Many Americans don't even know it, but a year ago the government cut every worker's taxes in order to pump a little extra money into the economy. The temporary, one-year measure lowered the withholding rate on payroll taxes—primarily used to fund Social Security—from 6.2 percent to 4.2 percent. That boosted the typical worker's take-home pay by roughly $75 per month, the equivalent of a couple tanks' worth of gas.
With that tax cut set to expire at the end of this year, Congress is now mired in another tiresome partisan debate over whether to extend it, and if so, how to pay for it. Keeping the payroll tax at the lower rate for another year would cost the government about $120 billion in lost revenue, so it would directly affect the mushrooming national debt, the most overtalked and underaddressed issue in Washington. So politicians are now considering other tax hikes or spending cuts to cover the lost revenue.
The standing assumption is that Congress will stop bickering briefly, extend the tax cut for another year, then start bickering again. The stakes are considerable. Ending the tax cut—which would be a de facto tax increase--might damage fragile consumer psyches and curtail spending. "Allowing payroll taxes to rise would be taking a big risk," writes Augustine Faucher of Moody's Analytics. Besides, politicians rarely vote to raise taxes after agreeing to cut them. No wonder both parties favor some form of an extension.
But this is one tax cut with diminishing returns, and extending it might ultimately do more harm than good. Here's why:
It could worsen the debt problem. Stimulus measures are effective when the government borrows to boost the economy during downturns, then pays off the borrowed money when the economy strengthens. But there's no real plan to pay down the national debt, which is close to becoming unsustainably large. At some point, stacking just a few more dollars on top of it could trigger some kind of financial tumble.
Washington is already flirting with further downgrades of the U.S. credit rating, thanks to the impotent debt "super committee" that recently disbanded after doing nothing at all to address the problem. The last downgrade sent stocks tumbling and depressed confidence, raising the odds of a new recession. It would be reckless for Congress to simply add another $120 billion to the debt, during a campaign season when politicians seem woefully unable to develop a coherent policy for dealing with the debt or assure the public that they even know what they're doing.
It might just move money from one place to another. Since the debt has become a financial time bomb, Congress is considering ways to pay for an extended payroll tax cut without having to borrow more money. That would require spending cuts elsewhere or a "millionaire's surtax" on high earners that would offset the $120 billion in lost revenue. But it's worth asking, what's the point?
Cutting taxes on one group of people, while raising them on others or reducing spending in ways that might affect the same people getting the tax cut, just shifts money around without benefiting the overall economy very much. It might even set the economy back. "Politicians seem to have lost sight of the basic rules of fiscal stimulus," Merrill Lynch advised clients in a recent research note. "If the offset comes dollar-for-dollar in 2012, it is almost certain to undercut growth." That's because government spending goes directly into the economy, while consumers tend to spend only part of the money from tax cuts, saving the rest.
It's one of the least effective ways to stimulate the economy. As structured, the payroll tax cut would provide a bigger savings for higher earners, because it would be applied to all income up to $110,100 (the 2012 threshold). Many people who earn that much consider themselves to be middle-class workers who struggle to pay all the bills, especially if they have kids. But it's still true that higher earners tend to save more of any tax cut, while lower earners tend to spend most or all of it, because they have to. It's smart for families to save. It just doesn't do the economy much good in the short term.
If a tax cut were strictly intended to boost the economy, it would be more effective to target it toward lower-income workers than to spread the subsidy among all workers, including higher earners. But of course it's politically appealing to cut taxes for as many people as possible. So extending the payroll tax cut would be more of a feel-good measure that might do a little to help the economy than an intelligent way to prime economic growth, which is what we really need in order to boost spending and bring back jobs.
It would condition taxpayers to unrealistically low tax rates. For some conservatives, this is precisely the idea: Force taxes down on a "temporary" basis, knowing full well that taxes may never go back up. "We all know what happens to time-limited tax breaks in Washington," writes Howard Gleckman of the nonpartisan Tax Policy Center. "Like vampires, they never die."
There's nothing wrong with low taxes, as long as government spending is also low and voters are comfortable with that arrangement. But the United States has become a low-tax, high-spending nation, and some politicians perpetuate the fiction that it's possible to cut taxes while maintaining extremely expensive programs like Medicare and Social Security. It's not possible, and voters practicing wishful thinking need to get a clue about the tough tradeoffs that are coming.
It would delay adjustments we all need to make. The recent history of temporary stimulus measures isn't very impressive. We're still mired in an epic housing bust, for example, despite two sets of tax credits meant to boost home sales. In retrospect, all those subsidies seem to have done is accelerate sales that would have happened anyway. Once the tax credits expired, home sales tanked all over again, suggesting that the credits may even have prolonged the housing bust. The same goes for the "cash for clunkers" stimulus in 2009, which generated a spurt of car sales, followed by a corresponding plunge, once it expired.
Still, Congress will probably pass another "temporary" tax cut, with the obligatory tweets and press statements proclaiming how Washington is looking out for the average Joe. If only. The smartest thing for most taxpayers would probably be to put every bit of that extra $75 into an emergency fund, because one way or another, Washington is going to ask for it back some day.