Q&A: US payroll tax cuts

US economy
Image caption The pressure is on the US government to continue with tax cuts

Republicans and Democrats have been locked in a last-minute battle to extend a tax cut to 160 million US workers worth about $1,000 (£638) a year.

The tax break will expire unless the dispute is resolved by 1 January, with analysts concerned that could make the US economic recovery even more fragile.

What is the payroll tax?

The tax is the part of Americans' wages withheld for both the Social Security retirement fund and for Medicare, a health scheme for the elderly.

A year ago, a cut to the tax was passed by Congress to help US workers struggling in the economic climate.

The cut has saved 160 million Americans an average of $1,000 a year. However, if it not extended, the cut will expire on 1 January.

Economists believe that this could hamper the country's already fragile economic recovery.

Why is Congress deadlocked over the issue?

The Senate passed a two-month, $120bn extension of the payroll tax break on Saturday 17 December, largely because Republicans and Democrats could not agree on how to pay for it for a full year. The short-term deal won support from 39 Republicans and overwhelmingly passed the Senate.

However, Republicans in the House of Representatives said the short-term tax-cut plan would create uncertainty for workers and employers and was unworkable.

What is the difference between the rival proposals to solve the problem?

Most of the uncertainty hinges on the length of any extension. The current impasse was preceded by weeks of debate about how to pay for any renewal of the tax cut.

House Republicans are demanding a one-year extension to the tax cut, a turnabout since for months they were openly sceptical of its economic benefits.

Democrats were proposing a 1.9% tax on millionaires earning more than $1m a year to pay for payroll tax cuts, but have now scrapped this idea.

As an alternative solution, legislation written by Democrats in the Senate and Republicans in the House would see extra levies placed on the two government-controlled mortgage companies known as Fannie Mae and Freddie Mac.

The two companies buy mortgages and package them into securities with guaranteed payments of principal and interest.

To guard against losses in case of default, they charge lenders premiums commonly known as "g fees". Lenders typically add the fees, which average about 0.27%, to a home loan's interest rate.

The House and Senate bills would add an additional 0.1% onto the guarantee fees.

If lenders pass them along to homebuyers, the increases would cost a borrower with a $200,000 mortgage about $4,000 over the life of the loan, according to the Mortgage Bankers Association.

What would be the long-term effects on the US of scrapping the tax cut?

Michael Feroli, JPMorgan Chase's chief US economist, believes there will be 0.5% growth in the first quarter and 1.5% in the second quarter of 2012 if the payroll tax cut and unemployment benefits are not extended.

If they are extended for the year, he expects growth of 2.5% in the first half of the year.

The US housing market is also in dire need of a kick-start, so any more taxes levied on prospective homeowners would be viewed as extremely damaging for the recovery.

It is also an election year for the US. Healthcare reforms were a key plank in President Barack Obama's original campaign for election and any change on the funding of such plans would be closely scrutinised.

What will Congress do next?

With a deal in the works to pass a two-month extension before Christmas, the tax cut would not expire until late February. That gives Republicans and Democrats a few more weeks to negotiate a year-long extension in a joint House-Senate conference committee.

Republicans bowed to pressure to accept the two-month extension after publicly denouncing it, but they have already extracted a concession from President Obama on the Keystone XL pipeline. If that conference cannot bridge the gap between the two sides, a tax rise would go into effect on 1 March.