Looking Beyond The Latest (And Last) Fiscal Stimulus For The Unemployed

Those collecting unemployment checks can rest easy - the Senate has just extended unemployment benefits through November 30 in another attempt to round up a few straggling votes for the mid-term elections. The fact that instead of creating jobs, the administration is still stuck with perpetuating the sugar high that achieves nothing but merely adds tens of billions more to the US debt, is just as appalling as the fact that this little sham is supposed to incite populist support for the president. Yet even as Europe is just starting out on its farstatic voyage, ours is slowly coming to its end: this latest fiscal stimulus could well be the last one. Here are the thought's of Goldman's Alec Phillips on just how great of an economic deterioration and slow down we should expect as a result of the eventual elimination of various fiscal stimuli.

The End of the Road for Fiscal Stimulus?

Today the Senate moved forward on a renewal of extended unemployment benefits through November 30. The good news is that this will avoid further income disruption for those who had expected to receive benefits, thereby reducing any additional drag on growth from fiscal policy in 2H2010. The bad news is that this latest extension of fiscal stimulus may be the last. Congress looks increasingly unlikely to extend ay more fiscal aid to state governments, despite ongoing shortfalls in state revenues, and they have already let several other items lapse.

We are therefore removing from our estimates an assumption of further fiscal stimulus beyond the policies in law (including this week’s unemployment extension), though we continue to expect extension of most of the expiring 2001/2003 tax cuts. This adds almost a full percentage point to the drag on growth from Q4 2010 to Q4 2011 to what we had already estimated.

The Senate today moved forward with a renewal of extended unemployment benefits through November 30. Enactment is likely by the end of this week. The result will be a resumption of benefits by next week for roughly 2.9 million workers whose eligibility lapsed since early June.

However, this latest renewal, which omitted some related policies (see below) and did not extend any of the other expired or soon-to-expire provisions enacted in the American Recovery and Reinvestment Act (ARRA), signals that the likelihood for extension of these other items has declined.  We have noted this possibility in the past (see most recently, “Stimulus Extension Becoming More Difficult,” US Daily, June 29), but with another congressional recess approaching and little legislative discussion of additional extensions, the likelihood has declined enough that we are formally revising our assumptions.  Most recently, this consisted of four sets of items:  

1. Unemployment insurance. Our estimates have assumed renewal through 2011 of the extended eligibility period (up to 99 weeks) for unemployment benefits, based mainly on our view that the unemployment rate would remain elevated. When Congress finally let extended benefits expire in previous cycles, the unemployment rate had peaked an average of 23 months prior, and had dropped by an average of 1.7 points. After this latest round expires November 30, extended benefits will have been in place for 28 months, or roughly the average period in previous recessions, though the unemployment rate will undoubtedly be higher than at any previous point at which extended benefits expired in the past (the highest rate previously was 7.4%).  It should also be noted that although Congress renewed the extended benefit period, it did not renew the tax deductibility of benefits or the extra $25/week payment, both of which were enacted in ARRA. So even with its renewal, the policy is becoming somewhat less generous.

2.  State fiscal aid. State governments have received just under two-thirds of the $145 billion Congress allocated for fiscal aid to state governments in ARRA.  There are two proposals on the table to provide additional fiscal aid to states: (1) renewing enhanced Medicaid payments to states for two additional quarters, through Q2 2011, at a cost of $25bn; and (2) adding another $10bn in spending to the “State Fiscal Stabilization Fund.”  We had assumed the former but not the latter would be enacted, but we are now removing this from our estimates.  More than half of the states have assumed in their own budgets that Congress will provide these additional funds; they will need to further cut spending or raise taxes unless Congress acts in the next month or two.

3. Other spending.  We had assumed a few other smaller items in our fiscal assumptions, mainly to reflect pending congressional proposals: the extension of subsidies for COBRA health premiums for the recently unemployed and roughly $10bn in additional infrastructure spending.  We are removing these from our estimates as well.

4. The “Making Work Pay” credit and other tax measures.  We are not changing our assumptions in this area.  We continue to expect Congress to extend the $60bn/year “Making Work Pay” credit meant to offset the payroll tax on the first $8,000 of earnings that was enacted as part of ARRA. We also continue to expect Congress to extend most of the 2001/2003 tax cuts, which under current law are scheduled to expire at the end of 2010.  Specifically, we believe Congress will extend tax rates and credits for households with incomes under $250,000, as the administration has proposed and as permitted under the pay-as-you-go rules Congress enacted earlier this year. However, we continue to believe that Congress will be hesitant to incur any cost in dealing with the expiring capital gains and dividend rates (these go from 15% to 20% and the ordinary income tax rate, respectively).  This could play out a number of different ways but the effect on growth should be similar (for more, see “Capital Gains and Dividend Taxes: Rising, But When and How?” US Daily, May 6). 

Compared with our previous estimates based on the assumptions noted above, removing the assumed extension of stimulus increases our estimate of the fiscal drag on growth by an average of just under one percentage point from Q4 2010 through Q4 2011, as shown in the chart below.

Estimated Effect of Selected Fiscal Policies on Growth 2009-2011

The debate over fiscal policy has swung back and forth a few times over the last year; at various points our assumptions looked too generous, at other times too austere.   Recently, the dominant risk to our estimates had been that Congress would follow a more austere policy than we had estimated.  Our revised estimates attempt to balance the risks as we see them, but may now lean to the austere side, since we assume no further extension of stimulus, and Congress might still be able to enact at least one of the items noted above. The following factors will be most important in determining whether the outlook for fiscal policy will deviate from our

above assumptions over the next year:

1. Growth in the second half. Our forecast calls for annualized sequential growth of just 1.5%  in the second half of this year, in large part due to the fading effects of fiscal stimulus and the inventory cycle. To the extent that our forecast plays out, there may well be a renewed effort to provide support through fiscal policy, though despite increased growth concerns over the last few weeks, there is no indication of additional policies coming out of Washington, nor is it clear that Congress could manage to enact new measures if such proposals did emerge.

2. Congressional appetite to delay offsets to near-term stimulus.  Resistance to additional stimulus measures has grown along with public concern over the budget deficit. A possible solution is to legislate additional stimulus now with offsetting savings a few years hence. This is easiest done with savings through mandatory spending cuts or tax increases, though some lawmakers have proposed offsetting the cost of state fiscal aid with a rescission of stimulus funds not expected to be spent until 2012.  If such middle ground is eventually found, fiscal policy could result in slightly less of a drag on growth in 2011 than we expect, with more of a drag in subsequent years.

3. The midterm election. While the outcome of this November’s midterm congressional election is still uncertain, it will clearly play a role in fiscal decisions late this year and next year. If there is to be a further extension of unemployment benefits beyond what the Senate voted on today, it is likely to occur in a “lame duck” session of Congress in November or December, at which point the election results will be known. The debate on extending some of the 2001/2003 tax cuts also seems unlikely to conclude before the election. Since most polls—and historical precedent—imply Republican gains in November and thus a Congress more closely divided than it is today, further stimulus measures are likely to face even greater resistance in Congress than they have over the last few months.  

4. Legislative gridlock.   The one area in which our assumptions rely on congressional action is tax policy. If Congress is unable to reach an agreement on the expiring tax provisions before the end of the year, rates will increase across the board on January 1, 2011, increasing the tax burden by an equivalent of 1.4% of GDP beyond what is now shown in the exhibit.  There is general bipartisan agreement on about 75% of these provisions (measured by revenue), so the risk is mainly that gridlock results in a temporary hiccup in early 2011 that Congress takes a few months to correct. Still, this is likely to become an increasing concern as we approach the end of the year.