The False Hope of a Payroll Tax Holiday

Commentary by Pete du Pont

The debate over economic stimulus is heating up. Republicans and Democrats are both crafting plans to get the economy out of the gutter and back on track. One of the proposals that has sprouted legs both in Congress and in the private sector is the idea of a short-term payroll tax "holiday."

The payroll tax has caught the eye of tax cutters in both parties because it is the most burdensome tax many Americans pay -- four in five Americans pay more in payroll taxes than in income taxes each year.

The payroll tax was first implemented to fund Social Security when it was created in 1937. Back then, it was only collected on the first $3,000 of wages, costing each worker a maximum of $60. It didn't stay that way, as Social Security has grown and Medicare was added. The payroll tax, which is currently set at 15.3 percent -- 12.4 percent on the first $89,000 of wages for Social Security and 2.9 percent on all wages for Medicare -- now tops out at $12,990, and it is only expected to keep growing if Medicare and Social Security are not reformed.

The Business Roundtable, a group of executives from 150 of the country's largest corporations, wants lawmakers to exempt the first $10,000 in individual earnings from the Social Security payroll tax. This would cost the government about $130 billion and would translate into about $620 in cash for each worker. Senator Mary Landrieu (D-LA) -- currently embroiled in a close re-election runoff fight - has proposed a similar plan. She supports the payroll tax cut because, as she says, it is "something everyone can benefit from now."

But is the payroll tax cut a good idea? As a supply-sider, I am not normally one to speak out against cutting taxes. I favor allowing people to keep more of their money. But there is a right way to cut taxes and a wrong way. Unfortunately, a temporary payroll tax cut is likely to do more harm than good.

Evidence shows that a temporary payroll tax cut will not induce people to spend much. If they did, last year's rebates would have been successful engines for economic growth - they weren't. The reason, according to Nobel prize-winning economist Milton Friedman, is people's spending is mainly a function of what they view as their permanent income. When they have temporary income gains, they tend save the money or use it to pay down debt, which is the same thing.

As my colleague Bruce Bartlett recently noted, studies of last year's tax rebate are confirming Friedman's theory. The thought behind the rebate was that people would immediately run out and spend it, which would in turn boost spending and raise growth. But according to a study by University of Michigan economists Matthew Shapiro and Joel Slemrod, only about 20% of the rebate was actually spent. The rest was saved or used to pay down debt. In the aggregate, there was virtually no change in consumer expenditures.

So if a temporary holiday from payroll taxes won't stimulate growth, what will they do? For one thing, a payroll tax holiday may further imperial the troubled future of Social Security. While Social Security can continue to pay full benefits for several years, even with the payroll tax holiday, over the long-term, taking the proposed $130 billion in revenue away from a program that already faces a $25 trillion long-term debt makes the problem much worse.

Of course the Social Security payroll tax should be cut, but not under the guise of economic stimulus. Instead of enacting a temporary payroll tax holiday it would be much wiser to use the payroll tax surplus to transition Social Security into a system that can continue to provide a secure and dependable retirement benefit for future generations, just as it provides to current retirees.

Under a preferred reform, each worker's payroll tax contribution could be permanently reduced by two to four percentage points, with the money flowing into a personal retirement account that would earn a market rate of return over the worker's life and provide a portion of their benefit after they retire. That way, we can be sure that Social Security continues to provide a dependable retirement benefit to future generations, just as it pays to today's retirees.

While a short-term payroll tax holiday may sound attractive politically, it would actually create no real short term benefit, while at the same time contributing to economic problems for generations to come.