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Decoding the Payroll-Tax Cut: How Well Does It Work?

Extending the payroll-tax cut is the latest fight in Washington. But how much would it help the economy?

Update, 12/19: A deal brokered last week by Senate Democrats and Republicans to extend the payroll-tax cut now looks likely to be blocked by House Republicans. House Speaker John Boehner said that the Senate proposal  a short-term deal that would only extend the payroll-tax cut by two months   would simply be “kicking the can down the road. The House votes tonight on the bill. As we’ve noted in our earlier explainer about the payroll tax cut, economists say allowing the cut to expire could have serious consequences for the still fragile economy.

As Congress tries to deal with its long list of unfinished business, among the top and most contentious items has been the proposed extension of the payroll-tax cut.    

It has certainly inspired plenty of political posturing. Democrats have charged Republicans with hypocrisy for opposing a measure that would put hundreds of dollars into the pockets of American workers; Republicans have fired back, accusing President Obama of failed economic policies and misguided efforts to grant tax relief to some while upping taxes on the rich, who they say often create jobs.

But looking beyond the rhetoric, how much has the cut helped the economy? And what do economists say would happen if it’s not extended? We run through the facts.  

First, what is the payroll tax — and how big has the cut been?

Take a look at your paycheck, and it will be very clear: The tax is the part of your wages withheld for Social Security and Medicare.

The Social Security portion of the tax has long been split evenly between employers and employees. Until last year, this meant that employees were paying 6.2 percent of their earnings and employers were paying the other 6.2 percent a total of 12.4 percent. The Medicare part of the tax is smaller 1.45 percent for employees and 1.45 percent for employers.

But a deal struck last December to extend the Bush tax cuts included a one-year cut to the Social Security portion of the tax. Employers kept paying 6.2 percent, but employees got a reduction of two percentage points.

That worked out to about $900 in savings for the average U.S. household last year, according to calculations by the Tax Policy Center. Unless Congress decides to extend it for another year, that tax cut will disappear.

It’s also worth noting that the payroll tax is a regressive tax. The main portion of it the part that goes to Social Security trust funds is a flat percentage on the first $106,800 of your paycheck. What that means is that people making more than $106,800 end up paying a smaller percentage of their wages in payroll taxes than do those whose paychecks fall short of that benchmark.  For instance, the cut aside, somebody making about $500,000 a year would pay only a little more than 1 percent to Social Security. (University of Chicago economics professor Casey Mulligan has a post in The New York Times’ Economix blog with some helpful background on the tax.)

So what’s Congress going to do?

The details are still being worked out, but it looks as if Republicans are moving toward reluctantly backing an extension of the tax cut, though not an expansion of it.  

The Obama administration originally proposed increasing the size of the cut and also cutting the portion employers pay. The administration put that proposal in its jobs bill, but that legislation is dead.

Divided on whether to even extend the 2011 cut, Republicans aren’t likely to back changes beyond the levels agreed upon last year, according to The Wall Street Journal. They’ve also opposed Democrats’ current proposal to offset the revenue gap by raising taxes on people making more than $1 million.

What’s the upside of extending the Social Security tax cut?

Well, you can see for yourself how it changes your paycheck. The White House has a payroll-tax cut calculator that can show how much you stand to lose if Congress doesn’t extend the tax cut.

But in terms of the larger picture, economic analysts have said that unless the payroll-tax cut and other short-term measures are extended, “fiscal drag will be intense in 2012.” Here’s The Washington Post:

Goldman Sachs economic forecaster Alec Phillips estimated that allowing the payroll-tax cut to expire would reduce growth by as much as two-thirds of a percentage point in early 2012. Macroeconomic Advisers estimates that it would reduce GDP growth by 0.5 percent and cost the economy 400,000 jobs by the fourth quarter. 

Mark Zandi, chief economist at Moody’s Analytics, went a little further [PDF], estimating that if both the payroll-tax cut and extended unemployment insurance are allowed to expire, real GDP growth will fall by nearly a percentage point and about 1 million jobs will be lost by the end of 2012.

Ultimately, a simple extension of the payroll-tax cut means a continuation of what workers already have. That’s why economists and analysts talk less about any possible upside such a boost to consumer spending and cast it as a way to avert further damage to the economy.

What are the limitations and downsides?

The tax cut isn’t cheap. This year, it cost the Social Security trust funds $110 billion in lost revenue money that the federal government reimbursed by borrowing.

So, while it’s not true that a payroll-tax cut is bankrupting Social Security, it is adding to the deficit. Critics worry that, over time, a pattern of shifting funds from general revenue to the Social Security trust funds will weaken what was a largely self-funded program.

Another obvious limitation to the payroll-tax cut is that only workers — not the unemployed — benefit directly from it, which is why a proposed extension of unemployment benefits is often mentioned in the same breath. It’s also why the Obama administration has pushed to expand the tax cut to employers, hoping it’ll spur hiring.

But if boosting spending and creating jobs is the ultimate goal, some policy experts such as Bruce Bartlett, who once held top policy positions in the Reagan and George H.W. Bush administrations, note that cutting the payroll tax isn’t the best way of accomplishing that. After all, consumers or employers may have a bit more to spend, but that doesn’t mean they’ll spend that money or use it to hire people. Some of those dollars will undoubtedly end up in personal savings or company profits, muting the macroeconomic benefit.

Ultimately, Bartlett writes, directly spending the money, such as launching a public works project, would pack a bigger punch, even if it would be a tougher sell in Congress.

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