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Cutting the Payroll Tax: Good for the Economy, Bad for Social Security

Posted on Sep. 5, 2019

Last month, President Trump floated the idea of a payroll tax cut, telling reporters it was “something that we think about.” The next day, he reversed himself. “I just don’t see any reason to,” he said. 

The flip-flop was fast — but not so fast that people didn’t notice. News outlets and think tanks spent the better part of a week debating the merits of using a payroll tax reduction to help stave off a possible recession.

What was most surprising about this debate wasn’t its speed or even its substance. Rather, it was the utterly routine nature of the basic idea.

Once upon a time, cutting the payroll tax was unthinkable. Linked inextricably to one of the nation’s most popular spending programs, the payroll tax was considered untouchable.

And then, we broke the taboo.

Boosting Growth

In 2011 and 2012, Congress and the White House agreed to a temporary reduction in the bifurcated payroll tax, cutting the employee rate from 6.2 percent to 4.2 percent. Designed to help goose the economy, the cut probably raised GDP growth by half a percentage point, according to many estimates.

A similar tax cut enacted in 2019 probably wouldn’t pack the same punch, Mark Zandi, chief economist at Moody's Analytics, told USA Today. With unemployment at historic lows, a cut of similar size and structure would probably add about three-tenths of a percentage point to growth, said Greg Daco, chief U.S. economist at Oxford Economics.

Still, that’s not nothing, and many economists believe that payroll tax reductions can still be a useful and effective weapon in the fiscal arsenal.

Steep Cost

Cutting any tax costs money, of course. According to the Committee for a Responsible Federal Budget, “a temporary cut in the employee’s Social Security payroll tax would cost $70 billion to $75 billion per percent cut each year in lost revenue.” Cuts in the employer portion would cost $55 billion to $60 billion per percent cut each year.

Of course, it’s the reduction in revenue that makes the cut a useful tool for stimulating the economy. And even in the face of rising federal debt, many economists think such cuts are vital. “We have plenty of capacity in the federal budget to undertake vigorous countercyclical tax and spending policies when the next recession arrives,” wrote Douglas Elmendorf, former director of the Congressional Budget Office, in a recent op-ed. “Given the economic and social costs of recessions, we should undertake such policies.”

But if tax cuts are a useful way to boost the economy, that doesn’t mean lawmakers should cut just any old tax. In general, it’s most helpful to cut taxes for those most likely to spend (rather than save) the extra money in their paycheck.

The “propensity to spend” argument is a point in favor of using payroll tax cuts as a tool for stimulus. But payroll tax reductions bring particular problems, too.

The Social Security payroll tax is used to fund the Social Security spending program. And it’s not getting the job done — even before we start making cuts. Both the old-age and disability elements of Social Security face funding shortfalls in the not-so-distant future. Cutting the payroll tax necessarily makes those problems worse.

In 2011 and 2012, Congress dealt with the funding problem by replacing lost payroll tax revenue with money raised through other taxes. Which is fine, from an accounting standpoint. But it creates a serious political problem.

Political Insurance

When Franklin Roosevelt devised the basic structure of Social Security in the mid-1930s, he insisted on using a contributory payroll tax to fund the program. His advisers were aghast, pointing out that regressive payroll taxes would work at cross-purposes with the program’s broader redistributive intent.

But Roosevelt stood firm, insisting that the payroll tax was crucial to protecting Social Security from its numerous enemies. As he told one critic of the payroll tax:

I guess you're right on the economics, but those taxes were never a problem of economics. They are politics all the way through. We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program.

Roosevelt was right. Americans have long viewed Social Security as an earned right — a pension bought and paid for through employee contributions. Whether that view is economically correct is debatable; but from a political point of view, what matters is that Americans generally believe it to be true.

The problem with cutting the payroll tax — even assuming that such a cut would be economically useful — is that it breaks the political linkage between Social Security taxes and Social Security spending. Once we start down the road of funding Social Security with general revenues, there is really no looking back.

That’s why the 2011-2012 experiment was so important — and possibly so damaging. Once the linkage was broken for the first time, breaking it again was really no big deal.

Veronique de Rugy made this point in a recent piece for the American Institute for Economic Research. “Once elected officials get used to thinking of the payroll tax as something to be used to boost the economy, it is only a matter of time before they will want to use it for many other purposes,” she wrote.

Sadly, I think that ship has already sailed.

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