A Payroll Tax Compromise

by Pejman Yousefzadeh on August 21, 2011

The Obama Administration is in favor of extending a payroll tax cut for workers. Currently, the payroll tax rate is at 4.2% as a consequence of the compromise that the Administration agreed to along with Congressional Republicans this past December. Unless the extension remains, the payroll tax will go back up to 6.2%.

Many Republicans are against the extension, which as this article points out, effectively means that those Republicans are in favor of a tax increase. This is, to say the least, a weird position for Republicans. But there is a point to the Republicans position; temporary tax cuts do little to nothing to stimulate the economy, a finding that is implied by Milton Friedman’s Permanent Income Hypothesis.

In order for a payroll tax cut for workers to stimulate the economy, then, it would appear to follow that the tax cut has to be permanent. Barring that, the following passage from the story is worthy of note:

The nonpartisan Congressional Budget Office says payroll tax reductions give the economy a short-term boost. But it says the benefit is bigger if employers get the tax break instead of, or along with, workers.

So let’s give businesses and workers a permanent payroll tax cut, and see if that grows the economy. It can’t hurt, and chances are, it will likely help. Sure, the fiscal situation may be hurt in the short term, but we will do more for the fiscal situation if we grow the economy significantly, and generate lots of revenue as a consequence of GDP expansion.

Of course, this approach seems like an entirely straightforward way of cutting the Gordian knot when it comes to the payroll tax, and stimulating the economy, which is why I don’t expect it to be agreed to anytime soon.

  • yclipse

    I think it is interesting that political commentators continue to refer to this as “the payroll tax”. In truth, there are three payroll taxes – Social Security, Medicare, and the withholding (income) tax. The reduction was in the Social Security payroll tax. Given the precarious financial condition of the Social Security system, the reduction is questionable. 

    But there is a bonus. The 2% reduction means that much less money being taken in as advance Social Security payins, then invested in Treasury bonds. Without the reduction, we may have hit the $14 trillion limit by May or so, rather than in August. 

    When the 2% is restored, the pace of the increase in debt will increase, hastening the next crisis point. That is why Obama wants to extend it. 

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