Bigger Payroll Tax Need to Stimulate Job Creation Amid Political Gridlock

The $787 billion economic stimulus program, which has now largely expired, helped avert an economic meltdown that was poised to rival the Great Depression. Despite public skepticism about the program, that was the conclusion of a detailed analysis by the nonpartisan Congressional Budget Office. At the outset, however, economists were warning that the stimulus program was far too small to offset an aggregate demand shortfall estimated at upwards of $2 trillion. All along, the struggling economic recovery has been handicapped by sharp spending cutbacks by state and local governments. And now, the zeal for budget deficit reduction has led Congress to mandate federal spending cuts as well.

In his speech last night, President Obama pushed back against austerity advocates and proposed another round of stimulus that would mix new spending on infrastructure and unemployment benefits with tax cuts.

Experienced policy economists from both parties are in broad agreement that the parts of this plan that entail direct government spending offer the best hope of putting the economy back on track, and would also result in much smaller budget deficits in the long run. The President’s proposed investments in infrastructure are especially important and, in fact, should be much larger. Americans rich and poor have been driving on crumbling roads and over unsafe bridges for decades. Many now live in the shadow of dams that could collapse at any moment. Water and sewage systems fail with alarming frequency. Chronically deferred maintenance has left countless schools in shambles. These problems demand immediate attention, quite apart from the fact that attending to them would help address unemployment. Workers and equipment needed to do the job are largely sitting idle today, and materials costs and interest rates are near record lows. If we wait to do needed work, interest rates and materials costs will rise, and we’ll have to bid workers and machines away from other useful tasks.

Still, most observers believe that big new investments in infrastructure will be very difficult to pass on Capitol Hill. In contrast, evidence suggests that the longstanding Republican opposition to taxes of all sorts makes them less likely to oppose temporary tax cuts aimed at stimulating growth and new hiring stimulus. In December of 2010, for example, the Republican majority in the House joined the Senate in approving the president’s proposal to reduce the employee portion of the payroll tax from 6.2 percent to 4.2 percent of annual salaries up to $106,400. That reduction is currently set to expire at the end of this year, but last night the President proposed expanding this tax cut and extending it for another year.

If tax reduction is the most politically feasible form of stimulus, Congress needs to consider a much more aggressive reduction of the payroll tax than even the expansion proposed by the President, which would cut the tax in half for all workers and employers (up to $5 million of payroll). That payroll tax, after all, constitutes the biggest tax burden currently faced by low-income workers, who typically owe little in federal income taxes. With the economy still struggling, the case for suspending this tax altogether is compelling. For a worker earning $1000 a week, a temporary full payroll tax holiday would translate into an immediate gain of $62 a week in take-home pay, much of which would be quickly spent. The University of Delaware economist Larry Seidman has estimated that suspending the employee’s share of the payroll tax would cause the national unemployment rate to decline by a full percentage point by the end of 2012 relative to what it would have been otherwise.

Employers also face a 6.2 percent payroll levy on each employee’s annual salary up to $106,400. The President’s proposal aside, Congress should leave that levy in place for existing workers but embrace his idea of providing a full holiday from the employer levy on all new hires until the economy recovers from the current downturn. (The HIRE Act of 2010 did waive the employer side of the payroll tax, a move that led to significant growth in new hiring, according to a Treasury Department study.)

Unlike many other business tax cut proposals, this two-part payroll tax holiday would immediately strengthen firms’ incentives to hire additional workers. The standard hiring criterion, found in every economics textbook, is that a firm will hire if and only if revenue from the sale of what new employees produce is at least as great as the cost of hiring them. The payroll tax holiday I propose would immediately affect both sides of that cost-benefit comparison. On the cost side, a newly hired worker whose pre-tax wage is $500 would cost $31 a week less to hire than before. And because all workers in the country would have more post-tax income to spend, demand for goods and services would increase, making it easier for employers to sell the new workers’ output.

The proposed payroll tax holiday would thus have a very different impact on hiring incentives than a reduction in the income tax rates paid by business owners. Advocates of extending the Bush tax cuts on the wealthy defended their position by saying that doing so would spur additional small business hiring. But that assertion completely defies economic logic, which makes clear that hiring decisions simply do not depend on business owners’ after-tax incomes. The only relevant question is whether new workers will boost revenue by more than they cost. If so, hiring them would make sense, even if the owner were poor. But if not, hiring wouldn’t make sense, even if the owner were a billionaire.

The White House estimates that its proposed payroll tax cuts would cost $244 billion. The larger payroll tax cut proposed here would raise that tab even further. But when the economy is mired in a deep and persistent economic downturn, short-run deficits are essentially irrelevant. With incentives keeping consumer and investment spending well below normal for the time being, the imperative is to increase total spending by enough to put everyone back to work as quickly as possible. Accomplishing that goal would actually be the most productive possible step toward achieving long-run deficit reduction.

President Roosevelt believed that the political viability of Social Security depended on the perception that recipients had paid for it with a specific tax. Some will object that because the payroll tax was originally implemented to generate revenue to fund Social Security, the proposed holiday would jeopardize the future of the program. But there is nothing sacrosanct about the payroll tax. We can raise all the revenue we need by taxing other things. A tax on any activity not only generates revenue, but it also discourages the activity. The payroll tax is an inherently bad tax because it discourages job creation, a quintessentially useful activity. If legislators could agree to link the Social Security program to specific taxes on harmful activities, such as emitting pollution or entering congested roadways, we should consider putting the payroll tax on permanent holiday.

This post is part of Demos' "America Can Work Better" Week and draws on material from his recently published book, The Darwin Economy.

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