Home Economic Trends Payroll Tax Cut Won’t Stimulate the Economy – Veronique de Rugy (09/03/2019)

Payroll Tax Cut Won’t Stimulate the Economy – Veronique de Rugy (09/03/2019)

When you think that you’ve heard it all, you probably have not. Take the latest talk by Trump officials about using a payroll tax cut to stimulate the economy. While the president has flip-flopped on whether he would support this measure — he first said no, then yes, then no again — it has triggered a lot of conversation in the media and the pundit/think tank world. 

Some of the supporters of this idea make for strange bedfellows. But that doesn’t make it a good idea. 

The payroll tax rate is currently 15.3 percent (12.4 percent for Social Security and 2.9 percent for Medicare) of earnings. The Social Security portion of the tax is imposed on earnings up to an annual maximum of $132,900 while the Medicare share of the tax applies to all employee earnings without limit. Then there is an additional 0.9 percent Medicare tax levied on all earnings above $200,000. 

While we tend to set it apart from the income tax, the payroll tax is nonetheless a tax on income. With the income tax, it amounts to a double taxation of income. It is also a pretty big deal from a tax-burden perspective as a majority of taxpayers pay more in payroll taxes than they pay in income tax. Maybe more difficult to grasp is the fact that even though the 15.3 percent tax rate is formally split equally between the employer and the employee, in reality the employee ends up shouldering almost 100 percent of the tax. I recently wrote about why that is: 

On paper, workers and employers each pay 7.65% of the employee’s salary and wages. Employers send their portion of the tax as well as the one collected from their employees to the government. But this fact doesn’t tell us anything about the tax’s true burden. Economic research shows that employers shift the burden of the payroll to their employees by decreasing workers’ wages by almost 7.65%. 

The biggest share of the payroll tax is used to pay for the benefits of current retirees. Ignoring all the problems with Social Security (including its unfairness, insolvency, and poor return on taxpayers’ “investment”), there is one feature of this tax that most people should appreciate: in order to become eligible for the benefits, you must first work for and earn money. Here is the earning requirement:

To be eligible for Social Security retirement benefits, a worker born after 1928 must have accumulated at least 40 quarters of work in “covered employment”. A “quarter of coverage” generally means the three-month calendar quarter. In addition, you must earn at least $1,320 in a quarter (in 2019) for it to count.

In other words, you contribute to the system before you can be eligible for the benefit. 

With this fact in mind, here are a few reasons why a payroll tax cut isn’t justified by a need to stimulate the economy. First, why would the government stimulate the economy now? Supporters of the idea will tell you that tax cuts put more money into people’s pockets, prompting them to spend more, thus stimulating the economy. But this argument is incorrect. Academic research shows that giving a payroll tax cut to people in the hope that they will spend it and spur the economy is misguided. The Congressional Budget Office estimated that tax cuts geared to lower- and middle-income earners usually return about 30 percent of their cost in the form of added spending. Moreover, the idea that consumer spending is what grows the economy is also wrong

Finally, even those who are simpatico to the idea of using government to stimulate the economy will tell you that some conditions are required for a government stimulus to actually stimulate. They argue that the timing and the implementation of the stimulus must be perfect for it to work. That means, among other things, that the economy must actually be in a recession and not be in the thrall of a massive debt accumulation. 

Our debt, of course, is growing faster and faster every year; it has now reached $22 trillion. Consumer spending has been the most consistent, strong spot in the economy. Also, employment levels are high, with the unemployment rate below 4 percent. And wages now are growing faster than inflation. So I would say, and the president would agree, that we are not in a recession. Hence, even from the Keynesian perspective, this stimulus is guaranteed to fail. 

Besides, the main reason people are talking about the potential need of a stimulus is because they want to avoid an economic slowdown before the 2020 elections. Yet, the single biggest economic risk we confront over the next year or two is the president’s destructive trade war — or, more accurately, his war on trade. In addition to creating a massive level of uncertainty in the economy, which reduces the level of business investment, the Trump tariffs on products coming from China alone (there are other tariffs on top of that), if fully implemented, will cost the typical American household $1,000

In spite of what Trump supporters argue, making consumers pay more for the goods they want to buy, and then trying to compensate Americans who suffer these losses by putting money in their pocket with a payroll tax cut is idiotic. The right thing to do is to stop the trade war and lift all the tariffs.

Finally, since the payroll tax cut will not be paired with equivalent Social Security and Medicare spending cuts, the tax revenue is going to have to come from general revenues if the administration doesn’t want to further impair the solvency of the program. That means more borrowing, larger deficits, and a heavier debt burden. 

Once elected officials get used to thinking of the payroll tax as something to be used to boost the economy, it is only a matter of time before they will want to use it for many other purposes. It won’t take long since some conservatives and legislators already want to use Social Security to pay for paid-leave benefits. For now, they offer to repay the program for the new benefit paid decades down the road by having beneficiaries delay their retirement. 

That said, we know that won’t happen. Sooner rather than later the program will be repaid by using more general funds. It is only a small step after that for those who want to expand Social Security benefits to start cramming the trust fund with general revenues to keep Social Security going without reforms. 

Now I will grant you that this idea may not be the worst one that we have seen come out of the Trump administration or the Washington swamp. Still, the thinking behind the idea is flatly incorrect.