Washington Flips From Helping the Economy to Hurting It

The good news is that consumers are learning to shake off destructive political standoffs.

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You don't know what you've got till it's gone.

Joni Mitchell wasn't thinking about tax breaks when she penned that famous lyric, but taxpayers suddenly feel like they've lost something they never knew they had: A bit of extra income.

The latest data shows that personal income plunged by 3.6 percent in January, which is the second-largest decline on record. Disposable income, the amount left over after taxes, fell by an even greater 4 percent. To maintain spending, consumers drained their savings accounts, with the saving rate tumbling from 6.4 percent to 2.4 percent.

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This might sound like the beginning of another deep recession, but in reality it's the chaotic outcome of abrupt policy shifts in Washington, which are clearly impacting the real economy. The January numbers aren't as bad as they sound, but they're making headlines just as another disruptive policy is going into effect: the deep spending cuts known as the "sequester." The combined strain of the policy mayhem in Washington will severely test the underlying strength of the economy.

The January income numbers were distorted by tax changes that went into effect at the start of the year as part of the "fiscal cliff" negotiations. The huge drop in disposable income was largely due to the expiration of the payroll tax cut, which had lowered taxes by two percentage points since 2009. So the government basically started reclaiming tax revenue it had been putting in taxpayers' pockets, as a stimulus measure, for the last three years.

There were other one-time reasons income plunged in January. Some companies accelerated bonus payments to workers at the end of last year, so they'd be taxed at 2012 rates, out of fear that 2013 rates would be higher (as they turned out to be, for people earning $400,000 or more). Many companies also accelerated dividend payments to shareholders, so those would be taxed at lower 2012 rates as well. A big part of the drop in January income was the mirror image of a surge in December income.

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What's encouraging about the latest numbers is that consumers are learning to shake off the tomfoolery in Washington, and carry on as if things are more or less normal. Economists had worried that a drop in income, which was expected, would cause a drop in spending, which didn't happen. Spending, in fact, rose slightly from December to January, and compared to a year ago, spending is up by a healthy 2 percent or so, after accounting for inflation.

Consumer confidence, in fact, ticked upward in February, after the tax hikes sent it lower in January. The housing rebound is a big help, since homeowners finally feel their wealth is rising once again, instead of deteriorating. Corporate profits remain healthy, and most people with jobs feel fairly secure in them.

The question now is how consumers will react to the sequester, which could lead to job cuts, and other economic setbacks if Congress does nothing to mitigate its impact.

[CHARTS: Sequestration Drama May Overstate the Stakes]

"The economy continues to move forward despite Washington's incessant attacks on it," economist Joel Naroff wrote in an analysis of the January income numbers. "Households seem to have taken a "cry wolf" approach to sequestration, believing that the wackos will not really do something crazy."

The risk, however, is that any further cuts to income could leave consumers without enough money to spend, no matter how much they're willing to ring up purchases for the good of the economy. And if bumbling in Washington starts to cause harm that seems irreparable, confidence could plunge and be hard to revive. Consumers might be resilient, but unlike some politicians, they're not reckless—or foolish.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.