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Payroll Tax Cut Signals Big Obama Shift to Supply Side

Wall Street cheered President Obama’s fiscal compromise with Republicans, not just the extension of the existing Bush-era tax cuts, but the addition of a payroll tax cut in particular as that measure may signal an even bigger shift on the part of the White House toward supply-side economics.

“The payroll tax cut was a surprise to most and perhaps a sign that the administration is willing to try the other side's potion to get job growth back in the U.S.,” said Bill O’Donnell and John Briggs, RBS bond strategists, in a note to clients. “There has been an endless debate among economists over the differences between private versus public sector multipliers. Looking at the just-announced tax compromise, it appears as if the markets will now get to see first hand what the debate's all about. The mid-term elections have apparently driven a shift away from public sector support (stimulus) to letting the private sector take a turn at the wheel with a heavier wallet.”

President Obama’s deal keeps the lower personal income, dividend and capital gains rates enacted under President George W. Bush the same for at least the next two years. What’s new is a 2 percent reduction in social security payroll taxes for one year.

The deal represents “a significantly more positive fiscal outcome for 2011 than we and most others have been expecting, including a one year reduction in the payroll tax,” said Jan Hatzius, chief U.S. economist at Goldman Sachs, in a note. “This proposal would add $185 billion in stimulus in 2011 beyond what we have been assuming, not including the corporate tax provisions.”

Stocks flirted with new highs for the year following the announcement as investors bet this fiscal stimulus, coupled with the Federal Reserve Chairman’s monetary stimulus, will foster a one, two punch for the economic recovery next year. Stocks most linked to economic growth, including industrials and technology shares, led the gains.

If Obama is ‘going Clinton’ then it is hugely constructive for the economy,” said Steve Cortes, founder of Veracruz LLC. “Once it was evident that Clinton would move to center and play ball with GOP, S&P soared in 1995 after 1994 mid-terms.”

Goldman also points out that Obama proposed a 35 percent estate tax rate, with a $5 million exemption that is “more generous than the policy many Democrats supported and is likely intended to attract support from Republicans and centrist Democrats.”

“Obama and his advisors found religion with the rise in unemployment announcement,” said Sean Egan, founder of Egan-Jones Ratings Company and one of the first to warn about the credit crisis that got us in this mess. “Also more quantitative easing is politically less palatable in the current environment.”

In speeches recently, Bernanke had called for a strong “fiscal” response. It couldn’t come at a better time for the Fed Chairman, who has been under fire for announcing a second round of Treasury purchases to keep interest rates low. The full purchase of the $600 billion the Fed is planning to buy may not even be necessary if this stimulus takes hold, investors said.

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President Obama’s first attempt at economic stimulus at the beginning of 2009 was largely Keynesian in nature and was forced through Congress. It contained minor tax cuts but was heavily loaded toward spending on infrastructure and education and extending unemployment benefits.

To be sure, this is new compromise is not a done deal yet. Both party leaders now need to discuss the finer details with their members and then the Senate will likely vote first, followed by the House. During these further discussions, you could have some strong protests from Democrats. The payroll tax cut, in particular, could become a target of an income limit in the final bill, according to FBR Capital Markets.

And some investors feel like President Obama is just playing politics and digging an even deeper hole for the country by switching to another kind of economic approach.

“The payroll tax cut will hurt the economy as the lost revenue will simply be borrowed instead,” said Peter Schiff, President of Euro Pacific Capital. “The additional borrowing to finance larger deficits will hurt the economy more then the offsetting benefit of lower taxes.”

May the best multiplier win.

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Trader disclosure: On December 7th, 2010, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s "Fast Money" were owned by the "Fast Money" traders; Seymour Owns (AAPL), (BAC), (BX), (CSCO), (GE); Adami owns (AGU), (BTU), (NUE), (C), (GS), (INTC), (MSFT); Adami’s wife works at Merck; Terranova Owns (C), (GS), (NKE), (OXY), (PEP), (PFE), (VRTS), (UPL)

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