Wednesday, December 10, 2008

Should we lower the payroll tax to stimulate the economy? I’m not so sure.

A number of economists are arguing that the best way to stimulate the economy would be to lower the payroll tax, which funds Social Security and Medicare. (E.g., see here and here.) Republican political bloggers like Ross Douthat and David Frum are also on board, arguing that payroll tax cuts have more salience for the middle class than income tax cuts, since most workers pay more in payroll taxes than income taxes.

To decide, we should consider how great the short-term stimulus would be versus the potential long-term costs to how we view and run Social Security.

How much would a payroll tax cut stimulate the economy? In theory, not very much. Friedman's permanent income hypothesis argues that consumption will rise in proportion to changes in people's permanent – meaning long-term – income. So if we made a permanent reduction in the payroll tax then we could expect that consumption would increase by a commensurate amount. But the consumption increase from a temporary payroll would be spread out over many years to come, meaning that the immediate effects would be minor.

This is probably even truer due to our current conditions, where people are worried about their jobs, their mortgages, their credit card statements, etc. Give that kind of person some extra cash today and what do you think he'll do with it? Probably save it by paying down some of his debt or putting it in the bank. (This news story cites both opinion polls and some economic research pertaining to the 2001 income tax rebates.) Certainly some people will spend it all, but a lot won't. So I'm lukewarm on the stimulus end.

In any case, it's important to weigh these positive short-term effects against the negative longer-term effects. Payroll taxes, particularly Social Security taxes, are dedicated to a specific program. Social Security taxes are often termed "contributions" because in many ways they function more like a contribution to a retirement account than like income taxes paid to the government. The reason is that Social Security benefits are pegged to Social Security taxes: you don't qualify for benefits unless you've paid into the system, and the more you pay the higher the benefits you receive.

This "contributory" structure was deliberate. One of the principles President Roosevelt outlined on founding Social Security was to "Rely to the maximum extent on contributory social insurance for protection against destitution…. By contributory social insurance, the President meant a system under which contributions and benefits were related to past earnings." The contributory structure, Roosevelt said, was

"politics all the way through. We put those pay roll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program. Those taxes aren't a matter of economics, they're straight politics."

Roosevelt also specifically mentioned the psychological effect of contributions in destroying the "relief attitude," which is what we today would call the stigma of welfare.

Cutting the payroll tax could lead Social Security to be seen more as a welfare program than a contribution, which will tend to reduce public support for the program. When people are receiving benefits that they didn't pay for, it's not unfair to term that welfare.

Moreover, cutting payroll taxes repeats a mistake the GOP made on income taxes. Many Republicans are so focused on cutting marginal rates for high earners that in exchange they were willing to take more and more low earners off the tax rolls entirely. As a result, around 40 percent of Americans currently pay no income taxes. Under Sen. Obama's plan, I believe that share would rise to around 50 percent. These folks have much less incentive to monitor the level or quality of government spending, since they have very little stake in financing government. By cutting the payroll tax, we'd be taking more Americans off the federal tax rolls entirely.

I don't see that as a particularly helpful trend in general, and less so with regard to Republican partisan interests. After all, President-elect Obama already has a plan to cut the payroll tax, which would cost $779 billion over 10 years. Do Republicans think they can compete with Obama's plan? Should they even try?

Ironically, I generally agree with both Douthat and Frum on the need to modernize the Republican Party and accept many of their proposals to do so. I just don't think cutting payroll taxes moves things in the right direction.

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