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The Quagmire of Temporary Payroll Tax Cuts

November 15, 2011

Lost in the shuffle this weekend was a moment in the XXX Republican debate where none of the candidates expressed any willingness to even consider letting the two percent temporary payroll tax cut expire. The tax cut was approved as a temporary measure last fall. The law cut the tax paid by employees, which supports the Social Security program, to 4.2% of the first $106,800 of a worker’s income from 6.2%.

 Each candidate in turn claimed that they would not even think of raising taxes in the middle of a recession, which is what they would consider allowing the payroll tax cuts to expire. The cuts to the payroll tax rates were designed to allow struggling individuals keep more of their income in a flagging economy, and intended to boost consumer spending and bolster the countries attempts to drag itself out of the recessionary doldrums.

            The logic of the payroll tax cuts seemed straightforward; lowering the payroll tax would likely provide a small boost to growth by increasing the amount of cash workers have to spend, putting an extra $1,000 in the average worker’s pocket this year. The resulting extra spending would then prompt more hiring to meet the extra demand for goods and services, so in this line of argument, the payroll tax cuts would combat stubborn unemployment and boost growth.

            As many proponents of Keynes know, the most effective stimulus is temporary, timely and targeted. The payroll tax cuts were enacted towards the end of 2010, months and months after the initial shock of the recession, so they were not timely by any stretch. Nor are they targeted, everyone, even the very wealthy, benefits from a payroll tax cut; the only groups not benefiting from the cut are the unemployed and the retired. By their nature, temporary tax cuts would appear to be temporary, and at least fulfill the first criteria of effective stimulus, but the reticence demonstrated by the Republican candidates to even consider reverting the rates to their previous levels, and  President Obama’s proposal to cut the rate by and additional one percent, these payroll tax cuts are not really temporary either. 

As the figure shows, personal income expenditures got no real significant stimulative effects from the payroll tax cut, which was originally implemented in December 2010. Consumption of durable goods spiked to some degree in January and February, perhaps in response to the payroll tax cut, but then consumption of durable goods flatlined, so total consumption has not increased.

This graph shows a similar story, personal consumption expenditures were increasing steadily until 2011, and the introduction of the payroll tax cuts did not result in a spike in consumer spending.

On the opposite end of the ideological spectrum, Milton Friedman won his Nobel Prize in Economics in large part for his work on the permanent income hypothesis, which stated in a much simplified form, that consumption choices made by  individuals are determined not by current income but by their longer-term income expectations. The key conclusion of this theory is that transitory, short-term changes in income have little effect on consumer spending. Friedman concluded that there was no correlation between transitory effects in income and consumption and their permanent counterparts. In order to be a factor in consumption decisions these previously transitory effects would have to be translated into effects lasting beyond the immediate horizon, and he determined this threshold to be three years. If the effect was extended out this far, and there was no uncertainty, then the effect would become part of  permanent income. While in some ways it now seems like an inevitability that no one will seriously attempt to revert payroll tax rates to their previous levels, there is still far too much uncertainty, especially over a longer time horizon, for these effects to register in the permanent income component in Friedman’s system. As a result, Friedman would conclude that people would not adjust their consumption in response to the temporary payroll tax cuts, and as a result, there would no significant stimulative effect

The payroll tax cuts are now in the nebulous realm, a no man’s land where neither Keynes nor Friedman would consider them to be effective. The cuts are no longer temporary as most economists and politicians expect that they will be extended, but neither are they permanent or certain; as the disappointing supercommittee and the debt ceiling situations showed, partisanship and gridlock can prevent expectations from becoming a reality. In the end it is a situation pervaded by uncertainty and achieving almost none of the intended results while posing a serious negative externality to the largest government program in the world.

Payroll taxes finance almost the entirety of Social Security, and the payroll tax cuts accelerate the insolvency of Social Security. The two percent payroll tax cut has already caused Social Security to take in $120 billion less in revenue, which is especially troubling given that Social Security is now, six years ahead of projections, running an annual cash flow deficit. President Obama has promised that Social Security as a program will not see revenues decline as a result of the payroll tax cuts, meaning that funds will be shifted from general revenues to Social Security, to the tune of $120 billion this year. This is not a tenable situation, because the government already spends much more than it takes in, it has to borrow this money to fund Social Security, contributing to the ever-expanding debt and annual deficits.

This is in addition to the already projected cash flow deficit that Social Security is running, and although in the abstract that portion of the shortfall is paid out of the Trust Fund, in reality the government has to pay the Trust Fund back that money that has already been spent by further borrowing. If the cost of redeeming the money in the Trust Fund is included, Social Security could add more than $300 billion to the annual deficit.

The financial outlook for Social Security would be even worse of Obama’s proposal to further slash payroll taxes is passed. This further one percent reduction, with another measure that would lower the payroll tax rates businesses pay if they met certain criteria, would lead to a $289 billion revenue shortfall for Social Security from 2012-2013.

The payroll tax cuts undoubtedly put more money into the pockets of working individuals, and it did result in some job creation, to a degree. However, further analysis shows that ultimately it is a stimulus of dubious effect, and it makes the Social Security problem much worse, and as the Republican debate showed, once these cuts are enacted, it is exceedingly difficult to let them expire.

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From → Economics

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