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The Payroll Tax Holiday Is a Bad Bipartisan Idea

Tuesday, December 6, 2011

Attempting to manage the business cycle by turning on and off temporary provisions is risky business and creates uncertainty for taxpayers.

Congress is getting in the holiday spirit, and top on their gift list for American workers is extending President Obama’s payroll tax holiday, set to expire at the end of the year. But, as is the case with many gift ideas, this one sounds better in theory than it is in real life.

The bipartisan support we’ve seen for extending the policy doesn’t mean it will be easy to pass, considering the disagreements on if and how to offset its impact on the deficit. But more importantly, bipartisan support for the tax holiday doesn’t make it good economic policy.

The economic argument in favor of a payroll tax holiday is that putting more dollars in workers’ hands will make them spend more, driving up demand for goods and services and ultimately causing the economy to grow. Extending the holiday would likely benefit 160 million workers, totaling about $1,500 per family. This is estimated to add over $250 billion to the deficit. Is it worth it? A review of related academic literature suggests not. In fact, it appears that politics, rather than sound economic evidence, is the motivating factor.

It appears that politics, rather than sound economic evidence, is the motivating factor.

Research on a similar policy—tax rebates—employed in 2001 and again in 2008 suggests that this type of economic stimulus does not work as intended. Matt Shapiro and Joel Slemrod found that among recipients of tax rebates in 2001, only 22 percent spent the rebate, while the rest saved it or used it to pay off debt. In a similar survey of 2008 tax rebate recipients, Shapiro and Slemrod, as well as Claudia Sahm, confirmed these results, determining that only 20 percent of recipients spent the rebate. For a policy intended to stimulate spending, this is not a positive result.

Here’s another important question: Is an extension of the payroll tax holiday actually harmful? According to Social Security expert and trustee Charles Blahous, cutting the payroll tax poses a danger to Social Security because the tax funds the program’s trust fund.

Beyond Social Security, the impact on the overall economy is best understood by looking at how the holiday would be funded. In this, there is disagreement. Democrats want to pay for the tax holiday by raising taxes on the rich, while Republicans want to freeze government employee wages and cut the federal workforce.

Among recipients of tax rebates in 2001, only 22 percent spent the rebate, while the rest saved it or used it to pay off debt.

Offsetting the cost of the holiday with a marginal tax increase on high-income earners is definitely a bad idea. At present, the top marginal tax rate for federal individual income taxes is scheduled to rise to 39.6 percent in 2013. State income taxes push that rate even higher. A surtax of 3.25 percent, as Senate Democrats have proposed, would further escalate the harmful distortions of high marginal rates. Imposing higher rates on the wealthy, as my colleague Alan Viard points out, “will discourage saving by the group that finances much of the business investment on which economic growth and wages depend.” Thus, a tax cut for the masses and a tax hike for the well-to-do is not a recipe for more saving, more investment, or more long-term growth.

Unfortunately, the Republican package is also unlikely to result in a measurable economic boom.  Offsetting a payroll tax holiday with a freeze in government salaries might make for good politics and might result in more appropriate compensation for federal employees—a worthy goal, as my colleague Andrew Biggs has documented—but it won’t create stimulus.

Furthermore, both approaches fall back on a misguided strategy for tax policy. The incentive and disincentive effects of tax policy can be large. When they are used to good effect, it is in pursuit of long-run goals: work, saving, research, and entrepreneurship, to name a few. Attempting to manage the business cycle by turning on and off temporary provisions is risky business and mostly just creates uncertainty for taxpayers.

Alex Brill is a research fellow at AEI.

FURTHER READING: Brill also writes “Who Among Us Doesn't Pay Income Tax?” Alex J. Pollock asks “Would You Settle Your Claims on Social Security for 83 Cents on the Dollar? (I Would).” Phillip Swagel says “Good Economic Policy Takes Back Seat to Elections.” Alan D. Viard wonders “Do Taxes Narrow the Wealth Gap?

Image by Rob Green | Bergman Group

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