The payroll tax cut isn't working

March 1, 2011: 10:33 AM ET

When Congress approved sweeping tax cuts last year in hopes of giving the economy an extra boost, it might not have anticipated how much oil and food prices would weigh on consumers.

rising gas prices

Is $4 gasoline around the corner?

Consumer spending, which makes up about 70% of the U.S. economy, cooled in January. It rose by 0.4% after a modestly bigger 0.7% gain during the previous month, the Commerce Department reported this week. This comes even as many workers saw a bump in their paychecks as the new Social Security tax break approved in December took effect, helping to boost personal income by 0.4% and disposable income by 0.7%.

But for better or worse, that extra income isn't translating into extra spending for many workers. The personal savings rate edged up to 5.8% in January, reversing its steady fall from a 6.3% high last June.

It might be too early to say why exactly consumer spending has slowed. Perhaps, as Daniel Indiviglio of the Atlantic pointed out, they took a break after all the holiday shopping. Or maybe, as some economists suggest, winter storms kept more people home and away from stores.

But it's also possible that factors like rising commodity prices and consumers' desire to save more are overriding the extra spending that Congress had hoped for with the passage of the tax cuts.

Though crude oil has fallen some this week, prices briefly touched the psychologically significant $100 a barrel mark in New York last week. The commodity gained 5.2% last month and is 24% higher than a year ago, translating to higher prices at the pump. With unrest in the Middle East and North Africa, gasoline prices have been on a steady climb for the past seven days, reaching a new national average of $3.38 per gallon, up from $3.17 last month.

What's more, global prices for everything from corn, wheat and soybeans have been trending up, rising in January for the seventh month in a row, according to the U.N. Food and Agriculture Organization. Its monthly food price index rose to 231 points, up 3.4% from December 2010 and the highest level since the index has been backtracked in 1990.

Food inflation is expected to surge in the second half of this year as wholesale prices filter through the supply chain, impacting consumers even more in the grocery aisles.

Despite the boost to incomes, it's clear higher prices have started putting a dent on consumption. Nominal spending (which is adjusted for inflation) rose by just 0.2% in January over the previous month, but real spending (which does not adjust for inflation) fell by 0.1% during the same period -- the first drop in a year, according to Capital Economics senior economist Paul Dales.

Dales sees this as a sign that higher gasoline and food prices have already started putting downward pressure on real consumption. Severe snowstorms in January, he adds, probably pulled back spending as well. Consumption will likely bounce back in February and possibly also in March. But while consumption is likely to be relatively strong during the first half of the year, higher prices at the pumps and in grocery stores will probably thwart the attempt by Washington policymakers to try and stimulate the economy.

"The way things are going at the moment, all the payroll tax cut will do is offset the rise in gasoline and food prices, rather than provide a boost to real spending." Dales says.

It remains to be seen how consumers will respond in the coming months. Workers might start noticing that they're taking home more pay and therefore save less. But even then, higher prices might just keep them from anything much beyond basic necessities.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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