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Why Economy Could Slow Even With 'Fiscal Cliff' Deal

Daniel Acker | Bloomberg | Getty Images

No matter what happens with the "Fiscal Cliff," every working American is likely to see a substantial pay cut after Jan. 1—and that could slow the economic recovery.

That's because the payroll tax holiday, which was launched in 2010 to help spur consumer spending, is scheduled to end this month. Though there's a chance it might be extended under a fiscal cliff deal, it's mostly been on the back burner with lawmakers.

The tax holiday lowered taxes for some 160 million Americans. Instead of paying a 6.2 percent rate, they've paid 4.2 percent. That meant a worker making $50,000 saw an increase of $960 for the year, while someone making $100,000 had over $1,900 in extra spending money. (Read more:AMT Patch in Cliff?)

"It's been a very effective tax cut for the economy," said Mark Zandi, chief economist with Moody's. "It's kind of the Rodney Dangerfield of taxes in that most people are not aware of it but it could bring on a significant hit to growth if it ends."

The payroll tax cut—part of the Obama administration's deal with Congress in 2010 over extending the Bush tax cuts— was only supposed to be a temporary fix, and that's why it hasn't taken a bigger role in the fiscal cliff talks, say analysts.

But it's clear that the coming increase in payroll taxes will hurt consumers in the pocketbook and slow an already sluggish economy.

"The impact will be hard on consumption as that makes up 70 percent of U.S. GDP," said Timothy Nash, an economics professor at Northwood University in Midland, Michigan.

"Where it will show up most is in retail, dining out and vacations," Nash said. "It also means lost revenue on savings and investments."

The intent of the payroll holiday—to help stimulate the economy and specifically consumer spending—seems to have worked. According to a report by Moody's Analytics, every $1 cut in the payroll tax expanded the economy by $1.27.

At the same time, projections for the payroll tax hike say it would reduce disposable income by $125 billion each year and slow overall GDP by 0.6 percentage point.

"The increase will be bad for people who live paycheck to paycheck," said Greg McBride, senior financial analyst at Bankrate.com. "For many, the reduction in payroll taxes was the only kind of pay increase they got in the last two years."

Still, extending the tax holiday has costs, specifically the funding of Social Security, which is where the payroll tax money goes. The government has made up the difference in revenues to Social Security, but the question is how long does it want to do that. (Read more: Obama's Social Security Plan)

"if we want to keep the holiday, then we do need to think about the long term effects for Social Security," said David Hasen, a tax law professor at Santa Clara University School of Law. "I don't think Social Security is in trouble, but what's the plan to keep funding it if the tax holiday continues."

Where the payroll tax holiday stands in the "fiscal cliff" talks is not known. Some Senate Democrats, like Bob Casey of Pennsylvania have called for it to be extended regardless of the cliff, while several Republicans such as Utah's Orrin Hatch, have called for it to end as scheduled.

Mark Zandi said that if the payroll tax holiday is a bargaining chip in the negotiations, that might not be so bad if it's part of a good deal. (Read more:Obama: Only $200 Billion Apart in 'Cliff' Deal )

"I'd give it up if it meant getting something like extended unemployment insurance benefits," said Zandi. "I think the tax cut is important for consumer spending but not as important as UI benefits."

In the end, the coming increase of payroll taxes will be another burden for workers and the economy to get through, said Greg McBride, noting a Bankrate study on Wednesday that said a third of Americans have cut back on personal spending as a result of the fiscal cliff showdown in Washington, D.C.,

"I'm not sure the payroll tax holiday was a real game changer for the economy but it's going away will be noticed," said McBride. "People have come to rely on it."

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