A Payroll Tax Holiday?

If policymakers wish to stimulate consumer spending through temporary tax reductions, a cut in the FICA payroll tax offers a couple of advantages.

First and probably most important, it is comparatively straightforward and would be inexpensive to administer. It can be implemented with little delay. The IRS does not need to process a year’s worth of income tax returns in order to determine who is eligible and the size of the rebate. Second, a FICA tax cut would reduce the marginal tax on labor earnings faced by workers or employers (or both). This may slightly improve labor market incentives and speed job market recovery. Finally, depending on the way the FICA tax cut is designed, it can be targeted on workers in the middle and at the bottom of the earnings distribution. These are the workers who are most likely to respond to a temporary tax cut with a spending increase.

Set aside the question of whether taxpayers would consume most of the tax cut in the short run. The possibility that taxpayers will save rather than consume a tax cut is an objection that can be raised against nearly all temporary tax cut plans, except plans based on a temporary cut in the sales tax. The main practical objection to a cut in the FICA tax is that it would deprive Social Security and Medicare of needed revenues. Both programs already face severe long-term funding problems. A cut in the FICA tax would worsen those problems unless Congress replaced the lost revenues with a transfer of funds from the U.S. Treasury. If this transfer of funds takes place, I think the advantages of a temporary FICA tax cut make it a potentially attractive method for delivering temporary tax cuts.

Voters and policymakers should bear in mind, however, that the FICA payroll tax provides a relatively crude instrument for delivering finely targeted tax relief. If, for example, Congress cuts workers’ Social Security contributions by 2%, workers earning $20,000 a year would enjoy a tax cut of $400, and workers at the taxable maximum ($106,800 in 2009) would receive $2,136. A large portion of the tax relief would go to high income workers, and these workers are likely to save rather than spend most of their tax relief. To reduce this problem Congress could place a limit on the tax cut, perhaps by capping tax relief at $1,000 per worker. Even with this kind of restriction, a substantial part of the overall tax cut would be received by families with high taxable incomes. It is obviously much easier to target tax relief to low and middle income families if tax cuts are calculated using information on the IRS 1040 form. Carefully calibrated tax relief is easier to deliver through an income tax cut than through temporary reductions in either the payroll tax or the sales tax.

If policymakers prefer speedy and administratively simple tax relief, a FICA tax cut has much to recommend it. However, if they want to target tax relief on taxpayers who are most likely to spend it in the short run, a temporary cut in income taxes is the way to go.