Payroll Tax Holiday is not Perfect, but Far Better than Inaction

By :: December 2nd, 2011

Congress is now shadow boxing about the payroll tax holiday that is set to expire at the end of this year. Currently, workers are getting a break equal to 2% of earnings up to the Social Security taxable maximum of $106,800. The temporary tax cut was part of a deal struck last year to extend the Bush tax cuts for two years. The payroll tax cut and unemployment benefits for the long-term unemployed were extended for only one year, presumably based on (unwarranted) optimism about the economic recovery, but the implosion of the Eurozone and the continuing overhang from the housing market collapse have kept the economy very weak. There clearly is need for continuing economic stimulus.

The president has upped the ante, proposing that the Social Security payroll tax rate be cut in half (from 6.2 to 3.1 percent) for 2012 and also for a similar payroll tax break for employers on the first $5 million of payroll.  And he has also urged extension of unemployment benefits.

As Howard Gleckman points out, this is far from optimal policy. Higher income people will save over $2,000 in payroll taxes in 2011, and they stand to gain more than $3,000 in 2012 under the president’s proposal. Tax cuts for high earners will mostly be saved, which does nothing to boost the economy in the short run. The employer tax break is also poorly targeted.

But low- and middle-income workers who are living paycheck to paycheck are likely to spend most of any payroll tax cut.  Some of the tax break might go to pay down credit card debt or substitute for borrowing, which also won’t boost the economy, but with credit much less available than it was a few years ago, I expect this effect to be relatively modest.  And extending unemployment benefits is an almost ideal economic stimulus because long-term unemployed people have little choice but to spend any additional income.

With the economy producing almost a trillion dollars less than its capacity, there’s as strong an argument as ever for government intervention.  The $250 billion in tax cuts would only close a fraction of the gap and the money could surely be spent more effectively, but if this is all that’s politically possible, it would surely help. Mark Zandi of Moody’s Analytics has estimated the whole Obama proposal, including $200 billion in new spending, “would add 2 percentage points to GDP growth next year, add 1.9 million jobs, and cut the unemployment rate by a percentage point.”  (Zandi also has many excellent suggestions for improving the proposal, which might gain traction in a less toxic political environment.) More recently, Zandi has argued that failure to extend the payroll tax cut would cut economic growth by almost 1% and might even thrust the economy back into recession.

Critics have raised some serious issues with the proposal that I’d like to discuss:

  • Cutting payroll taxes attenuates the linkage between Social Security taxes and benefits, which could undermine support for the program.
  • Extended unemployment benefits discourage the unemployed from taking new jobs, which slows economic recovery.
  • Adding to our enormous debt is fiscally reckless and could cause a much greater economic crisis than we are currently experiencing.

One of my colleagues was apoplectic when the President agreed to a temporary payroll tax holiday last year, fearing that it would become another temporary provision that is extended year after year. Her view is that Social Security is so politically popular because people view the retirement benefits as earned, rather than a handout. That becomes harder to justify when the trust fund is routinely being replenished out of general revenues (or borrowing) year after year. Last year, I bet her that the payroll tax holiday would not be extended because conservatives didn’t much like the policy and liberals understand her point. I now owe her a bottle of wine. But I still believe that if a payroll tax holiday is the only way to inject serious cash into the economy, it’s worth the risk. When the economy shows serious signs of being self-sustaining, liberals and conservatives will both happily let the tax break expire. I hope.

As for the effect of unemployment benefits on employment, they allow workers to be picky about new employment when the economy is healthy. But that’s not the situation right now. There are many more people seeking work than there are jobs. And unemployment benefits are really paltry—averaging about $300 per week or about 1/3 of average wages. Few people would choose the poverty of subsisting on unemployment benefits to a real job.  Like the payroll tax holiday, extending unemployment benefits makes sense now, but won’t when the economy has recovered.

Then there’s the effect of additional spending on the debt. The president’s proposal includes a new surtax on high-income people to offset the cost and the Republicans’ counter-proposal includes offsetting spending cuts so neither option would technically increase the deficit. The president’s proposal is better on this score because high-income people are unlikely to spend less when their taxes rise whereas the spending cuts proposed by Republicans would lead to more layoffs of government employees and directly add to unemployment, which is clearly counter-productive.

The ideal policy from my perspective would include credible cuts in spending—especially entitlement spending—and tax increases that do not take effect until the economy is healthy. In the current political environment, I’m not sure how this happens. The best hope is that the presidential election becomes a referendum on competing views about how to tame the debt and the next president enters office with a mandate for change.

I know that’s a long shot, but sitting on our hands while the economy is teetering would be unconscionable.

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  1. Michael Bindner  ::  4:46 pm on December 2nd, 2011:

    One way to fund extending UI benefits is to add an additional UI payroll tax on firms who have people on extended UI that are now profitable – in other words, punish them for firing people to improve their bottom line. I suspect that there would be call backs shortly.

    The payroll tax holiday is a dumb idea, but the idea that a making work pay credit is better puts the government on the hook for subsidizing low wage work, which usually occurs in a monopsonistic environment that would absorb an increase to the minimum wage without job losses. An increase in the Child Tax Credit would more likely be spent than a payroll tax holiday – and it could be made permanent without objection. You could pay for it by limiting or eliminating the mortgage interest deduction.

    Fixing the Doc Fix will also be part of the mix. It should just be extended with Ways and Means and Finance being charged with a long term solution that saves money – like increases to Part B and D premiums and higher basic benefits in Social Security to offset this. Any linked CPI must be enough to compensate seniors for the increase in these premiums each year, which will be higher. We can either mess with the basic benefit and bend points while raising the income cap or can credit all employer contributions equally and drop the bend point system entirely, raising the income cap so that the base benefit so derived is as least as generous as the current benefit, if not much higher. Don’t expect the last bit from this Congress, however, unless you are willing to include Personal Accounts in the solution (not in an election year).

    The key factor will be a likely demand for a repatriation holiday for overseas corporate income. This possibility should be talked about now, since letting it come up on the GOP’ terms does not allow informed discussion on how to pay for it. Because it will likely be used for dividend distributions, the obvious payfor for the whole package, barring agreement on other taxes mentioned above, is to roll back some of the dividend and capital gains tax cuts. TPC can calculate how much this needs to be. Can it be done at a 20% rate for each? How about 25%? As the alternative is the expiration of the Bush Cuts entirely in 13 months, locking in a permanent 25% rate should look better while the 25% middle class rate remains. Once that expires, the permanent rate for capital gains and dividends would be 28% or the normal income rate (except for capital gains, which go to 20%, but should not be allowed to stay that low).

  2. Brian Dell  ::  11:45 am on December 3rd, 2011:

    “when the economy has recovered” is frequently mentioned. I’m concerned about how frequently this is just assumed as inevitable. Maybe current unemployment is the new normal such that even increased demand would not create jobs for Americans who are not educated or skilled enough to be globally competitive at typically American wage levels. Perhaps the higher level of employment in 2007 was not sustainable and the financial crisis was just brought forward an inevitable right sizing of US employment.

    If the current situation is the new normal, then continuing to run down America’s capital base (by rejecting all policies that might divert national income into investment instead of consumption) is a dubious strategy.

  3. Ralph H  ::  12:33 pm on December 3rd, 2011:

    So if we do the payroll tax holiday what do we do this time next year when the Bush Tax Cuts, Payroll tax holiday and increased Obamacare taxes result in an overall hit. Do we expect a miracle in 1 year? As an alternative why not start on XL pipeline and offshore oil? No tax impact excep increased payroll and income tax receipts, and a guaranteed increase in private sector jobs. Oh, sorry it would tick off a Seinfeld retread.

  4. Monday Morning: Linked and Loaded | Punditocracy  ::  9:07 am on December 5th, 2011:

    […] Payroll Tax Holiday is not Perfect, but Far Better than Inaction But low- and middle-income workers who are living paycheck to paycheck are likely to spend most of any payroll tax cut. Some of the tax break might go to pay down credit card debt or substitute for borrowing, which also won’t boost the economy, but with credit much less available than it was a few years ago, I expect this effect to be relatively modest. And extending unemployment benefits is an almost ideal economic stimulus because long-term unemployed people have little choice but to spend any additional income. […]

  5. Around The Dial – December 7, 2011 | South By North Strategies, Ltd.  ::  3:03 pm on December 7th, 2011:

    […] TaxVox argues that the payroll tax cut is better than inaction. […]

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