Posted December 2, 2011

A payroll tax cut is one of the most efficient policies for creating jobs and growing the economy

By Loren Adler and Shai Akabas

Jonathan Goldstein contributed to this post.

As Europe stands on the brink of economic collapse, the American economy continues to putter along with slow growth and a relatively stable (though severely elevated) unemployment rate. That is the good news. The flip side is that given the United States’ precarious position, a sudden fall in Europe’s balancing act or any other unforeseen shock could easily throw the nation back into recession.

With the current payroll tax cut scheduled to expire next month, Congress should take advantage of this opportunity to significantly expand the policy – making it a complete payroll tax holiday for both employees and employers – to accelerate growth.

According to the Congressional Budget Office (CBO), a payroll tax cut is one of the most efficient policies for creating jobs and growing the economy. BPC’s proposal will relieve workers of their payroll tax burden for the year – putting that money back in their pockets – which will increase consumer demand. On the business side, the holiday will incentivize companies to increase wages and lower the costs of hiring and retaining workers.

Critically – as this has been the topic of much discussion, of late – this policy will not have any detrimental effect on Social Security’s finances. Let’s take a step back to see why.

Almost all workers in America are taxed on their wages up to a certain income level for the purpose of funding the Old Age, Survivors, and Disability Insurance program (or informally, Social Security). Normally, the rate is 6.2 percent for employees, and an identical tax is levied on their employers’ payroll, for a total of 12.4 percent of payroll. These revenues are received by the Social Security Administration, and utilized to purchase special interest-earning securities that are placed into the Social Security Trust Fund.* When beneficiaries are due to receive payments, securities are redeemed from the Trust Fund in order to pay them.

For many years (until this past one, which we will return to momentarily), the revenues collected have exceeded the benefits paid out, creating surpluses that have built up the Trust Fund’s value. This was orchestrated during the 1980s, as policymakers anticipated the retirement of the baby boomers and attempted to ease the coming demographic shift. Additionally, the Trust Fund’s securities have earned interest, further boosting its total holdings. As a result of these two sources combined, the Trust Fund has accumulated roughly $2.6 trillion of assets.

As of last year, however, Social Security began to pay out more in benefits on an annual basis than it collected in revenues. With the retirement of the baby boomers accelerating in the coming years, this shortfall will grow. While entering the red is not cause for panic, it does mean that the Trust Fund will be drawn down and eventually exhausted over the next few decades, leaving the program on unstable financial footing. (That is why BPC’s Domenici-Rivlin Task Force, the president’s Fiscal Commission, and many others have developed packages of modest reforms that would strengthen the program for future generations.)

Wouldn’t expanding the payroll tax holiday just make this problem worse? No. Under the current payroll tax cut that expires at the end of this year, employees are only paying 4.2 percent – instead of the standard 6.2 percent – of their wages into the Trust Fund. The original legislation for this policy (as well as the BPC proposal for a full holiday), however, ensures that the Trust Fund is not shortchanged. The General Fund of the government will transfer the foregone revenue dollar for dollar back to the Trust Fund, such that it is made whole in real time with no impact on Social Security’s financing. This is one apprehension that can be put to rest.

But this response begs the question: Since you cannot make the money appear out of thin air, if you implement this policy, aren’t you simply adding to the deficit? Yes, but that is precisely why the payroll tax holiday should not be done in a legislative bubble. Both parties acknowledged this in yesterday’s Senate votes, each providing deficit reduction policies to offset the costs. Ideally, a holiday would be tied to a comprehensive long-term deficit reduction plan – one that will do far more than just pay for the holiday. Such a package should be built to stabilize the debt and put America on a path towards fiscal responsibility. With time running short before the end of the year, however, policymakers should compromise on a pay-for that at least offsets the cost of the holiday, and then revisit the larger deficit issues shortly thereafter.

The challenge of deficit reduction becomes impossible if strong economic growth remains beyond our grasp. Allowing taxes to rise next year on every working American is entirely the wrong way to encourage immediate growth. Increased revenues must be part of the long-term fiscal solution, but they should not come from middle-class families in the midst of a delicate recovery.

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* The "Social Security Trust Fund" refers to two separately managed accounts: the Old-Age and Survivors Insurance Trust Fund and the Disability Insurance Trust Fund -- each of which funds the corresponding program. Payroll taxes are split percentage-wise between the two. For purposes of this post, they are described jointly for simplicity.

Related Posts

• A Menu of Cures for America’s Ailing Economy, November 23, 2011
• Putting America Back to Work, November 15, 2011
• It’s Time for a Holiday!, October 19, 2011

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Economic Policy Project