CRS Analyzes Effects of Payroll Tax Relief Options

In December 2010, Congress temporarily reduced the employee and self-employed shares by 2 percentage points (to 4.2% for employees and 10.4% for the self-employed), with the Social Security trust funds "made whole" by a transfer of general revenue.³ The temporary reduction is scheduled to expire at the end of 2011.

Several proposals are pending before Congress to extend and modify the temporary reduction in payroll taxes. Some proposals would extend the temporary extension through 2012 (The Temporary Tax Holiday and Government Reduction Act, S. 1931 and The Economic Growth and Reducing Unemployment Act, H.R. 3060), whereas other proposals would increase the reduction to 3.1 percentage points and broaden the reduction to include the employer share (The American Jobs Act, S. 1660; and The Middle Class Tax Cut Act, S. 1917).⁴

Proposals to extend the temporary reduction in Social Security payroll taxes have prompted debate among policymakers. Some are concerned about the potential of the temporary reduction to endanger the Social Security trust funds, signal a departure from the self-finance structure of Social Security, and increase the federal deficit. Supporters of an extension have emphasized the potential of an extension to stimulate the economy and the general revenue "repay" as a way to counter concerns about endangering the Social Security trust funds.

This report briefly discusses economic stimulus considerations related to temporary payroll tax reductions. For a discussion of Social Security policy considerations concerning a temporary payroll tax reduction, see CRS Report R41648, Social Security: Temporary Payroll Tax Reduction in 2011, by Dawn Nuschler.

The Stimulus Effects of a Temporary Reduction in Payroll Taxes⁵

Short-term fiscal stimulus measures aim to boost economic activity primarily through increases in the demand for goods and services.⁶ The goal of these measures is to break a cycle of decreasing output leading to decreasing employment, lowering consumption leading to further decreases in output. Without stimulative policies the economy would eventually stabilize and recover, but recovery would take longer and the overall disruption to the economy would be greater.

The Congressional Budget Office (CBO), in testimony before Congress, has identified three key criteria for assessing proposals to stimulate the economy.⁷ The criteria are timing, cost-effectiveness, and consistency with long-term fiscal objectives.

Timing

Effective short-term stimulus should happen during the period of economic weakness. In addition, since recessions are historically short lived, effective stimulus should also be short lived. ⁸

An extension of the reduction in payroll taxes could be implemented quickly and be designed to expire as the economy strengthens. The resulting increase in household income would be experienced quickly, as well. A modification of the reduction in payroll taxes, through either a greater reduction or an expansion to employer contributions, could be similarly designed.

Cost-Effectiveness

Effective short-term stimulus maximizes the increase in output and employment per dollar of budgetary cost. The effectiveness of a policy aimed at households would then depend upon the fraction of additional income spent (as opposed to saved) on goods and services relative to the lost federal revenue. Provisions targeted at low-income individuals or the unemployed should be more cost-effective than broad tax rate reductions, as those facing financial constraints are more likely to spend any additional disposable income. In addition, theory suggests small recurring increases in income may be more likely to be spent than a similarly sized (in total) lump sum payment, but the empirical evidence for this effect is weak.⁹

An extension of the reduction in payroll taxes would not be targeted to those facing the greatest financial constraints, but the increase in disposable income would take the form of a small recurring increase. CBO estimated that a temporary reduction of payroll taxes would raise output cumulatively in the next two years by $0.10 to $0.90 per dollar of total budgetary cost and would increase employment by between one and nine jobs per million dollars of budgetary cost.¹⁰ These estimates assume that the majority of the increase in disposable income would be saved or used to pay down debt rather than spent on goods and services.

Compared with other household tax reductions, an extension of the reduction in payroll taxes may be a cost-effective stimulus -- though well-targeted direct spending may be still more cost-effective.¹¹ According to CBO estimates, the short-term stimulative effect of an extension of the reduction in payroll taxes would be greater than the stimulative effects from extending the Bush Tax Cuts,¹² on par with a one-year AMT patch,¹³ and less than for an increase in refundable tax credits.¹⁴

Expanding the reduction in payroll taxes to include employer contributions -- as proposed in S. 1660 and S. 1917 -- would be expected to provide a slightly greater degree of stimulus per unit of budgetary cost than an employee-side reduction, according to CBO.¹⁵ The policy could encourage hiring by temporarily reducing the cost of labor. However, other evidence suggests that subsidies provided on the employer side, whether to subsidize hiring or investment, may be relatively ineffective, because employers are unlikely to hire in the absence of increased demand.¹⁶ The cost-effectiveness of this policy, however, would ultimately depend on firms' responses to the incentive.

Consistency with Long-Term Fiscal Objectives

Effective short-term stimulus should not hinder long-term fiscal sustainability.

An extension of the reduction in payroll taxes, by itself, would add to short-term budget deficits. The current reduction was estimated to increase the deficit by roughly $110 billion¹⁷ and the expansion provided by S. 1917 has been preliminarily estimated to cost $265 billion.¹⁸ By themselves, these proposals would be inconsistent with the long-term goal of deficit reduction and may signal a lack of resolve to reduce deficits to investors.¹⁹

To address long-term fiscal objectives, most proposals to extend or expand the temporary reduction in payroll taxes include one or more offsets to reduce or eliminate the net budgetary cost of the proposals. These offsets are, by definition, contractionary as they either cut spending or raise taxes.²⁰

Who bears the burden of the offsets, and when, will influence the degree to which an offset reduces the stimulative effect of a reduction in the payroll tax. For offsets aimed at households, the short-term contractionary effect of the offset will be less if the burden results in decreases in savings, as opposed to reduced spending on goods and services. Further, having the offset occur after the period of economic weakness has passed could place the contractionary effect outside the immediate policy horizon for stimulus and help address long-term fiscal sustainability.

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² The Social Security trust funds are also credited with tax revenues from the federal income taxes paid.

³ The temporary reduction was enacted as part of The Jobs Creation Act of 2010 P.L. 111-312. The provision was itself a partial extension and modification of a temporary reduction enacted as part of the HIRE Act, P.L. 111-147. For more on the topic, see CRS Report R41648, Social Security: Temporary Payroll Tax Reduction in 2011, by Dawn Nuschler.

⁴ In addition to the payroll tax provisions, these proposals also differ on additional hiring incentives and measures used to offset the budgetary impact of the payroll tax provisions.

⁵ See CRS Report R41034, Business Investment and Employment Tax Incentives to Stimulate the Economy, by Thomas L. Hungerford and Jane G. Gravelle for a discussion of the effectiveness of other selected policy options to stimulate the economy.

⁶ In addition, existing programs often termed "automatic stabilizers" provide a measure of stimulus aimed at reducing the severity of an economic downturn in the absence of new stimulative measures. Examples of these programs are unemployment insurance and the Supplemental Nutrition Assistance Program (SNAP, formerly known as Food Stamps).

⁷ Testimony of Congressional Budget Office Director Douglas W. Elmendorf before the Committee on the Budget, U.S. House of Representatives, The State of the Economy and Issues in Developing an Effective Policy Response, January 29, 2009.

⁸ Congressional Budget Office, Policies for Increasing Economic Growth and Employment in 2012 and 2013, November 2011, http://www.cbo.gov/doc.cfm?index=12437.

⁹ See CRS Report RS21126, Tax Cuts and Economic Stimulus: How Effective Are the Alternatives?, by Jane G. Gravelle for a discussion of this literature and Jonathan Parker et al., "Consumer Spending and the Economic Stimulus Payments of 2008," NBER Working Paper No. 16684, January 2011, for a discussion on consumer spending from the 2008 economic stimulus payments.

¹⁰ Congressional Budget Office, Policies for Increasing Economic Growth and Employment in 2012 and 2013, November 2011, http://www.cbo.gov/doc.cfm?index=12437.

¹¹ See CRS Report RS21136, Government Spending or Tax Reduction: Which Might Add More Stimulus to the Economy?, by Marc Labonte for information on the relative stimulative value of alternative fiscal policy levers.

¹² See CRS Report R42020, The 2001 and 2003 Bush Tax Cuts and Deficit Reduction, by Thomas L. Hungerford for information on the Bush Tax Cuts.

¹³ An AMT (Alternative Minimum Tax) patch would effectively provide a cumulative inflation adjustment to the amount of income exempt from the AMT, reducing the number of taxpayers subject to the AMT. See CRS Report RL30149, The Alternative Minimum Tax for Individuals, by Steven Maguire for information on the Alternative Minimum Tax.

¹⁴ See CRS Report R41999, The Impact of Refundable Tax Credits on Poverty Rates, by Margot L. Crandall-Hollick for information on refundable tax credits and their effect on poverty.

¹⁵ Congressional Budget Office, Policies for Increasing Economic Growth and Employment in 2012 and 2013, November 2011, http://www.cbo.gov/doc.cfm?index=12437.

¹⁶ See CRS Report R41034, Business Investment and Employment Tax Incentives to Stimulate the Economy, by Thomas L. Hungerford and Jane G. Gravelle for a full discussion.

¹⁷ Joint Committee on Taxation, Estimated Budget Effects of the "Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010," Scheduled for Consideration by the United States Senate, JCX-54-10, December 10, 2010.

¹⁸ Joint Committee on Taxation, Estimated Budget Effects of the "The Middle Class Tax Cuts Act of 2011," November 28, 2011.

¹⁹ See CRS Report R40770, The Sustainability of the Federal Budget Deficit: Market Confidence and Economic Effects, by Marc Labonte for information on the sustainability of the federal budget deficit.

²⁰ See CRS Report R41849, Can Contractionary Fiscal Policy Be Expansionary?, by Jane G. Gravelle and Thomas L. Hungerford for more information.