Thursday, December 22, 2011

Extending the Payroll Tax Cut

The hottest political issue related to the economy right now is the extension of the payroll tax cut passed last year, which is scheduled to expire on Dec 31.  How did we get here and what is likely to happen without an extension?  One part of the Obama stimulus package was a tax cut of up to $400 per person or $800 per household for 2009 and 2010.  Instead of renewing that, a new tax cut was passed for 2011, reducing the employee share of the payroll (social security) tax from 6.2% to 4.2%.  Thus, the median household earning about $50,000 per year received a tax cut of $1000 instead of $800 (effectively a $200 tax cut beyond what they were already receiving).  The maximum tax cut under the new program was qbout $2120 (2% of the maximum amount of income subject to the tax).  If the tax isn't extended, all workers will face a tax increase equal to 2% of the earnings up to the first $110,000 ($1000 reduction in take-home pay for the median household, $2200 for high-income workers).

Did the 2011 payroll tax cut work?  Of course it's hard to "prove" what would have happened without it.  However, it's hard to imagine that a reduction in income of between $1000 and $2000 would not have affected consumer spending.  Given that consumer spending is 70% of the economy, it seems clear that there was a significant economic impact.  Given that the economy is still experiencing a sluggish recovery with weak income growth, allowing the tax to rise in 2012 will adversely affect consumer spending and thus economic growth, making a weak recovery even weaker.  Thus, most economists favor extension of the payroll tax cut.

Is this the best policy for the US economy right now?  Probably not.  Serious tax reform, both individual and corporate, would provide much more short-term and long-term benefit.  However, that's unlikely to occur until at least after the 2012 election.  The existing payroll tax cut is providing a temporary stimulus to demand without any long-term benefit.  A temporary reduction of the employer portion of the payroll tax would make hiring workers less expensive (as in Obama's proposal from earlier this year), but, given that it's temporary, would have little impact on hiring.  Of course there's the problem of the huge budget deficit, which limits policy options.  In the ideal world, tax reform that eliminates most deductions/loopholes and lowers tax rates would be the best policy, but given today's political environment, an extension of the payroll tax reduction is advisable to keep government policy from being a drag on an already sluggish recovery.