Subsidizing Profits, Weakening Social Security: The Employer Payroll Tax Cut

These days, it appears as though the main goal of government policy is to give as much money as possible to corporations and the wealthy. This is an area where there has been considerable success, with the profit share of GDP at near record highs and the richest 1 percent holding a larger portion of the nation's wealth than at any point since the late '20s. The proposals for an employer-side payroll tax cut should be seen in this light.

The argument being pushed by proponents of the cut is that a temporary reduction in the employer's side of the payroll tax will give them more incentive to hire workers. This argument does not pass the laugh test, but of course, most of the things being said in elite Washington circles these days do not pass the laugh test.

As usual, the flaws can be exposed with simple arithmetic. The employer's side of the payroll tax is 6.2 percent. The argument goes that if we temporarily eliminate this tax, then it is cheaper to hire workers, so employers will hire more.

This argument depends on the responsiveness of labor demand to the price of labor. The employer tax cutters would say that labor demand is quite responsive to changes in price. However, the evidence points in the opposite direction.

Over the two-year period 1995 to 1997, we raised the minimum wage by more than 15 percent, after adjusting for inflation. There is a large body of research that shows that this increase had no measurable impact on employment. There also have been two subsequent increases in the national minimum wage as well as several increases in statewide and citywide minimum wages. The overwhelming majority of research on these hikes shows that there was no measurable impact on employment.

If we can permanently raise wages by 15 percent and see no measurable decline on employment, how can we think that a temporary reduction in wages of 6.2 percent would have a major impact on employment? Even in Washington, 15 percent is larger than 6.2 percent. A smaller change in the cost of labor cannot have a bigger effect than a larger change, and a temporary change cannot have a bigger effect than a permanent change. (If the tax cut is in place for one year, then an employer hiring in July gets the lower cost for six months.)

There are ways to make an employer-side tax cut more effective, for example by tying it to hiring new workers. However, this is a difficult one to enforce. There is enormous churning in the economy, with roughly four million people leaving their jobs and getting hired at new ones every month.

Most likely, if we restrict the tax cut to firms that hire new workers, we will just be rewarding firms for hiring that is part of this monthly churning. Of course, if a temporary 6.2 percent cut in taxes doesn't provide much incentive to hire in any case, then the consequence of making the tax cut more narrowly focused will be primarily to reduce its cost, not increase its effectiveness.

Many of the proponents of the employer-side payroll tax cut have cited the Congressional Budget Office's (CBO) estimate of the multiplier for this policy. They point out that CBO puts the multiplier for this policy at 1.2, meaning that $1 billion in additional spending or lost revenue leads to $1.2 billion in addition GDP. That figure puts the tax cut near the top in CBO's rankings.

However, the 1.2 multiplier is just the top end of a large range that has 0.4 as its bottom. A multiplier of 0.4 would put the policy near the bottom in CBO's ranking. It means that $1 billion in lost revenue would lead to just $400 million in increased output.

A large range like this suggests that CBO sees a high degree of uncertainty on the impact of this policy. As noted, the recent research on the minimum wage suggests that the impact would be small, but there could be other factors pointing in the opposite direction.

One aspect of this tax cut that is not in dispute is that it raises important issues about the future of Social Security. And this is true whether the tax cut is on the employer side or employee side.

While the plans at present call for crediting the Social Security trust fund with the full amount that it would have received had there been no cut in the payroll tax, this is a departure from past practice in which the trust fund's revenue came entirely from the designated payroll tax or interest earned on bonds bought by the trust fund. The 2 percentage point employee-side payroll tax cut that is currently in place and any future cuts, imply that general revenue is now being used to finance Social Security.

There is nothing wrong with using general revenue for Social Security in principle, however, several Republicans have already indicated that they intend to use the revenue shortfall as an argument for cutting benefits. They may not get far in this effort, however, giving the Obama administration's openness to cuts in Social Security, it is dangerous to go down this path.

It is possible to give whatever cut is intended through a reduction in the payroll tax through an income tax cut or credit. There is no obvious reason to prefer that the cut be designated as a “payroll tax” cut, unless the point is to raise issues about Social Security. Presumably, this is why the Republicans insist that tax cuts take this form.

In short, the employer-side payroll tax cut is not only bad policy for boosting the economy; it also unnecessarily puts Social Security in jeopardy. This is one form of stimulus that we can certainly do without.