When it comes to political posturing, the current fight over extending this year’s payroll tax cut is a classic.
While they differ on the details, Democrats and Republicans both favor the proposed extension. Leaders of both parties claim that the reduced payroll tax, which saves the average family about $1,000 a year, will stimulate the economy. And, as is usually the case, they are wrong.
All the squabbling makes for amusing political theater but distracts from the real problems America faces. Nothing in any of the proposals for extending the tax “holiday” addresses America’s fundamental economic problems, nor will any of the proposals do much to speed the economic recovery.
Temporary tax cuts may modestly and temporarily increase spending, but they do little to grow an economy. The reason is simple: People make serious spending and investment decisions based on long-term expectations. If your employer tells you that you are going to get a $10,000 salary increase, you are far more likely to change your spending behavior — finance the purchase of a new car over the next six years, perhaps, or apply for a home equity loan so you can redo your kitchen — than if he gives you a one-time $10,000 bonus. The increase is permanent; the bonus is transient.
The same logic applies to tax changes. A permanent tax reduction that individuals and investors can count on over many years will generate much more economic activity than a temporary reduction.
But nobody in Congress is proposing a permanent cut. Besides, such a promise wouldn’t be credible because such a permanent cut would merely put us further in the hole.
Remember: The payroll tax funds Social Security. According to the 2011 Social Security and Medicare Trustees Report, Social Security is already operating in the red, with a $49 billion deficit last year (excluding interest income), an expected $46 billion deficit this year and “deficits … expected to grow rapidly [after 2014] as the number of beneficiaries continues to grow at a substantially faster rate than the number of covered workers.” Cutting the tax that funds Social Security would make the deficits larger and would increase the likelihood of future tax increases.
A payroll tax cut would be more credible if it was matched with some serious spending cuts. Instead, both parties are proposing the opposite: pairing the payroll tax cut with spending increases, such as an additional extension of unemployment benefits.
While this may seem like good politics, paying people not to work is surely the wrong way to increase employment.
Leaders of both parties have come to the belated realization that extending the 2011 payroll tax holiday for another year has serious financial consequences. So they’re looking to offset the tax cut.
Democrats want to offset the cut with a surtax on incomes over $1 million. From an economic perspective, however, balancing a tax cut with a tax increase will do little to boost the economy. Republicans want to offset the tax cut with spending decreases. At least one plan would temporarily freeze government salaries and reduce the size of the federal work force.
Make no mistake: Washington’s real problem is runaway spending. The government is more than $15 trillion in debt and the Congressional Budget Office forecasts another $10 trillion of deficits in the coming decade. Congress failed to make significant cuts to address these problems when it raised the debt ceiling last August and the “super committee” did no better.
Deficits of this magnitude create uncertainty and lead investors to expect higher taxes in the future. As a result, investors don’t make the investments that would stimulate the economy.
The good news is that another one-year payroll tax cut won’t make the economy worse. But it won’t improve the situation either.
Benjamin Powell is an associate professor of economics at Suffolk University in Boston and a senior fellow with the Independent Institute, Oakland, CA.