The Corner

The Problem with Payroll Tax Relief

The discussion about another payroll tax cut has been bothering me for a while:

President Barack Obama’s advisers have discussed seeking a temporary cut in the payroll taxes businesses pay on wages as they debate ways to spur hiring amid signs that the recovery is slowing, according to people familiar with the matter.

The idea, which is in preliminary stages of discussion, is among several being talked about at the White House as the economy holds center stage for the administration and Congress, the people said on condition of anonymity to discuss internal deliberations. The unemployment rate in May rose to 9.1 percent, the highest level this year.

And as Andrew mentioned yesterday, a payroll tax cut is also a piece of the Senate Democrats’ new stimulus request. But while this may sound good to everyone, a reduction in the payroll tax is problematic in the sense that it requires additional borrowing and the use of accounting gimmicks to disguise the effects of the payroll tax revenue shortfall on Social Security.

First, let me say that of all the possible forms a stimulus could take, a payroll tax relief — especially on the employer’s share — is probably the best. The rationale is that if the government makes it less expensive for businesses to hire workers, businesses will tend to hire more workers. That being said, we shouldn’t forget what the payroll tax is supposedly paying for and the consequences of not raising that money while continuing to deliver the benefits.

For instance, my colleague Jason Fichtner warns that this would take money out of Social Security to fund a questionable initiative with limited stimulus value and no potential for long-term job growth:

This is yet another example of tinkering around the edges of the tax code on a temporary basis to artificially stimulate job creation when what is really needed is fundamental and permanent tax reform.  While lowering the tax burden on hiring is a good idea, doing so via another temporary payroll tax cut will not lead to job creation because the idea of a payroll tax cut on the employer side does nothing to strengthen long-term economic growth or improve Social Security’s financing.  If we want to stimulate jobs, only through fundamental tax reform that permanently lowers tax rates for individuals and corporations can we hope to change the business environment to spur business investment and economic growth that will lead to greater job creation.

Currently, the 12.4 percent payroll tax on workers (employers and employees) is used to fund Social Security benefits. Those taxes are credited to the Social Security Trust Fund, where they establish the program’s authority to make benefit payments. Until last year, and with rare exceptions, the government collected more payroll taxes than were paid in benefits. However, based on the most recent Trustees’ Report, we know that from now on, the program will run a permanent cash flow deficit — meaning that the payroll taxes collected aren’t enough to pay for all the benefits paid out in a given year.

However, in an accounting sense, the trust funds will still have surpluses and even continue to grow through 2022 due to the inclusion of interest payments on the bonds held in the trust funds and the taxation of some Social Security benefits. But interest payments and revenue from taxation of benefits are credited to the trust funds out of the federal government’s general revenue and borrowing, thus currently adding to the deficit.

Therefore, the direct implication of any payroll tax cut is that the gap between the amount collected in payroll tax and the amount paid in benefits is bigger than it would have been without the cut. Maybe more importantly, to pull this off without cutting Social Security benefits, the government will have to borrow more money and transfer money from the general fund to the Social Security Trust Fund to make it look as if this tax revenue had been collected even though it won’t be. This budget gimmick has been used already to “pay” for the $120 billion revenue shortfall from the December tax deal.

Remember that Social Security spending is statutorily limited to the amount of assets in the Trust Fund, so basically this accounting gimmick increases the program’s spending authority by the amount of the payroll tax cut (plus interest to be accumulated over decades to come) based on phantom revenues. In other words, a payroll tax cut that isn’t matched by an equivalent cut in Social Security spending authority (future benefits) is yet another unfunded promise to seniors that will be paid for by future’s generations. Is it reasonable? Is it fair? It certainly doesn’t feel like it.

Moreover, it is adding insult to injury. If you remember, the money is the Social Security Trust Fund, isn’t really there. The program bought some Treasuries with its surplus Social Security taxes. Now, to repay that bill, the government will have, starting now, to borrow more money, which adds to our deficit and adds to the debt.

So while it is bad to spend surplus Social Security revenues, it is much more deceptive for the government to record as incoming Social Security revenues taxes that were never even collected. This isn’t a new practice. For years, we have been recording tax revenues from the beneficiaries of the earned income tax credit (EITC) even though their share of the payroll tax is refunded to them. Also, the Making Work Pay tax credit that was part of the stimulus bill also refunded payroll taxes a second time over to many of these same workers, as Andrew Biggs noted.

What is new, however, is that we are now at a point where the notion that Social Security benefits are fully backed by payroll-tax contributions is a fiction that rests entirely on bookkeeping gimmicks.

Update: The employee’s share of the payroll was cut by 2 percent in December. The gimmick stems from the fact that the uncollected revenues from the tax cut were still credited to the Trust Fund–as if the government were still collecting 12.4 percent.


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