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How Effective Would a Payroll Tax Holiday Be In Spurring Employment and Stimulating the Economy?

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Obama’s tax deal with Republicans extends the Bush tax cuts for the wealthy for another 2 years.

As Bloomberg notes, Obama said that “he still believes the nation can’t afford to permanently extend the top tax rates”.

But as Mish points out:

Of course the last extension was “temporary” and the next extension will be “temporary” as well.

Obama’s plan would also extend aid for the long-term unemployed for another 13 months.

And the payroll tax (which funds Social Security and Medicare) would be cut by 2 percentage points during 2011 in an effort to help spur hiring.

Will cutting the payroll tax really help to spur hiring?

The Center on Budget and Policy Priorities argued in January 2009 that it wouldn’t.

Suspending employees’ payroll taxes would immediately translate into higher take-home pay for workers. Suspending employers’ payroll taxes, by contrast, would put cash into companies’ coffers, where it is likely to sit as long as sales are weak and factories are operating below full capacity. Indeed, according to the Congressional Budget Office [here's the CBO report], suspending employer’s payroll taxes is “not a particularly cost-effective method of stimulating business spending: Increasing the after-tax income of businesses typically does not create an incentive for them to spend more on labor or to produce more, because production depends on the ability to sell output”. In other words, firms will not hire (or retain) more workers than it takes them to produce the goods and services they can sell. Simply giving them a general tax break is unlikely to affect their hiring or investment in most cases, and thus would be largely ineffective as stimulus.

Standard economic analysis suggests that over the long run, a permanent reduction in the employer payroll tax would increase wages, as competition forced employers to pass on the benefits of the tax cut to their workers. But a two-month holiday on the employer share of the payroll tax would not have that effect: according to the Congressional Budget Office, “[s]uspending the employers’ portion of the tax for a short period of time is unlikely to alter wage rates by very much and so would not alter consumers’ resources very much.” Firms generally would not raise wages for two months and then cut them, and the reduction in wage costs would be too brief to make it worthwhile for employers to increase hiring. Instead, businesses would likely retain all or nearly all of the benefits from the tax holiday.

Would infusing cash into businesses in this manner constitute effective stimulus? Probably not. The primary problem that employers face in a recession is a shortage of demand for their products, not a shortage of cash. Therefore, most firms would likely keep much or all of any tax windfall they receive — or pass it on to shareholders and business owners, two groups that tend to have higher incomes and thus quickly spend relatively little of any additional income they receive.

***

The Urban-Brookings Tax Policy Center estimated that in 2006, 51.2 percent of payroll taxes were paid by the top 20 percent of tax units.

(Obama is proposing a year-long payroll tax holiday, not the 2 months discussed by CBPP. I’m not sure how much difference CBPP would find in an additional 10 months).

But as Annie Lowrie noted in September:

The Congressional Budget Office examined (PDF) the effectiveness of a variety of tax cuts this winter [in an updated report], and found payroll tax cuts to be a good option, compared with, say, extending tax cuts for the wealthiest Americans. Moreover, they have positive impacts on employment — and the sustained high rate of joblessness remains the biggest drag on the American economy and a pressing public-policy issue.

How Effective Would a Payroll Tax Holiday Be In Spurring Employment and Stimulating the Economy? CBO 480x391

According to the CBO, a payroll tax cut is about 25 to 33 percent more stimulative than providing a refundable tax credit for lower- and middle-income households, for instance.

As I noted in 2008, Mark Zandi – chief economist for Moody’s – calculated which stimulus programs give the most bang for the buck in terms of the economy:

How Effective Would a Payroll Tax Holiday Be In Spurring Employment and Stimulating the Economy? bang for the buck

Zandi lists a cut in payroll taxes as being less stimulating to the economy than food stamps, unemployment benefits (which Obama extended), infrastructure, and aid to the states, but more stimulating than tax cuts and tax rebates.

The Washington Post’s Ezra Klein turned to Zandi in July for updated figures on the effects of a payroll tax holiday:

Zandi’s most recent number estimate of the per-dollar economic impact of a payroll tax holiday is $1.24. This is a relatively high figure, but there are a number of better options, including expanding food stamps, work share programs, direct aid to states and a jobs tax credit.

Klein ran a back-of-the-envelope cost-versus-benefit analysis of a partial payroll tax:

How Effective Would a Payroll Tax Holiday Be In Spurring Employment and Stimulating the Economy? stimulative impact of a employee payroll tax holiday

As Zandi’s numbers suggest, the stimulative benefit is just slightly greater than the budgetary cost.

***

With better options, such as work sharing or food stamps expansion, available, it’s not clear to me that the focus should be on payroll tax relief.

And see this.

This article was posted: Tuesday, December 7, 2010 at 5:17 am





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