making Work Pay credit.
  • Several smaller personal tax incentives that were part of the original ARRA stimulus package are being extended for two years.
  • There is an expanded incentive for business investment in the form of 100% upfront depreciation (i.e., expensing) in 2011 for equipment and software. In 2010, there is a 50% first-year bonus depreciation scheme already in place. In our December forecast, we had not assumed any special depreciation schemes for 2011.

Implications for Our Forecast

Full details on the package have yet to emerge, and nothing has yet passed into law. But an initial look suggests that the package is likely to raise our 2011 GDP growth forecast from the present 2.4% to around 3.0%, through extra consumer spending generated by the payroll tax cut and extra business equipment spending generated by the expensing provision.

There have been suggestions that the payroll tax cut on its own might produce a bigger impact than that. The payroll tax cut is worth 0.8% of GDP and if the multiplier for such a tax cut exceeds one, then the GDP impact would be greater than 0.8 percentage point. But there are two factors that will dampen the impact, making it highly unlikely that the multiplier for this particular payroll tax cut will exceed one. We think a more plausible multiplier is 0.6 or less (which would generate a GDP impact in 2010 from the payroll tax cut alone of at most 0.5%).

First, the cut is only for employees. It gives no extra incentive for employers to hire. For employees below the earnings limit, there is a reduction in the marginal tax rate that does give a greater incentive to supply more labor, but that effect is likely to be small. In any case, the problem in the labor market is not lack of supply, but lack of demand. For employees above the earnings limit, the payroll tax cut is just a lump-sum that does not affect the marginal tax rate.

Second, the payroll tax cut is temporary, not permanent. In effect, it is very similar to temporary tax cuts that have been tried before (for example, in 2008), except paid out gradually through lower tax withholding over the course of the year instead of as a lump sum. The response of consumer spending to temporary tax cuts tends to be lower than that to permanent tax cuts, because consumers try to smooth out their consumption spending instead of splurging and than having to pull back when the tax cut expires.

We are also skeptical that 100% expensing will have a huge impact on business spending. Expensing is effectively an interest-free loan from the government, because depreciation taken up front cannot be taken later on. So it shifts taxes into the future. The value of that benefit (through present-value discounting) depends on the interest rate, which is low at present, making the benefit relatively low. Expensing does provide a big upfront cash benefit to corporations, but lack of cash flow does not seem to be an important factor holding back spending, except possibly for small companies. Overall, corporations are already awash in cash. There may well be a surge of spending at the end of 2011 to lock in the depreciation benefit before it expires—although that will depend on whether it really is expected to expire in 2012.


Global Insight (Reino Unido)

 


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