An emergency deal reached after weeks of rancorous negotiations will keep the U.S. from driving off the so-called fiscal cliff, but higher taxes and continued political bickering in Washington threaten to shake the fragile U.S. economy well into 2013.
A bill passed by Congress late Tuesday averts widespread tax increases and delays spending cuts that had threatened to take a bite out of the economy.
But critical issues, including reduction of the deficit, remain unresolved. Meanwhile, the economy doesn't have much growth to give. Mark Vitner, senior economist at Wells Fargo, predicts it will expand just 1.5 percent in 2013, down from a lackluster 2.2 percent in 2012. Unemployment stands at 7.7 percent.
Ben Schwartz, chief market strategist for Lightspeed Financial, said unemployment was still likely to edge up and retail sales growth was likely to be weaker than last year.
"Regardless of a deal getting done, people on Wall Street are not going to run around giving high fives," Schwartz said. "The federal government is obviously dysfunctional, to say the least."
A months-long political standoff over fiscal policy has already taken its toll, adding uncertainty that has discouraged consumers from spending and businesses from hiring and investing. The squabbling seems sure to persist.
Lawmakers postponed tough decisions on government spending, giving themselves a reprieve from cuts that were scheduled to begin taking effect automatically Jan. 1. That just sets the stage for more hard-bargaining later. Spending cuts, when they come, could crimp growth even more.
And another standoff is likely to arrive as early as February when Congress will need to raise the $16.4 trillion federal borrowing limit so the government can keep paying its bills. House Republicans probably won't agree to raise the debt limit without offsetting spending cuts that Democrats are sure to resist.
Obama warned Republicans late Tuesday that "if Congress refuses to give the United States government the ability to pay these bills on time, the consequences for the entire global economy would be catastrophic, far worse than the impact of a fiscal cliff."
Financial markets abroad rallied on news that the fiscal cliff had been forestalled.
Hong Kong's Hang Seng index shot up 2.9 percent to close at 23,311.89, its highest finish since June 2011. Australia's S&P/ASX 200 surged 1.2 percent to close at 4,705.90, its strongest finish in 19 months. South Korea's Kospi jumped 1.7 percent to 2,031.10.
European stocks jumped shortly after opening. Britain's FTSE 100 rose 1.6 percent to 5,989.24. Germany's DAX advanced 1.7 percent to 7,740.12 and France's CAC-40 also gained 1.7 percent at 3,701.90.
The bill will raise taxes on individual incomes over $400,000 and household incomes over $450,000, on investment profits and dividends, and on the portion of estates that exceeds $5 million.
Those higher taxes on the wealthy - which will deliver some $600 billion in revenue over 10 years - are likely slow the economy a little bit. But a bigger drag on the economy will come from a tax hike Democrats and Republicans didn't even bothering to fight over: the end of a two-year Social Security tax cut.
The so-called payroll tax is scheduled to bounce back up to 6.2 percent this year from 4.2 percent in 2011 and 2012, amounting to a $1,000 tax increase for someone earning $50,000 a year.
"It's a huge hit," says Joel Naroff, president of Naroff Economic Advisors. "It hits people whether they're making $10,000 or they're making $2 million. It doesn't matter who you are ... The lower your income, the more of your income you're (spending). So if you're taxes go up, it's going to come out of your spending." And that is bad news for an economy that is 70 percent consumer spending.
Mark Zandi, chief economist at Moody's Analytics, calculates that the higher payroll tax will reduce economic growth by 0.6 percentage points in 2013. The other possible tax increases - including higher taxes on household incomes above $450,000 a year - will slice just 0.15 percentage points off annual growth, Zandi said.
The fiscal cliff itself was created to force Democrats and Republicans to compromise, and it succeeded - barely.
To end a 2011 standoff over raising the federal debt limit, they agreed to a Jan. 1, 2013 deadline to reach a deal over taxes and spending. If they didn't, more than $500 billion in tax increases would hit the economy in 2013 alone, along with $109 billion in cuts from the military and domestic spending programs. The sharp tax hikes and spending cut would threaten to send the economy over the cliff and back into recession.
But negotiations to avert catastrophe have highlighted once again how far apart the two parties are on taxes (Republicans don't want to raise them) and spending (Democrats are reluctant to cut government programs).
Ethan Harris, co-head of global economics at Bank of America Merrill Lynch, asked: "What induces the two sides to stop fighting and start compromising?"
Political gridlock has been rattling financial markets and shaking consumer and business confidence the past two years.
After a fight over raising the debt limit last year, the credit rating agency Standard & Poor's yanked the U.S. government's blue-chip AAA bond rating because it feared that America's dysfunctional political system couldn't deliver a credible plan to reduce the federal government's debt. S&P cited an overabundance of "political brinksmanship" and warned that "the differences between political parties have proven to be extraordinarily difficult to bridge."
The Dow Jones industrials dropped 635 points in panicked selling the first day of trading after the S&P announcement.
Outside Washington the economy has been getting some good news. Europe's financial crisis appears to have eased, reducing the threat of a renewed financial crisis. And the U.S. real estate market finally appears to be recovering from the housing bust.
But the old worries have been replaced by new ones about political gridlock, says Joseph LaVorgna, an economist at Deutsche Bank.
The partisan divide has left businesses and consumers wondering what's going to happen to their taxes and to federal contracts.
Companies have plenty of cash. But they reduced spending on industrial equipment, computers and software from July to September, the first quarterly drop since mid-2009 when the economy was still in recession. And hiring has been stuck at a modest level of about 150,000 new jobs per month this year.
Consumer confidence fell in December for the second straight month, according to a survey by the Conference Board, which blamed the drop on worries about the fiscal cliff. The uncertainty is also believed to have dinged holiday shopping, which grew at the slowest pace this year since 2008.
Many economists are disappointed that Congress and the White House couldn't reach agreement on a broader deal that significantly reduces the deficit over the next 10 years. That could have boosted business and consumer confidence and accelerated growth.
No progress has been made on reforming the government's big entitlement programs, mainly Medicare and Social Security.
"Nothing really has been fixed," Lavorgna says. "There are much bigger philosophical issues that we aren't even addressing yet."