D.C. Gridlock Could Hurt Economy in Early 2012

By Zachary Roth and Daniel Gross

On the long list of risks the economy faces in 2012, the prospect of Congressional inaction would seem to rank quite low. But thanks to legislative tripwires on issues such as the payroll tax, unemployment benefits, and Medicare reimbursement rates, gridlock over the next few weeks may have a significant impact on growth next year.

The economy grew at a 2.0 percent annual rate in the third quarter, and Macroeconomic Advisers pegs fourth quarter growth at 3 percent. The White House had hoped to address all three issues as part of a grand bargain on deficit reduction. But the failure of the "supercommittee" to hammer out a big deal nixed that plan. Economists suggest the cumulative cost of inaction on all three measures could result in a reduction of several hundred billion dollars of demand — not enough to tip the economy into recession on its own, but enough to slow it down and boost the unemployment rate.

"It increases the headwinds for this economic expansion," Gary Burtless, a senior fellow in economic studies at the Brookings Institution, told Yahoo. "It makes it much much harder for a weak economy to expand at all."

In the accompanying video, we discuss the relevant items:

Payroll tax cut. Late last year as part of a White House-GOP deal to extend the Bush-era tax cuts, Congress and the White House agreed to a temporary, one-year reduction in the payroll tax that funds Social Security. Instead of paying 6.2 percent on the first $106,800 of income, individuals would only pay 4.2 percent. Come January 1, 2012, the rate reverts to 6.2 percent — unless Congress and President Obama agree on an extension.

That would amount to a significant tax increase on wages — about $180 billion — and a reduction of spending and demand in the economy at large.

Michael Pond of Barclays Plc told Bloomberg TV last week that a failure to extend the payroll tax cut would likely cause his bank to reduce its estimate for first quarter growth next year by 1.5 percent. "It's that big," Pond said.

Estimates that look at 2012 as whole tend to be more conservative -- though still significant. Our analysis of a study released last month by the non-partisan Congressional Budget Office (CBO) suggests that the end of the payroll tax cut would mean a hit to GDP of anywhere from $18 billion to $108 billion. Using the mid-point of that range, that means a roughly $63 billion impact for the year -- or over 0.4 percent of GDP.

Unemployment Benefits. Typically, unemployed workers receive 26 weeks of benefits. But since the onset of the recession, Congress has repeatedly passed extended benefits. Last December, as part of the same deal that extended the Bush tax cuts and temporarily reduced payroll taxes, Congress agreed to reinstate the Emergency Unemployment Compensation (EUC) program, which extends benefits for workers in high-unemployment states for 34-53 additional weeks. Combined with other programs, some workers can receive up to 99 weeks of benefits. But the EUC, like the payroll tax, is scheduled to expire on January 1, 2012. Extending the benefits for another year, as President Obama proposes, would represent an additional $45 billion in spending.

The dollar amount is smaller than the payroll tax cut. But economists argue that the economic impact of extending benefits (or not extending them) is larger than it might seem. People on unemployment tend to spend their benefits quickly — on rent, groceries, or gas — thus providing a jolt. The Economic Policy Institute, a labor-backed group that supports extending the benefits, projects that failing to do so would cut GDP by $72 billion in 2012, or half a percentage point. Again, the CBO study is more conservative. It finds a mid-range estimate of around $42 billion, or 0.3 percent.

If neither the tax cut nor the extended jobless benefits are extended, then, the combined impact on GDP would likely be around 0.8-0.9 percent of GDP. That jibes with a prediction by Mark Zandi, chief economist at Moody's Analytics, who recently put it at nearly one percentage point.

Burtless projects that failing to extend both measures would add about 725,000 Americans to the jobless rolls next year. That translates into an increase in the unemployment rate of around half a percentage point, compared to what it would have been had both measures been extended.

The Doc Fix. The third potential economic hit is both the smallest and the most familiar. Several years ago, Congress decided to hold down Medicare costs by cutting back the amounts it paid to health care providers over time. But each year since 2003, as doctors howled and lobbied, Congress has acted to spare the healing profession from unkind cuts, requiring billions in extra spending. The annual routine has become know as "the Doc Fix." For 2012, the Doc Fix is likely to cost $22 billion. If Congress fails to act, in other words, a large group of professionals will face significant wage cuts. While few people weep for the financial predicament of generally well-paid doctors, it would nonetheless have a significant effect.

All in, it's likely that inaction on these three items could make growth 1 percentage lower in 2012 that it otherwise would have been.

What's the likelihood of this trifecta of this coming to pass?

The White House has been mounting a full-court press for the payroll tax cut. Failing to extend the cut, President Obama said this week, would deal a "massive blow" to the economy, and raise taxes on 160 million Americans. Republicans tend to like tax cuts, and they've said they're open to the idea, but they oppose the White House's plan to pay for it by raising taxes on millionaires. Instead, they want to cut federal pay, and reduce the number of people who get benefits like food stamps and healthcare for the elderly. The usual cycle of proposal, counterproposal, and brinksmanship has already kicked in to high gear. Most observers expect a deal to get done before the end of the year, but given Washington's level of dysfunction (remember the debt ceiling fiasco?), and the short-time frame, there are certainly no guarantees. Chance of action: 80 percent.

The odds on an extension of jobless benefits -- also being pushed by the Obama administration -- seem somewhat lower. Many Republicans opposed the original extensions last year, arguing that they reduce the incentive to find work. While the main Republicans running for president have come out in favor of a payroll tax cut extension, they've generally been quiet on unemployment insurance. Politically speaking, spending programs like unemployment insurance are much less potent political issues than tax cuts. Change of passage: 50 percent.

As for Medicare reimbursement, Congress has acted every year since 1996 to avert a drop in the rate. And this tends to be a non-partisan issue: Democrats like their parents' physicians as much as Republicans do. So it's likely they'll do so again, whether before or after the end of the year. "We are confident they will act," the American Medical Association told Yahoo in a statement. (Of course, most Washinton organizations were confident the Supercommittee would hash out a grand debt bargain.) Chance of passage: 95 percent.

Our odds — and recent history -- suggest that the largest chunk of the potential fiscal hits will be averted in the next few weeks. But as investors, policymakers and companies fret about the impact of the European debt crisis and the moribund housing sector, they shouldn't completely write off the potential for Washington-imposed fiscal blows.

Zachary Roth is senior national affairs reporter at Yahoo! News

Daniel Gross is economics editor and columnist at Yahoo! Finance

Follow him on Twitter @grossdm; email him at grossdaniel11@yahoo.com