Tax Policy – A History and Analysis of Payroll Tax Holidays
As Congress and the White House consider ways to shore up the economy in the face of a public health crisis, President Donald Trump has suggested suspending the entire payroll tax for the duration of the year. This would cost about $950 billion if the tax is suspended between April 1 and December 31, and if implemented would be a major change in tax policy in terms of revenue and economic effects. A payroll tax cut or suspension may support firms facing liquidity problems and considering layoffs, easing the impact of an economic slowdown.
It is important to keep in mind the history and arguments behind payroll tax holidays before moving forward. Payroll tax holidays have a mixed economic record, repeat the problems that plague temporary tax policy more broadly, and may not be the most effective tool for responding to a growing economic downturn.
History of Payroll Tax Holidays
In 2010, the employer-side payroll tax was reduced from 6.2 percent to 4.2 percent for 2011 and 2012 to stimulate the economy. General revenue was used to replace the revenue loss for the Social Security trust fund over those two years. The economic evidence suggests the tax holiday was mostly saved by households, reducing the effectiveness of the holiday as an economic stimulus.
This payroll tax cut replaced the Making Work Pay (MWP) refundable tax credit which provided a 6.2 percent tax credit on earnings for a maximum credit of $800 for joint filers ($400 for single filers) in 2009 and 2010. The credit began to phase out at $150,000 ($75,000 filing single) and phased out completely at $190,000 in income ($95,000 filing single). This credit was more narrowly targeted than the payroll tax cut that followed, which accrued to workers across the income distribution.
Back in 1977, the Carter administration enacted a New Jobs Tax Credit which provided a tax credit of 4 percent of Social Security payroll taxes paid by employers, with the aim of encouraging job growth. The credit’s design was complicated and ended up not creating many additional jobs while depriving the Social Security trust fund of revenue. The credit eventually phased out in 1978.
The Case for a Payroll Tax Holiday
A reduction in or suspension of the payroll tax may accrue to workers in the form of higher wages. The economic effect of the payroll tax holiday depends on which side of the tax is cut. Reductions in the employer-side of the payroll tax may have larger economic effects than reducing employee’s payroll taxes, though the latter also stimulates aggregate demand.
An employer-side payroll tax reduction or suspension would ensure greater liquidity for businesses that may otherwise become insolvent in the face of falling demand. While the burden of the payroll tax is borne by employees in the long run, removing it in the short run may give firms room to prevent layoffs or a reduction in investment they would otherwise be forced to make.
George Washington University economist Steven Hamilton argues that improving liquidity for firms via a payroll tax holiday and reducing the rate of business failure improves the odds of a speedy economic recovery once the public health crisis abates. This argument is distinct from a payroll tax holiday as a fiscal stimulus; rather, the payroll tax holiday prevents cascading business failures that may hamper a return to economic growth once the crisis ends.
Drawbacks of a Payroll Tax Holiday
A reduction or outright suspension of the payroll tax would not be well-targeted to those most vulnerable to economic disruption. Retirees are not in the labor force and will not benefit from the tax cut. Hourly and low-income workers are more likely to experience job loss.
As a fiscal stimulus, payroll tax holidays have a mixed record. The benefits of a payroll tax holiday would accrue to employers and workers over time, spreading out the demand-side effect of the tax change. Payroll taxes appear to provide more fiscal stimulus than an equivalent rebate as households tend to spend more due to a reduction in tax withholding than when they receive a tax rebate. However, payroll tax reductions are not well-targeted toward taxpayers most likely to spend the additional funds (higher-income earners), as higher earners tend to consume less as a proportion of their income.
As the Congressional Research Service frames it:
“Compared with most other options to reduce taxes paid by households, a reduction in payroll taxes may be a cost-effective stimulus because, depending on the policy’s design, it might reach more lower-income households than other tax cuts. That said, well-targeted direct government spending may be still more cost-effective, and a payroll tax reduction only directly helps those who are working.”
On top of the mixed economic effects, payroll tax holidays weaken the relationship between Social Security benefits and payroll tax revenue. This may incentivize policymakers to use payroll tax revenue for purposes other than Social Security in the future, undermining the foundation of the social insurance program.
Finally, payroll tax holidays are costly in terms of forgone revenue. A suspension of the payroll tax for the remainder of 2020 would deprive the U.S. of about 26 percent of federal revenue based on Congressional Budget Office (CBO) estimates. Even a smaller tax cut, such as reducing the payroll tax by one percentage point, would cost between $50 billion and $75 billion per year. While U.S. Treasury bond rates are at all-time lows, policymakers should still consider the most efficient ways to boost the economy per dollar of forgone revenue.
Distributional Effect of a Payroll Tax Holiday
Suspending the payroll tax would benefit taxpayers in the 20th to 90th percentiles the most when looking at the percent-change in after-tax incomes. High-income taxpayers tend to earn a lower proportion of income from wages, as much of their income comes from capital and business income not subject to the payroll tax.
Suspending the Social Security payroll tax—levied at 12.4 percent and split between employers and employees on wages up to $137,700—would also increase after-tax income across the income distribution but would affect high earners less given the wage cap on the Social Security payroll tax.
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Source: Tax Foundation General Equilibrium Model, November 2019. |
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| Income Group | Suspending Entire Payroll Tax | Suspending Social Security Payroll Tax |
|---|---|---|
| 0% to 20% | 14.00% | 11.36% |
| 20% to 40% | 12.59% | 10.21% |
| 40% to 60% | 13.37% | 10.84% |
| 60% to 80% | 12.83% | 10.40% |
| 80% to 90% | 12.28% | 9.95% |
| 90% to 95% | 12.01% | 9.69% |
| 95% to 99% | 9.56% | 7.41% |
| 99% to 100% | 3.10% | 1.78% |
| Total | 10.84% | 8.63% |
As former House of Representative tax counsel George Callas argues, the distributional effect on the top 1 percent is likely lower than this estimate, as most taxpayers in this income group have hit the Social Security wage cap of $137,700 for 2020. This means that they will accrue no benefit from a reduction in the Social Security portion of the payroll tax for the rest of the year, though they would benefit a small amount from a reduction or suspension in the 3.8 percent Medicare portion of the payroll tax.
Conclusion
Temporary tax policy should be viewed skeptically, as there is a large literature suggesting that temporary changes in tax policy do not spur long-run changes in saving and investment decisions. While temporary tax policy may help improve a shortfall in aggregate demand, this must be balanced with the mixed economic record, revenue impact, and unintended consequences such policies create.
Skepticism of payroll tax holidays comes from tax policy experts on both the center-left and the center-right, which shows that there is a shared sense that policymakers should consider alternatives to cutting the payroll tax if fiscal policy is warranted, in combination with other measures directly addressing the public health side of our country’s current challenges.
Source: Tax Policy – A History and Analysis of Payroll Tax Holidays
Upstate Tax Professionals