Personal income drops, but consumer spending up in January

US consumers increased spending modestly in January but cut back on major purchases that signal confidence in the economy. The decline in spending on goods suggests higher tax rates that kicked in on Jan. 1 may have made consumers more cautious.

The Commerce Department said Friday that consumer spending rose 0.2 percent in January compared with December. The gain was driven by an increase in spending on services, partly reflecting higher heating bills. Spending on durable goods, such as cars and appliances, fell 0.8 percent. Spending on non-durable goods, such as clothing, was essentially flat.

Income plunged 3.6 percent in January, the biggest drop since January 1993. But it followed a 2.6 percent rise in December, which reflected a rush by companies to pay dividends and bonuses before income taxes increased on top earners.

After-tax income fell 4 percent in January and after having risen 2.7 percent in December. Part of the January drop reflected higher Social Security taxes.

Americans adjusted to higher taxes by saving less. The savings rate declined to 2.4 percent of after-tax income in January, down from 6.4 percent in December and the lowest in five years.

"The sting of higher taxes hit home at the start of the year. This will cool spending in the next few months before consumers adjust to higher rates," predicted Jennifer Lee, senior economist at BMO Capital Markets.

In January, Congress and the White House allowed a temporary 2 percentage point cut in Social Security taxes to expire. That means a person earning $50,000 a year will have about $1,000 less to spend in 2013. A household with two high-paid workers will have up to $4,500 less.

Lawmakers and the Obama administration also agreed to let income tax rates rise on top-earning Americans.

Paul Dales, senior US economist at Capital Economics, said that spending growth in the first three months of this year could slow to just half of the 2.1 percent rate of increase seen in the October-December quarter. Consumer spending drives nearly 70 percent of economy activity.

A better job market may help offset some of the pain from the tax increase later this year.

Employers have added an average of 200,000 jobs a month from November through January. That was up from about 150,000 in the previous three months. And a drop in weekly applications for unemployment benefits suggests employers may have stepped up hiring further in February.

Sustained hiring, along with increases in home construction and business investment, could also support growth at a crucial time. The federal government is facing the automatic spending cuts that kick in Friday. If the cuts remain in place for an extended period, they could crimp growth.

The economy is coming off its weakest quarter of growth in nearly two years, according to a government report released Thursday. The Commerce Department estimated that the economy grew at an annual rate of just 0.1 percent in the October-December quarter, much slower than the 3.1 percent growth in the July-September quarter.

Still, economists said the weakness in the fourth quarter was caused by temporary factors — deep defense spending cuts and slower restocking by companies. They expect growth will rebound to a rate of around 2 percent in the current January-March quarter.

They note that residential construction, consumer spending and business investment — core drivers of growth — all improved in the fourth quarter.

Businesses and consumers are also showing greater confidence despite the automatic spending cuts scheduled to take effect on Friday. A measure of consumer confidence rebounded in February after a sharp fall the previous month that likely was a result of the tax increase.

Companies, meanwhile, sharply increased orders in January for a category of long-lasting manufactured goods that reflect their investment plans. That suggests they are confident about their business prospects.

The consumer spending report showed that inflation remains subdued. A price gauge tied to consumer purchases showed no increase in January and since January 2012 is up just 1.2 percent. That's the lowest 12-month increase since October 2009.