A Taxing Situation

 | Jan 02, 2013 | 4:00 PM EST  | Comments
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Some adverse effects of the fiscal cliff have been avoided for now, but we still have a spending dispute coming in the next two months, as well as a debate on raising the debt ceiling.

Those outcomes remain to be seen, but what wasn't up for debate was the extension of the temporary two-percentage-point payroll tax cut. This was designed as a temporary stimulus measure by reducing the contribution to the Social Security fund by most working Americans with the federal government covering the difference from federal coffers. Since we all know the concern about the long-term viability of Social Security in the future as the population ages, continuing the payroll tax cut wasn't seen by either party as a solid long-term measure, and these FICA withholdings will increase to 6.2% from 4.2%.

We do know that most workers will see their paychecks shrink in the new year due to the payroll tax cut, even if middle class income taxes don't change. Consumer spending, which is roughly two thirds of the economy, grew by an annualized rate of 1.6% in the third quarter. The savings rate is already a low 3.6%, particularly considering how consumers need to build retirement savings as the population ages and bearing in mind that the savings rate was previously as high as 8% to 10%. If faced with a smaller paycheck, would households further reduce their savings rate or cut their spending?

Not all households are created equal. The payroll tax cut would take about $175 billion from consumers, according to a Bloomberg calculation, with a household making $50,000 a year seeing a $1,000 hit to income, spread over the year in increments of about $84 less per month. But workers only pay payroll taxes, or FICA, on incomes up to $110,100. As such, the payroll tax cut will affect higher-income earners less -- unless they have household earnings more than $450,000 a year for a married couple or $400,000 for an individual.

Those in the top 1% of taxpayers (with incomes above $506,000) will see an increase in income taxes (not payroll taxes) that would subtract nearly $74,000 a year from their take home pay, according to the Tax Policy Center. Add in higher capital gains and other taxes, and the new provisions will increases tax revenues by about $600 billion, or about 4.5% of total consumer incomes (or 3.8% of GDP). Since wealthy households tend to save more of their incomes, however, the hit by the payroll-tax increase on the middle class arguably may have more of an effect on consumer spending.

Consumers may both reduce their savings rate and cut their spending. In real terms, consumers' aggregate wage and salary incomes grew by 3% from the third quarter of 2011 to the third quarter of 2012, but the average individual workers' weekly earnings only increased by 1.8% from 12 months ago. (The difference reflects more people working and other factors, such as year-end bonuses by some workers but not others.) When modeling consumer behavior, it behooves us to pay attention to individuals, not just the aggregate population, and the average weekly pay increase would theoretically be offset by the payroll tax cut.

Thus, if consumers split their payroll tax increase between cutting back on spending and reducing savings, we could see overall GDP growth reduced to 1% or so, according to some economists. This is a drop from the 3.1% pace in the third quarter, of which 0.73 percentage points came from inventories. In other words, growth of real final sales, the metric that excludes inventories (and where I focus my attention), would slow considerably from the 2.4% pace of the third quarter.

While we may avoid a recession, growth in consumer spending may be subdued. Consumers may focus more on the essentials and less on discretionary items. This, of course, will be determined by how inflation of food and fuel play out in the new year. Consumers don't have as much cushion to absorb any big price increases on these items, which tend to have volatile prices, before they cut back elsewhere.

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