The Paradox of Thrift, or What to Do with My Payroll Tax Cut?

By :: February 9th, 2011

A major goal of last December’s Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010 (aka extending the Bush-era tax cuts) was to boost the economy by avoiding scheduled tax increases and, at the same time, adopting a few new tax cuts. Both steps, supporters claimed, would put more money in people’s pockets and boost the still-weak economy. Temporarily extending the Bush-era and 2009 tax cuts and patching the alternative minimum tax staved off the tax hikes. The one-year cut in the FICA payroll taxes that finance Social Security will add about $110 billion to paychecks this year, disregarding the offsetting loss of roughly $60 billion from the expiration of the Making Work Pay credit (MWP). Give people more money and they’ll spend it, thus stimulating the economy, or so the theory goes.

The question is: What will we actually do with this windfall?

A recent candy-themed mailer from my retirement account adminis­trator suggested possible uses for my FICA savings. I could

  • Spend it (“the patriotic thing to do”),
  • Save it (build up an emergency fund or pay down credit card balances), or
  • Invest it (increase retirement savings).

Ignoring the fact that the last two are simply different forms of the same option, it’s not hard to guess which the flyer suggests I choose. It warns me to “consider the state of Social Security,” that Congress might extend the FICA cut “into 2012 or beyond,” and that my Social Security benefits “could fall short tomorrow.”

Which brings me to the paradox of thrift, the observation popularized by John Maynard Keynes in his General Theory of Employment, Interest and Money. In essence, the paradox says that although individuals may be better off saving more when the economy is weak, if everybody saves, the total demand for goods and services falls and thus hurts the economy. In good times, the added savings push down interest rates, which in turn induce firms to borrow and sustain demand by investing in their businesses. In bad times, firms may not borrow, even at rock-bottom interest rates, and the economy suffers. Today businesses are sitting on an estimated $2 trillion of cash, not wanting to invest with the future uncertain. With that kind of money sloshing around, additional personal savings won’t help things.

So what to do with my $2,000 payroll tax cut? Maybe I should do the patriotic thing and go shopping. Problem is that we’ve already got pretty much everything we want. And I’m not getting any younger so perhaps I should add to my retirement savings.

My situation points out the problem with the payroll tax cut as economic stimulus. People like me are likely to save a sizeable part of the added take-home pay—in econ-speak, our marginal propensity to consume is low (not zero but perhaps on the order of three-fourths). More than 40 percent of the $110 billion in payroll tax cuts will go to households bringing in more than $100,000, the relatively low spenders like me. Just one-quarter will go to households with income under $50,000, those most likely to spend the additional cash (that is, they have a high MPC, approaching 1).

By contrast, more than half of the expired Making Work Pay credit went to households making less than $50,000 and just one-sixth to those with income over $100,000. As a result, the MWP probably had greater bang-for-the-buck than the FICA tax cut. But because the latter is nearly twice as big—$110 billion versus about $60 billion a year for MWP—the aggregate stimulus from the payroll tax cut is almost certainly larger.

My genes push me toward contributing to the paradox of thrift—even without the nudge from my retirement plan administrator. But maybe the tax cut I didn’t need and the government couldn’t afford should go to a charity that will spend it immediately and help boost the economy. The flyer left out that option.

8Comments

  1. The Paradox of Thrift, or What to Do with My Payroll Tax Cut? | Tax Information  ::  5:13 pm on February 9th, 2011:

    […] is the original post:  The Paradox of Thrift, or What to Do with My Payroll Tax Cut? Posted in News Tags: economy, fica, general-theory, making-work, maynard-keynes, money, paradox, […]

  2. B. J. Amison  ::  9:13 am on February 10th, 2011:

    …or you could live in Illinois and give it back to the state since personal income tax increased by 2 percentage points.

  3. denim  ::  12:41 pm on February 10th, 2011:

    I bought a double leveraged ETF of agri futures(DAG)to hedge against spendthrifts who will remain nameless for the time being food price inflation.

  4. Fiscal Future Daily: Two Budgets At Once « Choosing the Nation's Fiscal Future  ::  2:19 pm on February 10th, 2011:

    […] firms prodding them to put the money they save from the payroll tax cut into a retirement fund, which, of course, doesn’t necessarily stimulate the economy as much as spending it right away. This is what economists call “the paradox of thrift”: “So what to do with my […]

  5. Around The Dial – Feb. 10  ::  3:09 pm on February 10th, 2011:

    […] TaxVox wonders what to do with its payroll tax cut. […]

  6. Kelly  ::  6:12 pm on February 10th, 2011:

    Very true. I can say that I personally decided to save it by increasing my 401k contributions by an additional 2%…kind of figured the money was supposed to be for retirement anyways and I feel better about my 401k than I do SS.

  7. Michael Bindner  ::  9:40 am on February 12th, 2011:

    My question is whether cutting the payroll tax will also lead to an EITC cut, further disadvanaging poorer taxpayers.

    I am not generally in favor of cuts like making work pay, since they put the government in the business of subsidizing employers who don’t pay enough in wages and benefits. A higher minimum wage is a superior idea. A monopsonistic employer will simply absorb the cost, since it comes from economic rent anyway (economic rent is the unearned profit – or rather the profit earned by the employee but not distributed to her).

    Some employers are not monopsonistic and may fail with a higher minimum wage. For them, the question arises as to whether such employers should be subsidized. My instinct is no. I would rather put equivalent amounts into spending on adult remedial and career education to train the affected employees for better jobs (and pay them while they do so).

  8. Michael Bindner  ::  9:41 am on February 12th, 2011:

    As to your personal dilemna, donate it back to TPC to fund the hiring of some of your commenters as Research Associates.