The Case Against a Payroll Tax Cut
By BRUCE BARTLETTBruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul.
It's rare for Republicans to find a tax cut they don't support, but last week The New York Times reported on just such an exotic creature. Many leading Republicans, it seems, are extremely cool to the idea of extending the temporary cut in the Social Security tax that took effect on Jan. 1 and expires on Dec. 31. It has lowered employees' share of the payroll tax to 4.2 percent, from 6.2 percent.
Perspectives from expert contributors.
In theory, the payroll tax cut has positive economic effects on both the demand side and the supply side. By increasing workers' cash flow, it should encourage additional spending in the economy – something that the economydesperately needs.
It also reduces the tax wedge between what it costs employers to hire a worker and the worker's after-tax reward. Thus, a cut in the payroll tax should increase economic activity and reduce unemployment.
However, there is no evidence that the lower payroll tax has done much of anything to stimulate either spending or hiring. There are a number of reasons for this.
First, the tax cut only helps those with jobs. While many have low wages and undoubtedly are spending all their additional cash flow, those with the greatest need and most likely to spend any additional income are the unemployed.
Second, the payroll tax cut helps many workers who have no need for it and will only pocket the tax savings.
Third, economic theory and the experience with tax rebates in 2001 and 2008 tell us that people are strongly inclined to save temporary increases in income. People only increase their spending when they perceive an increase in their permanent income.
Fourth, even if one assumes that the cost of employment has declined and employers can somehow capture some of the payroll tax cut, there's little sign that labor costs are the principal factor holding back hiring.
The main one is a lack of sales, as monthly surveys by the National Federation of Independent Business document. In the latest survey, 23 percent of businesses said poor sales were their No. 1 problem and only 4 percent cited the cost of labor.
Another issue is whether the Social Security tax is really a tax at all. A case can be made that it is really part of a worker's compensation, rather than a reduction of it – because the workers generally get back all of their contributions, plus more, in the form of Social Security benefits in retirement.
Although counterintuitive, economic research supports this view of the Social Security tax. In a 1999 paper for the World Bank, Peter Orszag and Joseph Stiglitz argued that Social Security was essentially a forced savings program that doesn't necessarily reduce labor supply at all. In a 2004 article, Richard Disney supported this argument:
To the extent that pension contributions are perceived as giving individuals rights to future pensions, the behavioral reaction of program participants to contributions will differ from their reactions to other taxes. In fact, they might regard pension contributions as providing an opportunity for retirement saving, in which case contributions should not be deducted from household's earnings and should not be included in the tax wedge.
To the extent that workers perceive a linkage between the Social Security taxes they pay and the benefits they receive, the Social Security system reinforces work incentives rather than being a tax on work, as is commonly believed. If this is true, then workers may well view a cut in Social Security taxes as diminishing their future benefits, which may cause them to increase their saving rather than spend the additional cash flow.
Thus, a lower Social Security tax could actually be contractionary rather than stimulative.
In my view, the $110 billion cost of the one-year Social Security tax cut would have been far better spent on measures that would actively raise spending in the economy. Public works would be the best way of doing that. Under current economic conditions, all tax cuts are essentially passive and do almost nothing to increase aggregate demand or economic output.
However, economic analysis is not what is driving the Social Security tax debate. Democrats are using the issue mainly as a political ploy. They may also think that some sort of tax cut is the only additional fiscal stimulus Republicans might possibly support.
Although Republican opposition to extending the payroll tax cut may represent little more than knee-jerk opposition to any Democratic initiative, at least some conservatives have long been uncomfortable with cutting the payroll tax without fundamentally restructuring Social Security at the same time.
For example, Andrew Biggs of the American Enterprise Institute has said that a temporary payroll tax cut "is a dubious idea that would give low-wage workers a modest temporary boost, but at the expense of the Social Security program they will depend upon in retirement."
Liberal groups like the Center on Budget and Policy Priorities have also voiced skepticism about the benefit of temporarily cutting the payroll tax. They are concerned about the possibility that a temporary payroll tax cut will become permanent, undermining Social Security's long-term finances.
And having the Treasury replace the lost revenue opens the door to general revenue financing for Social Security. A longstanding liberal concern is that this makes Social Security more of a welfare program and less of an earned pension, which undermines its political support.
Although the case for additional fiscal stimulus is overwhelming, it would be much better to find more economically stimulative alternatives to simply extending the temporary payroll tax cut.
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