Tax Cuts May Spur Economy, Limit Need to Extend Fed Purchases

President Barack Obama’s agreement to prolong Bush-era income-tax cuts may reduce pressure on the Federal Reserve to extend its $600 billion bond-purchase program while spurring U.S. economic growth.

Obama’s deal with congressional Republicans may raise gross domestic product next year by as much as half a percentage point to about 3.1 percent, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. Tom Porcelli, a senior economist at RBC Capital Markets Corp. in New York, is raising his growth forecast for 2011 by one point, also to 3.1 percent.

The agreement goes beyond what economists were expecting by including a 2 percent cut in payroll taxes, which fund Social Security and Medicare. The proposal also sets the estate tax at a top rate of 35 percent, extends aid for the long-term unemployed by 13 months and would allow companies next year to deduct the full cost of investments in equipment.

“I think it does reduce the odds that the Fed does more purchases,” Feroli said. “You’re going to have a pretty nice increase in disposable income and that should lift consumer spending.”

Stocks rallied after the agreement was announced, sending the Standard & Poor’s 500 Index to the highest level since the financial crisis in September 2008. Gains were erased in the final hour of trading after Obama said he’ll push to overhaul the tax code in two years. Treasuries fell and copper rose to a 31-month high.

Payroll Tax

The payroll-tax cut would apply to all wage earners, an administration official told reporters on a conference call Dec. 6. That would be an $800 savings for individuals with an income of $40,000. Those who earn salaries of more than $106,800 would save a maximum of $2,136. The proposal would cost the government $120 billion, another official said.

The S&P 500 rose 0.1 percent to 1,223.78 at 4 p.m. in New York after surging 1 percent earlier. The Dow Jones Industrial Average was little changed at 11,359.16.

“This is a big deal for the stock market,” said Allen Sinai, chief global economist at Decision Economics in New York. The S&P 500 may rise from 15 percent to 20 percent next year, compared with his earlier forecast for a gain of 13 percent to 15 percent, he said. Sinai raised his economic growth forecast for next year by half a point, to a range of 2.75 percent to 3 percent.

The tax cuts would amount to a $115 billion increase in wage and salary income, Deutsche Bank Securities economists Joseph LaVorgna, Carl Riccadonna and Brett Ryan said in a note to clients. As a result, Americans would spend $108 billion more than the three had previously forecast.

Inflation-Adjusted Growth

That would boost gross domestic product by 0.7 percentage point, bringing inflation-adjusted growth for the fourth quarter of next year to a 4 percent annual rate, LaVorgna said in an interview.

Obama said this week he would accept lower rates on high earners’ income, dividends, capital gains and multimillion- dollar estates for the next two years to break a stalemate over extending the George W. Bush administration’s tax cuts for middle-income taxpayers before Congress adjourns. The current tax rates, enacted in 2001 and 2003, are set to increase Dec. 31.

The extension, and the economic improvement it brings, may reduce pressure on the Fed to extend its program of asset purchases beyond the $600 billion planned through June.

The tax plan takes “some of the pressure off the Fed” and means the central bank “may not need to do more,” said Nariman Behravesh, chief economist at IHS Inc. in Lexington, Massachusetts.

‘Mutually Supportive’

“Any tax deal and current Fed policy are mutually supportive,” Drew Matus, senior economist at UBS Securities LLC in Stamford, Connecticut, said in an e-mail.

Fed Chairman Ben S. Bernanke on Dec. 5 said “it’s certainly possible” the central bank may increase purchases beyond that amount approved by the Federal Open Market Committee last month. Policy makers next meet Dec. 14.

Some economists said the Fed is still likely to expand its asset-purchase program. The purchases are intended to reduce long-term interest rates, making it cheaper for firms to buy new equipment or consumers to purchase houses and cars.

“I am not sure that even with the added stimulus the Fed forecast will be where Bernanke wants it to be in June,” said Roberto Perli, a managing director at International Strategy & Investment Group in Washington and a former Fed Board economist. “The new fiscal measures certainly help, but there is a probability the Fed will want to do more than $600 billion.”

‘Better Than Even’

There are “better than even odds that the Fed buys more assets” in the second half of 2011, said Ethan Harris, head of developed-markets economic research in New York at BofA Merrill Lynch Global Research. Harris said the cuts could boost his 2011 forecast by 0.3 to 0.6 percentage point from a current estimate of 2.3 percent.

Bernanke, in a Dec. 5 interview on CBS Corp.’s “60 Minutes” program, defended the central bank’s efforts to spur the recovery, saying it may take four or five years for the jobless rate to return to a “more normal” level of 5 percent to 6 percent. The rate last month rose to 9.8 percent, the highest level since April.

Some Republican lawmakers, including prospective House Speaker John Boehner of Ohio, have said the Fed’s policy of “quantitative easing” may do little to help unemployment and risks weakening the dollar and fueling asset-price bubbles.

Marginal Rates

The tax deal would leave in place marginal rates created in 2001, ranging from 10 percent to 35 percent. It would also preserve for two years the 15 percent rate on most capital gains and dividends, and would temporarily index the alternative minimum tax for inflation. The plan, if approved by Congress, would extend aid for the long-term unemployed for an additional 13 months.

One benefit for companies would be an expensing proposal. Under the agreement, companies in 2011 could deduct the full cost of investments in equipment instead of following typical depreciation schedules. The tax benefit will be available even for planned investments.

Obama yesterday called the agreement a “a good deal for the American people” and said he will fight to end the tax cuts for the wealthiest taxpayers in two years, when the new extension expires.

“A long political fight that carried over into next year might have been good politics but it would be a bad deal for the economy and it would be a bad deal for the American people,” Obama said at a White House news conference.

Little Benefit Seen

House Speaker Nancy Pelosi said the extension of the top tax rates would widen the deficit with little benefit to the economy. The estate-tax provision adds “insult to injury,” the California Democrat said.

The plan would set the estate tax at a top rate of 35 percent, which applies after a $5 million tax-free allowance per individual. That rate would be the lowest since 1931 -- not counting 2010, when the rate was zero and replaced with a capital gains tax that applies when inherited assets are sold.

House Majority Leader Steny Hoyer said a continued tax break for the wealthiest Americans “is not warranted.” House Democrats haven’t decided whether they will support the compromise, said Hoyer, a Maryland Democrat.

“The last thing we need right now is gridlock in Washington,” Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co., said yesterday in an interview on “Bloomberg Surveillance” with Tom Keene. Pimco, based in Newport Beach, California, runs the Total Return Fund, the world’s biggest bond fund.

“Up to this point, the Fed was being asked to do all the heavy lifting with imperfect instruments,” El-Erian said. “The results of which is that policy effectiveness was falling short of expectations.”

To contact the reporters on this story: Ian Katz in Washington at ikatz2@bloomberg.net; Rich Miller in Washington rmiller28@bloomberg.net

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