Payroll tax holiday isn't perfect, but it's better than nothing

The payroll tax cut is far from optimal policy, but the economy still needs the stimulus it provides

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.

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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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