Tax Cut Deal Improves Economic Outlook — But Economic Hole Remains Deep

Earlier this week Dean Baker threw some cold water on the tax cut/unemployment insurance deal President Obama recently signed.  While he’s right that most of the aggregate demand the deal will generate represents a continuation of current policy, not an injection of new stimulus, most economic forecasts had assumed until last week that Congress wouldn’t continue significant portions of current policy into 2011.

As I explain in a new paper, the legislation’s extensions of federal unemployment insurance and of Obama-era tax cuts for low-income households (i.e., the 2009 improvements in the Child Tax Credit, Earned Income Tax Credit, and college tuition tax credit) — all policies insisted upon by the White House — are welcome and unexpected.

Along with the deal’s payroll tax reduction, these unexpected measures have led Moody’s Analytics, Macroeconomic Advisers, and other forecasters to raise their forecasts for economic growth next year to about 4 percent — considerably higher than the 2.6 percent annual rate the Commerce Department just announced as its revised estimate of growth in the third quarter of this year.

Still, as Dean notes, it is premature to break out the champagne on the economic recovery.  Even with the additional boost from the compromise legislation, projected economic growth next year is modest compared with the depth of the economic hole that is the legacy of the Great Recession (see chart).  Severely constraining federal spending next year, as some in Congress favor, would also undermine the stimulative effects of the tax cut/UI deal and impede the recovery.