This Is What Happens to the Economy If the Payroll Tax Cut Isn’t Extended

NEW YORK (MainStreet) — If Congress fails to approve an extension on the payroll tax cut in the next two and a half weeks, the average household will see their take-home pay shrink by about $20 each week. While that may not sound like much at first, one research group predicts that it will significantly weaken an already fragile economic recovery.

The research firm IHS Global Insight originally forecast that U.S. economic output would grow by 2.1% in 2012, assuming that the temporary payroll tax cut was extended through the remainder of the year. However, according to Gregory Daco, an economist at the firm, the annual growth rate would fall by 0.3 percentage points to 1.8% if the tax cut expired at the end of this month.

“The tax cut might seem small, but it does impact the way people are feeling,” Daco says. “If after a couple months consumers realize they are being paid a little less, that will start to have a pretty big impact on their spending.” That in turn would have a ripple effect on businesses and their ability to hire.

Much of the reason for this drop in spending would of course be due to consumers having less disposable income, but Daco argues that a failure to extend this policy would severely weaken consumer confidence, which in turn reduces their spending even more.

“If you look back at the debt ceiling debacle last year, that had a tremendous impact on consumer confidence with it plunging by one of the largest amounts ever recorded,” he says. “If consumers don’t feel confident about the way Washington is handling policy, they will hold back on spending and be more cautious.”

To make matters worse, unemployment insurance will begin to expire for more than 3 million jobless Americans if it isn’t extended by the end of this month. If both of these policies were not renewed for the remainder of the year, Daco predicts economic growth would fall even lower to 1.6%.

To put that in perspective, economists generally say the economy needs to grow by at least 2.5% to prevent the unemployment rate from going back up. By this standard, if the economy grew by just 1.6%, the unemployment rate would likely remain flat or tick up by as much as a percentage point.

Given the many other threats to economic growth this year – from the debt crisis in Europe to the volatile housing market – that may be the last thing we need.

Seth Fiegerman is a staff reporter for MainStreet. You can reach him by e-mail at seth.fiegerman@thestreet.com, or follow him on Twitter @sfiegerman.