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October 25, 2012
Opinion: We Still Need the Lousy Payroll Tax Cut
Joseph J. Thorndike

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Who says bipartisanship is dead? Democrats and Republicans may not agree on much, but they share a preference for raising taxes on pretty much every working American.

For most of this year, Washington has been gripped by a modulated panic over the so-called fiscal cliff. Back in February, when Federal Reserve Chair Ben Bernanke coined the term, the cliff was still a distant threat. Lawmakers had plenty of room to fret and no imperative to act.

Now, however, the precipice looms large, and lawmakers across the political spectrum have promised to rescue the nation from impending disaster. Most recently, President Obama insisted that the cliff's contractionary collection of tax increases and spending cuts "will not happen."

That's reassuring, but probably misleading. Even assuming that Obama gets his way, he has already signaled his support for letting some parts of the cliff take effect as scheduled. In particular, tax increases for those making more than $250,000 a year are a key part of the Obama fiscal program.

But the rich aren't the only ones likely to see their taxes rise in a post-cliff world. The payroll tax cut -- which disproportionately benefits low- and moderate-income workers -- also seems slated to disappear. Indeed, it's more likely to give up the ghost than any other element of the cliff, because only a few people in Washington are willing to defend it.

Dueling Threats

The question is, why? For one kind of deficit hawk, the answer is simple: Letting the cut expire will add something in the neighborhood of $100 billion to $125 billion annually to the nation's cash-starved coffers. Of course, that money will be drained from the paychecks of working Americans, costing the average worker about $1,000 next year.

According to a recent estimate from JPMorgan, expiration of the payroll tax cut would reduce economic growth substantially, chiefly by slowing consumer spending. "That change alone is worth over half a percent of GDP growth next year," the firm concluded in a recent research note.

The economic effect of letting the payroll tax cut expire is magnified by its importance to low- and middle-income workers. That group, which JPMorgan describes as disproportionately likely to be "liquidity constrained" in this economic environment, has a tendency to spend rather than save.

Despite such projections, the payroll tax cut has attracted few defenders and a relative army of detractors. Notable among the latter are champions of Social Security, including lobbyists like the AARP (which recently advised Congress to let the cut expire) and policy experts who have devoted their careers to retirement security.

For instance, in a recent article for, Alicia Munnell, director of the Center for Retirement Research at Boston College and a leading expert on social insurance, urged Congress to let the tax cut die. "Messing around with Social Security's finances was always a bad idea," she argued. "And while no one wants the country to fall off a fiscal cliff, one small step towards sensible fiscal policy probably won't hurt the economy very much and will greatly reduce the risks to the Social Security program."

What are those risks? Well, they're chiefly political. Munnell acknowledged that Social Security has survived the current cut unscathed -- so far. While payroll tax revenues have fallen by $110 billion per year, Treasury has made up the shortfall using general funds.

But such subsidies are unrealistic over the long term, especially in light of current shortfall projections. "Absent the payroll tax cut, the Social Security financing story is one where the average cost rate for the next 75 years is 16.7 percent and the scheduled income rate is 14 percent, producing a deficit of 2.7 percent," Munnell explained. "That figure means that if the payroll tax were raised immediately by 2.7 percentage points -- 1.35 percent each for the employer and employee -- the government would be able to pay the current package of benefits for everyone who reaches retirement age through 2086."

All in all, such a tax increase is probably a manageable sacrifice for the sake of retirement security. But if the payroll tax cut remains on the books much longer, the shortfall will grow, as will the eventual tax increase needed to close it. A 2.7 percentage point tax increase might be politically feasible, but a 4.7 percentage point increase will be a much harder lift.

The Bigger Threat

Ultimately, arguments over the payroll tax cut boil down to a question of timing. If we accept the premise that the cut was helpful in bolstering the economy when it was first enacted in late 2010, then we have to decide whether the economy still needs that sort of boost. In her article, Munnell argued that it doesn't. "The economy appears to be bottoming out and should be able to absorb a tax increase of this magnitude," she wrote.

Maybe. But if you listen to the politicians and most economists, maybe not. Just last week, the Federal Reserve's Open Market Committee worried publicly that the recovery was still weak. "Without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions," the panel said. In this case, the "policy accommodation" in question was monetary, not fiscal. But Fed officials have also warned loudly about the dangers of contractionary tax and spending changes.

Admittedly, the payroll tax cut is probably not the best form of fiscal stimulus. In a recent paper on the nation's "fiscal obstacle course," economists at the Economic Policy Institute (EPI) made the case for replacing the payroll tax cut with more effective forms of stimulus. An optimal program would focus on infrastructure investment and aid to state and local governments, the EPI argued.

"But optimal policy responses are hard to come by these days," Andrew Fieldhouse of the EPI acknowledged in a subsequent blog post. "Restoring full employment -- which should be the top policy objective for our depressed economy -- requires measures that would dwarf the Recovery Act, which regrettably seems highly unlikely. Which brings us to political compromise and second best policy responses."

Like, for instance, the payroll tax cut.

In recent days, some Democrats have seemed to embrace this argument. "We've gone through an extraordinarily difficult economic period," Rep. Chris Van Hollen of Maryland, the ranking Democrat on the House Budget Committee, told The Washington Post last week. "Everyone would agree the economy remains fragile. This should be considered for another year. Its multiplier effect on jobs and the economy is much more powerful than other ideas that have been put on the table. It's certainly more powerful than providing a tax break for very wealthy people, who are essentially sitting on their funds."

On balance, Van Hollen is right. Extending the payroll tax cut seems reasonable, even prudent. If it was worth enacting in late 2010 -- and extending in late 2011 and early 2012 -- then it's worth extending now.

Which is not to say that it's good policy. The folks at the EPI are right: Other forms of stimulus would be more effective.

And Munnell is right about the political danger of extending the cut. The link between the payroll tax and Social Security has always been a question of aesthetics rather than accounting. But aesthetics matter in politics. Franklin Roosevelt understood this when he made the unusual (and globally unprecedented) decision to fund his most progressive policy innovation with a distinctly regressive tax. Real or imagined, the link between that tax and its associated spending program has protected Social Security for more than three-quarters of a century. Breaking that link -- even partially -- is dangerous.

But that's a second-order concern, at least for the time being. The nation is still struggling to dig itself out of a deep hole. In such a challenging economic climate, the payroll tax cut is one of the best options to remain even slightly viable.

Eventually, of course, the cut will have to go, if only to protect Social Security from those who would love to chip away at its revenue foundation on a yearly basis (the likely result of long-term funding support from general revenues). Someday soon, the time will come to make good on the temporary element of this tax cut.

But now is not that time.