The Last Stimulus: Would a Payroll Tax Cut Help the Economy?

In our Flashcard series, The Atlantic aims to decode the concepts and terms readers encounter every day but seldom see explained. Today's installment: the big payroll tax cut plan in the president's compromise with Republicans.

The News

The president's compromise with Republicans on the Bush tax cuts goes like this. In exchange for keeping taxes low on the highest earners, the White House agreed to a two-year extension of the entire Bush tax cut plus its own signature stimulus, which includes 13 months of unemployment benefits and tax credits for both working families and businesses. The biggest part of the new deal is a one-year $120 billion payroll tax cut. What will that do, exactly, and is it a good idea?

The Gist

Every year, you pay 6.2 percent of your wages to Social Security, and your employer pays the same. That's the payroll tax. In Obama's plan, next year you would only pay a 4.2 percent tax on your wages. That's the payroll tax cut. This small change can amount to big savings. If you make $50,000 a year, a 2% cut saves you $1,000. The White House hopes we'll spend that extra cash, increase aggregate demand, and create jobs.

This is a decisively middle class tax cut. Workers with lower salaries get a smaller tax break for the simple reason that they pay taxes on a smaller chunk of income. Workers with high salaries don't pay the Social Security above $106,800, so they also won't get a payroll tax cut on all of that higher income. Rather this particular provision especially benefits middle- and upper-middle income workers who see the tax break hit all of their income.

[More: read our Social Security FLASHCARD here]

The Debate

The payroll tax cut idea is simple. Is it smart?

Depends whom you ask. The Congressional Budget Office, Washington's official oracle of spending policy, said reducing employees' payroll taxes is one of the most effective ways to create jobs. Wall Street bank economists have revised growth up and employment down by about 0.4 percentage points based on this tax stimulus. Moody's Mark Zandi, another trusted stimulus wiz, pointed to this chart showing the payroll tax holiday gets you good bang for the buck.

But there are conservative and liberal critics of the plan that break down into three groups. The first group says short-term tax policy creates all sorts of harmful uncertainty about future tax rates, which can paralyze spending and investment. The second group thinks a payroll tax holiday is a fine idea, but it would be smarter to cut taxes on employers rather than employees. [My colleague Megan McArdle explains here.]

The third group points out that the payroll tax cut doesn't help low-income families as much as the provision it's trying to replace: The Making Work Pay tax break from the 2009 Recovery Act. Very simply, Making Work Pay gave an extra $400 to every worker (or $800 for families), whereas the payroll tax cut pays back less to low earners and much more to high earners. If the president's plan flies, a single worker earning $10,000 will see her taxes jump by $200 from this year to next, according to the Tax Policy Center's Bob Williams.

Okay, enough math. Is this a good idea or not? I'm listening to the folks most likely to hate it: deficit hawks. Payroll tax reductions were endorsed by both the president's deficit commission and the Bipartisan Policy Center -- so long as we pair it with long term budget reform. "Stimulus now, austerity later!" has been the banshee call of mainstream economists for two years now. This is our stimulus, and probably our last stimulus. Let's pass it now, and start thinking about ways to pay for it soon.

Derek Thompson is a staff writer at The Atlantic, where he writes about economics, technology, and the media. He is the author of Hit Makers and the host of the podcast Crazy/Genius.

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