Beware the Payroll Tax Cut
A temporary moratorium on payroll taxes is being talked about as a substitute for a fiscal stimulus package. Beware: While any tax cut that reduces the ability of Congress to overspend should be welcome, this particular one requires a costly trade-off and fails to accomplish its primary objective of economic stimulus.
The proposal would eliminate payroll taxes for one month. But to pay for this moratorium, it would rescind a scheduled $300 tax credit for low-income workers and an acceleration in rate cuts for upper-income taxpayers. The moratorium’s only positive attribute is that it transfers income from the feds back to wage earners.
It is not surprising that Democrats such as House Ways and Means member Charles B. Rangel of New York are buying into the old theory that these transfers magically create new consumer spending and thus provide a stimulus. But so are leading Republicans.
This theory ignores the reality that such consumer spending is not created from political fairy dust. Unless the feds cut their spending (don’t hold your breath), every dollar returned to consumers would be paid for either by someone else’s offsetting tax increase or by an additional dollar of government borrowing. Either way, a dollar that otherwise would have been spent on consumer goods or capital investment is sacrificed at no net positive effect for the economy as a whole.
Moreover, in today’s environment, consumers are not spending or investing all their tax refunds. They are merely increasing their “walk around” money for emergencies. Thus such a tax cut may actually be a drag on the economy. Rather than increase the stock of idle currency, we might be better off letting the feds use the dollar to invest in the bond market, thus allowing for increased capital investment and productivity.
A permanent payroll tax cut would have considerable virtues, but precisely because a tax moratorium is temporary, it has practically no effect as an economic stimulant. If a Burger King franchisee knows that his payroll costs will be reduced permanently, he may hire additional workers, thus laying out first steps on the ladder of success and productivity to young people. But who among us is going to hire more people or work longer hours because of a one-month tax cut?
The worst parts of this tax proposal, however, are the significant trade-offs it will require. Trading a $300 rebate for low-income workers may be an even deal, but canceling an acceleration in rate cuts for upper-income taxpayers is unequivocally bad. It eliminates a permanent reduction for those most likely to invest and add workers and thus taxable income to their companies. Hand an upper-income individual a payroll tax rebate and he or she may buy a nice dinner out; all the economy has to show for it is dirty dishes. Give that person a permanent tax rate cut and you will get dividends of increased productivity and taxable income into perpetuity.
It also is likely that Democrats will attach health care benefits to laid-off workers (a potentially costly new entitlement) and extended unemployment compensation to the bill. While these welfare programs may be justified as humanitarian measures, they are not economic stimulants and should be considered separately.
Interestingly, cutting payroll taxes, even temporarily, opens a Pandora’s box for Social Security because it reduces funding to the Social Security trust fund, already crippled by trillions of dollars of unfunded liabilities. If Democrats push for the funds to be repaid from general revenues, they risk shaking the very foundations of the program, in which, as FDR pointed out, “those payroll contributions . . . give the contributors a legal, moral and political right to collect their pensions.”
Washington needs to get over the false promise that converting capital investment to short-term consumption can provide economic stimulus. A job created by the demand for new computers is just as valuable as a job created from the demand for a movie or dinner out, but the new computer will provide productive dividends for years to come.
Accordingly, the recipe for short-term stimulus is the same as for long-term prosperity: cuts in capital gains taxes and across-the-board reductions in all tax rates.
Let’s not trade our future for political promises and economic mythology.
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John Palffy, a former fellow for tax and budget studies with the Heritage Foundation, is a managing partner and chief economist with an investment banking firm in Grosse Pointe, Mich.
