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Payroll tax cut, meet $4 gas

February 16, 2012: 10:27 AM ET

The payroll tax cut is more of a cushion than a stimulus for the U.S. economy. With higher fuel prices, that cushion may already be deflating.

FORTUNE – On Thursday morning, Washington lawmakers were pleased to announce a deal to extend a cut in payroll taxes paid by most Americans.

The compromise was reached ahead of the tax cut's March 1 expiration date, and will keep the tax rate at 4.2% from its usual 6.2% for another year. So for a family earning $50,000 a year, that would translate to a savings of about $1,000 a year or roughly $80 a month.

But don't expect that extra money to be plowed back into the economy.

Too often the tax cut is presented as a way to give the nation's fragile economy an extra boost (it's one of the key planks in President Obama's jobs program announced last September). After all, the thinking goes, about 70% of the U.S. economy is based on consumer spending. Workers who take home more of their pay will likely spend it on everything from restaurant outings to movie tickets. And because the pay bump goes largely unnoticed, workers would likely spend much, if not all of it, rather than save it.

But because the tax cut only extends cuts that workers' previously enjoyed, it isn't expected to generate much additional spending. It's not to say the tax cut is unnecessary, but we should see it as more of a cushion for the economy than a stimulus for it.

And there's a dark cloud on the horizon that could erase any benefit from the payroll tax cut extension: Rising gas prices.

Since the end of 2011, the national average for a gallon of regular gasoline is up more than 8% to $3.52, according to data released on Monday by the U.S. Energy Information Administration. Gas prices tend to increase during the first half of the year, but this is the earliest the average price per gallon has surpassed the $3.50 mark. Prices at the pump could break $4 later this year – typically the point where fuel costs start eroding economic growth, says IHS Global Insight economist Chris Christopher.

Last year gas prices approached $4, hitting an average of $3.98 in April before falling. And it was around that time when some economists noticed fuel prices were eating away at consumers.

Though prices haven't reached the $4 mark, consumers are nevertheless feeling the pressures from a higher bill at the pump. In his daily newsletter on Wednesday, Gluskin Sheff chief economist David Rosenberg pointed that one of the big drivers of relatively strong retail sales in January were escalating prices on food and fuel. Gasoline sales rose 1.4%, the steepest increase since last March. Grocery bills also rose 1.3%, the largest jump since August 2010.

"Strip out these two areas, sales barely rose at all last month – by less than 0.1% versus an average advance of 0.5% over the prior three months, and the weakest showing since last May."

Given expectations of rising prices, it's hard not to wonder if Washington policymakers should expand the tax cut further, or perhaps even focus on deeper cuts for lower-income households, which some economists say are more likely to spend their extra cash instead of saving it.

For months, there's been much drama over the tax cut. Earlier this week, Republicans gave up their long-held stance that the reduction had to be paid for with spending cuts elsewhere. Though Democrats probably feel they've won and Republicans think they no longer look like the bad guys to the middle class, particularly amid an election year, it remains to be seen who else might come out as winners.

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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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