Illustration by Bloomberg View
Illustration by Bloomberg View

Almost lost in the fiscal cliff debate is whether to extend two programs, the payroll-tax holiday and extended federal unemployment benefits. They have helped gird the economy over the past four years by putting more money in consumers’ pockets. They should be continued, though perhaps in less-generous form.

Both initiatives will end in January absent congressional action. Although their expiration would save the U.S. about $145 billion next year, allowing the benefits to cease would shave about 1 percentage point off economic growth in 2013, according to estimates by the Congressional Budget office and others.

The U.S. economy is simply too fragile to withdraw support cold turkey. About 12 million people are unemployed and 40 percent of them have been out of work six months or longer. The Federal Reserve expects the 7.7 percent unemployment rate to decline slightly if at all next year, with the economy growing just 2.3 percent to 3 percent. Retracting fiscal support now would slow that growth, push many unemployed workers into poverty and undermine the Fed’s efforts to juice the economy.

Smaller Scale

A more prudent course would be to continue both programs for another year, perhaps on a smaller scale. The payroll tax cut, for example, could be scaled back. The U.S. now deducts 4.2 percent from paychecks, down from the standard rate of 6.2 percent. Moving to a 5.2 percent tax would halve the program’s estimated $114 billion annual cost while still allowing workers to take home more pay.

What would happen if the payroll cut went away entirely? The move would result in an immediate tax increase of $920 for more than 122 million workers on average, according to the non-partisan Tax Policy Center. That financial bite would slow growth by 0.6 percentage point, according to estimates by Goldman Sachs Group Inc. and Moody’s Corp. To put it all in context, this is about the same rate of economic lift the Federal Reserve is trying to achieve through its bond-buying program. In other words, ending the payroll-tax holiday would essentially neuter the Fed’s efforts.

Cutting off extended unemployment benefits would be similarly misguided. States can now bolster their roughly 26 weeks of unemployment benefits with up to 47 additional weeks through two federally financed programs. Yet the duration of benefits, which are pegged to a state’s jobless rate, have been decreasing as the employment situation improves. Benefits already have gone from a maximum of 99 weeks to as little as 40 in 10 states.

The number of weeks available will continue to fall in tandem with the jobless rate and should not be increased. The Congressional Budget Office estimates that extending federal insurance another year would cost the U.S. about $30 billion in 2013, down from $159 billion in 2010.

The biggest knock against extending unemployment coverage is that it provides an incentive to remain out of the workforce. One economist at the University of California at Berkeley found that the jobless rate in December 2010 would have been about 0.2 percentage point lower, absent extended benefits. A paper by economists at the Federal Reserve Bank of San Francisco concluded that 99-week benefits pushed up the jobless rate even more -- by as much as 0.8 percentage point.

While extended benefits may dissuade some from taking jobs or engaging in more intensive searches, the primary driver of long-term unemployment is a slack labor market. Fed Chairman Ben S. Bernanke has said weakness in total demand (in other words, consumer and business spending and investment) is the “predominant factor” in persistent long-term unemployment.

Powerful Stimulus

Unemployment benefits are a powerful form of stimulus: The money is likely to be spent on food, rent, gas and other immediate needs. Cutting off the program would hurt demand and slow economic output in 2013 by about 0.35 percentage point, according to various estimates. (It would also result in 2 million people losing benefits the first week of January. In the past, benefits have been phased out to avoid such a sudden financial hit.)

There’s no question that the U.S. needs to spend less, yet it also needs to be smarter about when it retracts stimulus spending. It would be folly if lawmakers, in their zeal for immediate fiscal tightening, eliminated extensions to the payroll tax cut and unemployment insurance only to see the economy go wobbly again -- and the deficit shoot back up.

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