By Colin Barr
December 18, 2010

Could the tax package passed Friday by the House unexpectedly unleash the pent-up power of the U.S. economy?

It sounds unlikely. The $858 billion deal has been picked over pretty thoroughly by now, with proponents saying it will boost spending and add as much as a percentage point to U.S. growth next year. The deal also has been savaged over the past week and a half as a giveaway to the rich, a drain on the poor and an inefficient means of stimulating demand.

Perhaps most damningly, it has been taken as the latest example of policymakers kicking down the road a budget-management can they are going to have to actually heft one of these days.

Yet Andrew Goldberg and David Kelly, strategists for J.P. Morgan funds, say many analyses of the tax deal overlook what might well be its chief contribution: an improvement in investors’ outlook for both tax policy and the general drift of government.

It is this shift, rather than any improvement in the economic data, that will ultimately lift the United States economy out of its funk, they suggest.

Currently, a lack of confidence is restraining economic activity in the broadest possible way – by holding consumers back from spending on autos and houses, causing corporations to hesitate to hire, to invest or to pay out dividends and causing individual investors to funnel cash away from equities and toward low-yielding asset classes.

This deal not only removes uncertainty about tax rates over the next two years, but it also shows that, much as the Clinton Administration tacked towards the center in the wake of the 1994 elections, the Obama Administration seems willing to do the same in reaction to the results of the midterm elections. A removal of uncertainty is always a positive for confidence and so is a belief that Washington will govern from the center rather than the extremes.

Goldberg and Kelly say they expect interest rates and stock prices to continue to rise in coming months, as a gradual pickup in the economy lifts corporate profits and worries about trillion-dollar deficits weigh on bond prices.

But you won’t catch Goldberg and Kelly calling the tax deal a mistake, because they believe Washington must do whatever it can to get the economy rolling again. That is a lesson being learned the hard way now in places like Greece and Ireland, where austerity plans have been implemented to great applause but, months later, to no apparent avail.

It is important for investors to appreciate that the ultimate price tag for extending these tax cuts depends upon their impact on the performance of the economy. If economic growth accelerates and the economy begins to create more jobs, the resulting higher tax revenues will offset some portion of the cost incurred by extending the tax cuts. In fact, it is hard to see how the United States can ever begin to deal with its deficit problems without above-trend economic growth and faster job creation.

And thus back to confidence. Admittedly, it’s a squishy concept and one that has been a bit discredited by having been one of Hank Paulson’s favorite watchwords during the early stages of the financial crisis in 2007-2008. Failing to grasp the scale of our losses, Paulson and others initially diagnosed an acute financial problem as a psychological one that could be cured, believe it or not, by talk of super-SIVs and bazookas and all the rest.

But the case for people being less overexended but still economically shell shocked is at least a little easier to carry off now, and so it’s worth considering whether a big shift in expectations could indeed contribute to a self-sustaining expansion. As Kelly told me last week, “The question is, to what extent do people finally throw off the gloom and start believing in themselves?”

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