Why the Time Isn’t Right to Cut the Payroll Tax By Karl Smith Severalmonthsintothecurrentcrisis,thecase forreducingthepayrolltaxasawaytoreboot theeconomyisnuancedatbest

Why the Time Isn’tRight to Cutthe Payroll Tax

by KARL SMITH

When the coronavirus pandemic first hit the payroll tax suspension could boost the economy. The United States in March of this year, I recommended first is the classic supply-side effect. When you tax that Congress immediately suspend the payroll tax something you get less of it. Economists agree that for both employers and employees through the rest the burden of both the employer and employee sides of the year. My reasoning was simple. A payroll of the payroll tax fall on labor. tax suspension could be implemented immediately, Cutting the payroll tax should reduce the would reduce the cost of burden on labor and thereby keeping workers on staff, and increase total employment. put more money in the hands This is basically the analysis of workers. that Casey Mulligan — an

The U.S. was facing an economics professor at the unprecedented economic and University of Chicago who health threat. We knew little served as chief economist about how the threat would for the Council of Economic unfold or how deeply the Advisers from September economy would be impacted. 2018 to August 2019 — What was clear, however, uses when he estimates that is that many businesses and suspending the payroll tax for households were going to six months would create 2.7 take an immediate hit to their million new jobs. liquidity. In particular, businesses Karl Smith This type of supply-side analysis starts by looking at would have a hard time what would happen to the holding on to their employees as the virus induced lockdowns Facing an uncertain threat, economy in the long-run after all markets have full across the country. I was also with untested tools, a adjusted. As Mulligan admits, skeptical about how quickly payroll tax suspension it is very difficult to estimate and effectively the Small Business Administration would have served as a how quickly an economy will move towards its long-run would be able to implement useful backstop against equilibrium, especially in the a new nationwide system of unforeseen events. midst of a pandemic. lending. Mulligan deals with this

Facing an uncertain threat, uncertainty by first estimating with untested tools, a payroll that a permanent payroll tax tax suspension would have served as a useful backstop elimination would generate 10.7 million jobs and against unforeseen events and the difficulties in then assuming the economy gets to about one-quarter getting what became the Payroll Protection Program of the long-run equilibrium within six months. started. Reasonable people can disagree about whether the

Now, however, several months into the crisis, the economy could adjust that fast, but there are two case for a payroll tax cut is far more nuanced. One immediate concerns with this analysis. of its major selling points – that it quickly injected First, the same reasoning would suggest that enormous amounts of liquidity into the economy – the economy would shed 2.7 million jobs in the six has turned into a drawback as many lawmakers are months after the payroll tax suspension expired. looking to limit the total size of future relief bills. Second, knowing that the expiration was coming,

There are three basic channels through which a would employers be willing to create additional jobs

that they knew were soon going away? of hiring new workers to do so.

This type of analysis is best understood as That brings us to the third channel — a payroll tax estimating how much benefit the economy could see suspension, which could increase the speed at which by the end of the year if Congress decided now to new matches between employers and employees are eliminate the payroll tax entirely. There is no doubt made. One of the issues during a recession is that that permanently eliminating the payroll tax would employees are reluctant to take a job at a wage rate have a profound impact on the job market. However, that is below what they were making before. that’s a proposal much larger than anything that Businesses, however, facing reduced sales and lawmakers have suggested an uncertain market, are they are willing to reluctant to hire workers at entertain. the same wage they were

Still, there are ways paying before the crisis that even a temporary started. This gap could payroll tax suspension be partially closed if the could affect the demandworkers wages could be side of the economy temporarily boosted while during a crisis. That the cost of hiring new brings us to the second employees is temporarily channel — liquidity. The subsidized. payroll tax injects money As the economy into the economy, which improved, both the wage helps households increase boost and the hiring savings and pay down subsidy could be removed. debt without cutting back This is precisely how a as sharply on consumer temporary payroll tax cut spending. could work. The problem,

During times of as with all such fine tuning uncertainty, households measures, is timing. To be and businesses naturally maximally effective, the become more risk-averse. suspension would have Households try to improve their finances by increasing Now, however, several to provide the right-sized boost to the right workers saving and reducing debt. months into the crisis, the case and employers at the right To do this, however, they for a payroll tax cut is far time. must decrease spending. That decline in spending more nuanced. If it were removed too soon, it would provide a then leads businesses, new shock to the economy. which are already more If it were held too long, it risk-averse because of the crisis, to reduce hiring. would create enormous revenue loss with little long

That reduction in hiring in turn weakens the job term economic benefit. It has to arrive just in time markets and makes households more risk- averse. to fill the temporary gap between the wages that This can create a self-reinforcing cycle that turns employers are willing to offer and employees are a temporary economic shock into a prolonged willing to accept. recession. Cutting off this cycle can help mitigate the For these reasons, I favor policy that permanently damage from the initial shock and jump-start growth. increases investment in the economy. It has the same sort

That’s part of the logic behind simply sending of jump-starting effect, but without the need to get the cash rebate checks to families when the pandemic timing right. Moreover, it provides much greater bangfirst struck. A payroll tax cut would have a similar for-the-buck in terms of long-term growth. A permanent effect, but would have the downside of excluding increase in cost recovery for investment would cost as many people who have lost their jobs. much over the ten-year budget cycle as a temporary cut

On the other hand, one might argue that Congress in the payroll tax. Yet the growth effects would persist has been especially generous in its benefits for the long after the crisis is over. RF unemployed and that targeting stimulus towards those with jobs would help mitigate that. It would Karl Smith is the Vice President for Federal Tax and also encourage businesses who were just on the cusp Economic Policy at the Tax Foundation.