Bush tax cuts 101: Would extension boost the economic recovery?

The tax cut deal that President Obama struck with Republicans this week could provide a sizable boost to the US economy throughout the coming year.

However controversial the tax breaks are for their politics, that's the view of many professional forecasters.

For one, the proposed extension of Bush-era tax rates would prevent Americans from having to pay more taxes next year amid an already weak economic recovery, they say. Moreover, other parts of the deal struck between Mr. Obama and Republican leaders – notably a payroll tax cut and measures to help businesses – could add fuel to the recovery.

That's not to say the tax cuts are a panacea for all the economy's troubles. And with Mr. Obama under fire from his own party for agreeing to extend tax cuts for the richest Americans, the plan's passage by Congress in the days ahead isn't a sure thing.

Bush tax cuts 101: Who will get what if the Obama deal passes?

But forecasters say the tax deal could account for as much as 1 percent of economic growth in 2011 – a number that could be enough to rev up a now-tepid recovery and begin to reduce the nation's high unemployment rate.

Richard Berner, chief US economist at the investment firm Morgan Stanley, says the package of tax breaks would boost his forecast for economic growth next year to about 4 percent of gross domestic product (GDP), up from his current view of 3 percent. Beyond the direct effects of a cash infusion into the pockets of consumers and businesses, the tax cuts could have some benefits that are hard to forecast, he says in a report for clients.

"It would reduce the uncertainty around the tax issue, [and such] clarity could be a plus for growth," Mr. Berner and colleague David Greenlaw write. "Second, it could boost investors’ risk appetite, which would further ease financial conditions."

At least some cuts were anticipated

Prior to this week's bargain, economists had already based their forecasts on an extension of at least some of the Bush tax cuts. But the deal included some surprises with positive implications for growth, like a temporary payroll tax cut worth $120 billion.

Failure to reach a deal would cause economists to cut their forecasts for growth. For example, a White House memo Wednesday cited forecasts that a failure to extend the Bush tax cuts for the middle class could shave 1.7 percent off of gross domestic product in 2011.

Mark Zandi, chief economist at Moody's Analytics, now predicts roughly 4 percent GDP growth next year – with a bit more than 1 percentage point of that coming from the tax-cut package. Unemployment could drop to 8.5 percent by the end of next year, he figures, a big improvement from his current outlook of 9.6 percent.

Not all economists predict such strong growth next year, or as big an impact from the tax cuts.

But at the very least, economists say the removal of uncertainty about whether Bush-era tax rates will expire would reduce the risk of slipping back into recession, due to consumer and job-market weakness.

At best, the tax cuts could help the economy gather self-sustaining momentum. Increased consumer spending could nudge more employers to hire, which in turn could put still more money in consumer bank accounts.

In an interview televised Sunday, Federal Reserve Chairman Ben Bernanke said the economy needs growth of about 2.5 percent just to keep the unemployment rate steady. That's because an average of 125,000 people are expected to enter the labor market each month. In the past three months, the economy has been adding only about 60,000 jobs a month.

The Obama-GOP deal

Centerpieces of the framework Obama announced this week include:

• Keeping the Bush tax cuts in place for two more years.

• Extending unemployment benefits for the long-term jobless.

• Providing new incentives for business investment.

• Reducing the payroll tax rate paid by working Americans for next year to 4.2 percent rather than 6.2 percent. That lift in paychecks would give millions of families an extra $1,000 or so to spend in 2011.

• Setting the estate tax at 35 percent (it is currently slated to be 55 percent next year), with an exemption for $5 million in assets.

Although boosting after-tax income for rich and poor alike, tax cuts would mean more borrowing by the government.

Higher federal deficits now mean more debt to pay off later. Some economists, who see a relatively small chance that the economy will dip back into recession, argue that more federal stimulus is unneeded and unwise.

The countering view, held by both Obama and many private sector economists, is that reviving GDP growth and reducing unemployment is the only way to ensure a healthy stream of future tax revenues. Today's tax cuts can be followed fairly soon with a long-term deficit reduction plan – as outlined recently by the president's bipartisan fiscal commission.

Moody's Analytics pegs the overall scale of the tax breaks at $592 billion in 2011 and $388 billion in 2012.

About half of the total stems from extending Bush income-tax rates and a longstanding "AMT patch" to prevent the alternative minimum tax from hitting more middle-class households. The rest is mostly accounted for by reductions in business, payroll, and estate taxes.