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The Muddled Economics of the Payroll Tax Cut

December 6th, 2011 . by economistmom

Here’s a blog post of mine just published over on Concord’s blog, The Tabulation; I’m cross-posting it here:

The current debate over extending the payroll tax cut well demonstrates that policymakers often mean different things when referring to policies that “help” or “expand” the economy. I often hear the words “stimulus” and “growth” used interchangeably, but when economists use them, we typically are making a distinction between different economic goals that apply to different circumstances.

“Stimulus” usually refers to short-term policies to increase demand for goods and services in an economy  operating at less-than-full capacity — i.e., an economy with high unemployment. In such a recessionary economy, the problem is not a lack of productive resources (capital and labor), but a lack of demand for the goods and services that those resources produce. Under such conditions, public sector deficits — whether through tax cuts or direct spending — can be an effective way to increase demand (consumption) and the level of economic activity.

“Growth” usually refers to the long-term expansion of the “supply side” of the economy — that is, the supply of capital and labor. When the economy is at “full employment,” the binding constraint on it is not the demand for goods and services, but the supply of inputs to production. Fiscal policies that are good at growing the economy over the longer term are therefore those that encourage greater educational attainment, labor force participation, and saving. Instead of the recessionary goal of increasing consumption, we want the opposite over the longer term: We want to increase saving. Reducing tax rates is often emphasized as a good “supply side” policy because raising the net-of-tax return to working or saving can improve the private sector’s incentives to supply these resources. But any deficit-financing of such policies is counterproductive in dollar-for-dollar reducing the public sector’s contribution to national saving.

In the debate over the payroll tax cut, we are hearing arguments from both sides that muddle the distinctions between short-term, demand-side stimulus and longer-term, supply-side growth. Many Republicans argue that the payroll tax cut is not an effective way to expand the economy, but they are probably measuring it against their favored supply-side yardstick. The Congressional Budget Office (CBO) shows that a payroll tax cut is one of the most effective tax cuts in stimulating demand for goods and services in a recessionary economy — not as effective as direct spending on unemployment benefits but still far more effective than high-end income tax rate reductions.

Both Democrats and Republicans seem torn about paying for the payroll tax cut, for probably different, yet both valid, reasons. Democrats don’t want to offset the cost with immediate spending cuts that could largely negate the short-term stimulative effect of the tax cut. If spending cuts are fairly immediate and significantly affect lower-income households, they would likely offset the stimulative effect of the tax cut. Republicans don’t want to offset the cost with other tax increases because they worry that supply-side incentives would worsen. These concerns are legitimate when the offsetting tax increases stretch into the longer term (after the economy gets back to full employment) and to the extent that the tax offsets adversely affect the returns to working or saving.

As the Concord Coalition has emphasized many times before, it is possible to effectively stimulate the short-term economy while being fiscally responsible about the longer term. Deficit financing should ideally be limited to short-term policies that have high “bang per buck” in increasing demand for goods and services. Longer-term policies designed to grow the supply side of the economy when it is back to full employment ought to be paid for in ways that protect the incentives  to work and to save. And any offsets to the cost of stimulus policies should be designed to have minimal damage to short-term demand — by steering the burdens toward higher-income households or stretching the offsets over the longer term.

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Postscript:  To these issues of the stimulative effect of the payroll tax cut and whether and how the costs are offset, I’ll be adding the additional confusing issue of how the payroll tax cut affects the Social Security program–short answer, “not”–in my next Tax Notes column.

17 Responses to “The Muddled Economics of the Payroll Tax Cut”

  1. comment number 1 by: Vivian Darkbloom

    I don’t want to steal EM’s thunder, but the reason the “temporary” payroll tax cut does not affect the Social Security program is that the payroll revenues “lost” due to the cut will be made up through general borrowing (to be re-paid, if ever, by general taxes).

    Those who preach “stimulus now, austerity later” should be happy with the following solution: those who enjoy the benefits of the temporary payroll deduction should have their social security earnings history reduced by a pro-rata amount. In other words, they should only get earnings credit for amounts actually paid into the system. And, it is extremely fair: those who get to eat their cake now don’t get a second piece later.

    The real issue, though, not mentioned here by EM, is that the “temporary” payroll tax reduction was never meant to be temporary. Rather, most of its proponents want it to be permanent so that in the future social security (or at least part of it) will be funded through general taxes. If one takes both benefits and contributions into account, social security is already quite “progressive” even though the contributions, considered alone, are not. Proponents of the payroll holiday want to make it permanent so that program funding will become more progressive but the benefits will remain as progressive as they now are.

    We saw a trial run of this strategy under the ACA where, for the first time, Medicare premiums are charged on non-payroll income. The progressivity battle is being fought on a number of fronts.

    Sorry, EM, this debate has *nothing* to do with either stimulus or the deficit. As with most other debates, it has *everything* to do with who gets what and who gets to pay for it. If your argument for the payroll tax holiday is to provide temporary *stimulus* then you would have to agree that the payroll tax, as such, has nothing to do with the debate. The payroll system is simply a delivery mechanism for that stimulus. Delivery of this stimulus could be done via other mechanisms such as a credit such as the Make Work Pay credit or a different sort of temporary refundable credit that benefits not only the employed but others, such as the unemployed elderly.

  2. comment number 2 by: Arne

    “this debate has *nothing* to do with either stimulus or the deficit”

    For anyone who looks closely it is clearly stimulus. The delivery mechanism has a slight advantage in coming with every paycheck, but it has a huge disadvantage in being easy to muddle. IMO, a refundable credit would be better because most people do not look closely.

    I don’t think people who support SS like this method because it does create confusion. The tie between taxes/premiums and benefits is a meaningful feature of SS. “You are paying for insurance, but not quite enough to cover costs” is a valid description of SS. The same is not true of Medicare. This temporary tax cut makes it harder to inform people about the real issues in entitlements.

  3. comment number 3 by: Vivian Darkbloom

    Arne,

    I was not saying the payroll tax cut was not stimulus. I was arguing that the policy *debate* is not really about the stimulus or the deficit—the policy debate is really about who is going to pay for it, and, more importantly, how these programs will be funded in the *long-term* because everyone involved in these negotiations knows that anything agreed to as “temporary” will constitute precedent that will likely become permanent. The argument that the payroll reduction is an effective, or the most effective way to deliver stimulus is just a head fake–it’s not the real issue. The *real issue* is who is going to pay in the future for our huge accumulated debt and growing deficits and whether that’s going to be through taxes or reduced spending.

    Your last sentence suggested, perhaps unintentionally, that the payroll tax cut involves Medicare payroll levies. The tax cut only applies to social security payroll levies. Again, this is a distributional issue because Medicare premiums are not subject to an income cap.

    However, your last point is quite valid. If there is no link between premiums paid for social security (or Medicare) and the amount of benefits one ultimately receives, or if that link is substantially weakened, then it will be much more difficult to control spending on those programs. If those who benefit from the spending don’t feel any direct effects of having to pay for it, there is little incentive for them to control the amount of that spending. Medicare spending is rising much higher than social security (i.e. much faster than the cost of living) and the reason for this, I suspect, is not just higher medical care inflation—the reason is in part exactly that there is an insufficient link between Medicare payroll levies (and premiums) and overall spending. Again, this points out the danger of funding this type of entitlement spending out of a *very* progressive income tax system (enter B. Davis).

  4. comment number 4 by: Patrick R. Sullivan

    “It’s not what he doesn’t know that bothers me … it’s what he knows for sure that just ain’t so.”–Will Rogers

    In that spirit, is this true; ‘Fiscal policies that are good at growing the economy over the longer term are therefore those that encourage greater educational attainment….’?

    And there are plenty more such dubious assertions from where that came.

  5. comment number 5 by: AMTbuff

    it is possible to effectively stimulate the short-term economy while being fiscally responsible about the longer term.
    Announcing a gradual increase in eligibility ages for Medicare and Social Security, to start in 2014, would accomplish this. I contend that this would be more effective than any spending stimulus. It would remove the threat of fiscal collapse that frightens all informed people.

    However as VD points out, the fiscal responsibility issue and the stimulus issue are both disguises for a partisan agenda. That agenda will not accept major reductions in promised benefits. Instead it will promote revenue increases in a vain attempt to fund the exploding costs of past promises.

  6. comment number 6 by: Arne

    “perhaps unintentionally” Well then, oops.

    You clearly understand the difference between entitlements, but using SS as a distribution channel for stimulus, (nothing to do with safety net/insurance) will make it harder for most people to keep track. That is sad because most people would be better at solving the issues than our politicians are being - if they were not mis-informed.

  7. comment number 7 by: Vivian Darkbloom

    “In that spirit, is this true; ‘Fiscal policies that are good at growing the economy over the longer term are therefore those that encourage greater educational attainment….’?

    And there are plenty more such dubious assertions from where that came.”

    Undoubtedly true (the latter). While I probably share Mr. Sulivan’s skepticism and even cynicism, I think it only fair that we not rely on a wink and nod to show what *we know* to be dubious.

    For what it’s worth, my objection to EM’s statement is:

    –Educational “attainment” which I perceive to be the obtaining of degrees as opposed to learning something useful (”acheivement”) is the wrong measure. If our fiscal policy has anything to do with it, there should be more emphasis on what the population learns rather than the degrees it manages to get through the degree mills. With due respect to Mr. Rogers, there is *no question*, that there is a direct correlation (and, dare I say causation) between educational acheivement (properly defined) and economic productivity. *Productivity* is a more appropriate measure here than * growth*. Educated people might well decide that their energies are better put to use doing things other than growing our GDP, but the time they do spend growing it will likely be better spent.

    –What does “fiscal policy” (taxing or spending), particularly at the federal level, have to do with educational acheivement and therefore “economic productivity” or even growth? Likely very little and what is done might well be counterproductive. We already spend much more on education in the US than other “developed” countries and are not getting a very good return on that investment, particularly our federal investment. Spending even more, particularly after the current fashion, will not make matters better, particularly when those students start defaulting en masse on the federally guaranteed loans they’ve gotten merely to obtain those degrees.

    But, who knows? Perhaps EM had something else in mind for a fiscal policy that “encourages educational attainment” than spending more federal dollars on trying to do so.

  8. comment number 8 by: economistmom

    Vivian: thanks for your comment. My reference to “educational attainment” is shorthand for any action that makes someone more valuable to our market economy and to our society’s “productive capacity” more broadly defined. It refers to more adequately investing in “human capital”–not just physical capital. It’s whatever makes us more valuable humans, so that could include better health care, even including care such as appropriate psychological therapy (which can often prevent certain people from being destructive–so that is productive for society). (Think Jerry Sandusky.) And yes, it includes “education” more traditionally defined–like helping kids actually graduate from high school learning useful things, and helping young people go to college under the assumption/presumption that it makes (most of) them more productive adults than they otherwise would be. Many economists–even conservatives like Alan Greenspan–have for years said that the U.S. does not invest adequately in human capital.

  9. comment number 9 by: SteveinCH

    EM,

    I think it’s better said that the US does not invest effectively in human capital. The adequacy of funding seems relatively obvious given the massive increase in inflation adjusted per pupil education spending.

  10. comment number 10 by: Vivian Darkbloom

    EM: And, thanks for your reply. You should not encourage me, particularly on this subject.

    With respect to your more detailed definition, it is so broad that you might as well throw out the original term you used. Improving healthcare, psych care, etc;, is so far removed from “educational attainment” that I’m afraid your readers (this one included) would have completed misinterpreted what you wrote. (I’ve never taken a course in shorthand). But, OK, I can live with legitimate investments that truly do improve our “human capital” which is a very broad concept.

    Where we likely part ways is in what I perceive to be your belief that *additional* federal spending to improve this human capital is per se a good investment. If history (or even the status quo) is any guide, it will not be. What is needed first of all is to improve the quality of the spending that we already have and, in doing so, it is very likely that we could even reduce that spending and yet get better results.

    “Helping young people go to college” and “helping kids actually graduate from high school learning useful things” are both valid goals. However, before you (or anyone else) wants to spend yet more federal money doing this, you are going to have to build a pretty strong case that that money will be a good investment. Simply throwing money at a problem and making bad investments towards an ostensibly lofty goal, particularly this one, is not the answer.

    I strongly believe that we already spend *enough* money on education at all levels. The problem with American education or, if you will, American “human capital”, is not money: it is the culture and that is a problem that no amount of money is going to solve. In fact, a large part of the cultural problem involves looking to “money” as the solution to everything rather than creating and enforcing educational standards (standards for both students and teachers).

    Most of the good ideas that have been proposed to improve our “human capital” actually involve cutting spending (that’s constitutes a main reason why they are “good”). For example: our collective “human capital” could undoubtedly be considerably improved if we were to de-criminalize a lot of the “victimless” crimes now on the books. This cut out a lot of spending that is now devoted to incarcerating people. Given our fiscal problems, both short and long term, maybe we should give much greater emphasis on this sort of solution than, say, spending more money on this or that.

    Likewise, most of the good ideas about improving the current state of the economy have nothing to do with spending *more* money on “stimulus” (payroll or not). For example, AMTBuff’s comment about signalling a change to retirement ages for social security and Medicare was spot on: This signal would constitute a significant positive boost to the economy in the short term and yet would involve cutting spending. Perhaps you should devote more thought to this sort of solution in our columns.

  11. comment number 11 by: Vivian Darkbloom

    PS. Perhaps the last sentence was Freudian, but I truly did mean to write “your columns” which, despite our frequent disagreements, I do enjoy, as well as the comments of nearly everyone who participates here.

  12. comment number 12 by: AMTbuff

    I truly did mean to write “your columns”

    That’s good. It sounded a bit like Occupy EconomistMom!

  13. comment number 13 by: Patrick R. Sullivan

    ‘My reference to “educational attainment” is shorthand for any action that makes someone more valuable to our market economy and to our society’s “productive capacity” more broadly defined.’

    Which is so vague as to be useless. But it sounds great! When you do get around to something more specific:

    ‘… helping young people go to college under the assumption/presumption that it makes (most of) them more productive adults than they otherwise would be. ‘

    What evidence is there that ‘most of’ our ‘young people’ will become ‘more productive adults’ by going to college? Does the bell-shaped curve not apply to young people?

  14. comment number 14 by: Arne

    Education is an interesting problem. We are trying to reach kids now that we have not reached before. Private schools are not better with hard to reach kids. This is a tough task, but it is also a market failure, so there is good reason for government to be involved.

    We are into diminishing returns. Increasing gains in productivity (of the entire economy) is a reason to be willing to allocate more (as time goes on), but with the current downturn, it is easy to conclude we have gone too far (for now).

  15. comment number 15 by: Vivian Darkbloom

    Per the following Op-Ed in the New York Times, it turns out that I was reading the mind of Eugene A. Ludwig, former Comptroller of the Currency (1993-1998) and major Democratic donor:

    http://www.nytimes.com/2011/12/08/opinion/why-the-fight-over-the-payroll-tax-matters.html?partner=rssnyt&emc=rss

  16. comment number 16 by: Vivian Darkbloom

    I think I was reading Harry Reid’s mind, too.

    http://tpmdc.talkingpointsmemo.com/2011/12/democrats-big-payroll-tax-cut-gamble.php

  17. comment number 17 by: AMTbuff

    it is possible to effectively stimulate the short-term economy while being fiscally responsible about the longer term.
    In post 5, I said: “Announcing a gradual increase in eligibility ages for Medicare and Social Security, to start in 2014, would accomplish this. I contend that this would be more effective than any spending stimulus. It would remove the threat of fiscal collapse that frightens all informed people.”

    Today Reuters provides support for this view. See http://news.yahoo.com/analysis-economy-shedding-debt-shackled-pessimism-161327829.html

    Excerpts:

    views of future inflation-adjusted income have been moving lower since around 2003, a trend that was only exacerbated by the recent recession.

    Research by JPMorgan economist Michael Feroli found inflation-adjusted income expectations might be the best single indicator for predicting future consumption.

    Other recent research also points to the importance of expectations, suggesting that shifts in the collective mood may have been the driving force behind the ups and downs of the U.S. economy over the last six decades.

    My opinion: Just as the real estate market needs to hit bottom before buyers will feel confident enough to clear the inventory, government promises of benefits need to hit bottom before the public will have confidence that the remaining promises will be redeemed in full. Until then, uncertainty will suppress risk-taking.