Stimulate This, Baby

By Frank Hagan | Related entries in Taxes

Michael Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. Today, in the Wall Street Journal, he proposes a temporary payroll tax reduction as a second try at a stimulus. He starts his argument with consideration of what would have happened with a temporary payroll tax reduction in February of this year:

My Stanford colleague Pete Klenow and Rochester economist Mark Bils estimated that cutting the payroll tax by six percentage points (of the 12.4% Social Security component) would, under standard assumptions, increase employment by three million to four million workers—an amount equal to all the job losses since the stimulus was passed.

The payroll tax cut would have reduced firms’ costs by roughly the same amount as from the entire decline in employment. It would have cost less than half as much as the stimulus bill, gotten far more income into paychecks quickly and, most importantly, greatly reduced incentives for firms to lay off workers. In fact, it would have created incentives to hire.

Instead, we choose a stimulus that critics called “porkapalooza”, and have seen unemployment exceed targets by about 25% (to over 10% instead of the promised maximum of 8.6%).

Boskin’s recommendation is a “partial payroll tax reduction”, cutting the tax in half for a few months. That means the average wage earner would see a 3% raise for those months (and the employer would also see a 3% drop in payroll taxes). On the employer side, that might spur hiring or help employers retain employees slated for layoffs, but I don’t think its enough of an effect for the wage earner.

Boskin also recommends accelerating some spending “that has to be done anyway”, such as replenishment of military stores. I have my own reservations about opening the door to any more government spending. The level of military spending is certainly something open to debate, anyway, and the current administration is more likely to try to cut military spending after huge increases for the war in Iraq and Afghanistan.

In my view, a better idea would have been a three-month payroll tax “holiday”, with workers enjoying an increase in wages equal to 6%, and employers enjoying an immediate 25% reduction in taxes for the first quarter of next year.

Unlike income taxes, payroll taxes are levied disproportionally on the lower and middle income classes, with every dollar of their income taxed. The Earned Income Tax Credit is designed to offset some of that disproportionate burden, but it is reduced and eventually phased out for those earning over $43,279. People in the third and fourth quintile of income pay more of this tax as a percentage of total income than any other class. Because the payroll tax is collected on every dollar up to $106,800 in income, the richest families see payroll tax free income above that level. (All rates are 2009 figures.)

The middle class is the “engine” of consumer spending, and a reliable, defined 6% increase in wages for three months would do much to spur delayed spending on consumer goods. And it would be “kinder” to our budget deficit than “stimulative” spending.

While taxes on the “rich” are often decried by my fellow conservatives, when all taxes and tax credits are added together our system looks moderately progressive and not “confiscatory”. Economists separate household income levels into 5 equally sized groups, or “quintiles”, with income and effective tax rates per quintile, as shown:

Quintile: First Second Third Fourth Fifth
Household Income: $0 $18,370 $35,095 $56,222 $88,774
Tax Rate: 4.3% 10.2% 14.2% 17.6% 25.8%

Quintile Income Bracket Source: http://www.bls.gov/cex/2006/Standard/quintile.pdf

These are the estimated percentages actually paid in 2006, not what the tax tables state. Note that “the rich” don’t pay 39% on every dollar of income; with lower taxes on the income up to their top level, tax deductions and other credits, they end up paying 25.8% of their income. It would be simpler to incorporate these tax rates into a tax code of a single page instead of the 70,000+ page tax code we now have, but that’s another issue entirely.

The tax percentages above include payroll, income, excise and other federal taxes, minus deductions and credits, as estimated by the Cato Institute. The income levels for the quintiles, from the BLS, are “household” income (two wage earners if filing jointly). Many are shocked to find their family is in the 4th or 5th quintile, but you are in the top 40% of wage earners if your combined income is over $56,222. If you and your spouse earn $89,000 combined, you are “rich”, in the top 5th of all income earners.

Unlike the Making Work Pay tax credit, passed with the 2009 stimulus bill, a payroll tax holiday would not be accompanied by a temporary adjustment in the withholding tables that might “bite” some taxpayers. The $400 per person “Making Work Pay” tax credit was offset by automatic deductions in the withholding tables, providing the average wage earner with a few extra dollars each paycheck. But that affects the total amount withheld, and some tax payers may see a tax bill due instead of a refund at tax time in the spring. That tax surprise will not be pleasant for families already pressed by salary reductions, rising credit card interest and other effects of the recession.

Rep. Louie Gohmert had proposed a payroll tax holiday as an alternative to multi-national corporate bailouts in late 2008, but the proposal went nowhere. It is time to reexamine this proposal, perhaps even on a bi-partisan basis – one can hope – for the first quarter of 2010.

Cross-posted to FrankHagan.com


This entry was posted on Wednesday, November 18th, 2009 and is filed under Taxes. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

17 Responses to “Stimulate This, Baby”

  1. frankhagan.com » Stimulate This, Baby Says:

    [...] Cross-posted to Donklephant.com [...]

  2. milo Says:

    While I agree that payroll taxes are the right place to look for solutions, this “tax relief” plan is unlikely to work as a stimulus.

    The problem with any form of tax relief (like the ineffective Bush tax credit in 08) is that the nature of our problem includes a shortfall of demand, as people quite rationally choose to horde money for an uncertain future rather than spend it now. Studies have shown this propensity to save is particularly acute when the extra money appears as a bonus rather than a predictable increase in long-term income that might instigate a bump to a higher standard of living.

    However, where I agree on the need to address the payroll tax is as part of a set of structural changes to encourage employers to hire more freely as the end of the recession approaches. The current system of benefits and payroll taxes makes it an expensive proposition to bring on a new worker if you are not certain there will be enough demand to require one. We need to move to a system where everyone works more like a freelancer, rather than like a union employee. Remove as many costs from the employer as possible and transfer them to the employee directly, so that bringing back employees part time carries no extra risk for the employer.

    This is what needs to happen, though I doubt the Dems have the will to do it, since so many people want the union jobs of the 50s that no longer exist. But look at how temporary employees have been the source of employment in Japan lately, or Sarkozy’s ideas for simpler employment contracts to reduce unemployment among the youth.

  3. milo Says:

    BTW, on the tangent about tax rates, I agree completely that the take-away from that data on “actual taxes paid” is that the tax code needs to be simplified. I’m in a high enough bracket that I literally cannot understand the returns my accountant prepares, thanks to the multitude of insane phaseouts. I would rather pay the same amount without having to go through all the hassle – and have it be transparent to the citizenry how the bills are paid.

    Any chance Independents will get behind this, since obviously the two existing parties are too corrupt to do anything about it?

  4. DougL Says:

    Could you cite where you got this “instead of the promised maximum of 8.6%”. Who promised that and when?

    On June 16, 2009, in an interview, Pres. Obama predicted that unemployment would rise to 10% before the end of the year.

  5. Justin Gardner Says:

    Frank,

    I agree with DougL. 8.6% was an original estimate, but they revised it up because of worse than expected economic downturn and consumers spending A LOT less. The government can only work with the numbers they have, they can’t force people to spend money.

    Also, the banks have been incredibly stingy with new business loans, and the administration is working on that too.

    In any event, I don’t think it’s that cut and dry that the stimulus hasn’t had an impact. We’re 8 months from when it passed and 6 months from when the money first started truly flowing in. We all knew it was going to take some time to take effect.

    As far as pay roll tax holiday, this could incent people to spend, but they could just save it. So I think what Obama was looking to do was create more long term, sustainable gains by rebuilding our infrastructure, thus creating the groundwork for jobs. We have to move away from consumer spending and into an economic structure that doesn’t rely on people going into debt, agreed?

  6. Michael Says:

    What we badly need now are jobs. The value of what Obama was trying to do with his stimulus package can be seen by the results of that package. The situation now is one where any option that will help save and create jobs is worth taking — and that means cutting taxes. Cut the payroll tax, cut the corporate tax, end the Estate Tax. All of those measures would help businesses remain afloat and give them the ability to add new jobs. In fact, repealing the death tax could add as many as 1.5 million new jobs to the economy. Does that mean that congress will do it? Most likely not.

  7. Frank Hagan Says:

    Justin and DougL, the stimulus was “sold” on the idea that unemployment would rise above 8.6% if it was not passed … see Time Magazine and US News on this. Obama himself stated that without the stimulus, unemployment would climb to “double digits” (see NY Times and his urging took on the appearance of crisis. Come to find out, the administration’s attempts have not appeared to have done anything to stem the tide. This recession appears to be following the same trajectory as all other recessions, even those without massive government spending on “stimulus” bills.

    We’ll never know if unemployment would have gone higher without the stimulus, but we do know the administration has been wrong so far. I’ll avoid saying they “lied” about unemployment numbers, because I don’t think they are devious. Just wrong.

    On the effect of a “tax holiday”: A three month reduction in the payroll tax would be spent. Unlike a single payment of a few hundred dollars, the 6% increase in wages would be deposited into checking accounts and appear in the balance. It wouldn’t be deposited into savings accounts without intervention by the wage earner. That did happen with many of the one-shot “bonus” tax reduction checks under the Bush administration (a stupid idea if I ever heard one). The withholding deduction started this year for the “Making Work Pay” tax credit is being spent, but its just too small to make much of a difference in buying decisions ($400 spread over 8 months isn’t that much in each check).

    Milo, I agree with you on most points. We should move from an economy where the employer sweetens the deal with benefits and other inducements, and just pays the worker. That would improve not only the tax situation, but also move health care into the market where people can make buying decisions (its actually hard to find out what a procedure costs if you have health insurance because you are not the customer, the insurance company is).

  8. Justin Gardner Says:

    First, sure the stimulus was sold on the idea that unemployment would be stemmed…and it was. Stimulus that was desperately needed by the states saved a ton of jobs that would have driven the unemployment rate up much higher than it is now. That’s not in dispute…at all. Why? Because most states are constitutionally mandated to balance their budgets, so they would have had to eliminate jobs. And that’s why ALL of the states eventually took the stimulus funding…because they had to. So all of this, “there’s no way to prove it talk” is not accurate. The stimulus helped make sure the pain was greatly minimized.

    Does this mean the stimulus has created a bunch of new jobs? No. But, as mentioned, it’s been 6 months since the money started really flowing into the system. Give it some time!!!! What is wrong with everybody???

    However, that’s not the only way the stimulus was sold. There were dozens of other reasons as well.

    Second, since a lot of the recent tax breaks were actually saved, not spent, I don’t know how you can say this so definitively.

    Last, I agree with both you and Milo on that notion. We’d all be better off if health care wasn’t so closely tied to employment. It’s a broken system and we need a radical change.

  9. Nick Benjamin Says:

    As for the main topic of this post I would like to point out that it’s coming from a Hoover Institute Fellow and was published in the Wall Street Journal.

    As Milo points out very few people will spend this money. Everyone else knows that we are in the midst a downturn that pretty much nobody predicted, that’s been worse than anyone predicted, and is greatly affecting their own personal bottom line. They’re gonna take that 3%, and if we’re lucky, they’ll put it into a bank. If we’re not it’s going straight under the mattress.

    IMO if there is a new stimulus it will have to be mostly direct aid to local and state governments. If they agree to rehire everyone they fired, plus a few more, the Feds will cover their budget deficits.

    ——————————————-

    As for health care radical change will come. If this particular proposal passes we may get it incrementally. If it doesn’t DC will conclude health reform is political suicide, and will refuse to face the issue for at least 10 years.

    In the meantime we’ll get half-assed reforms like the stupid automatic pay cuts Clinton and Gingrich implemented.

  10. Vast Variety Says:

    Past results of stimulus packages where rebates were handed out didn’t result in a huge change in spending. People tend to take those “extra” funds from the government and pay off things like credit cards and debt. It’s what I did.

  11. kranky kritter Says:

    As Milo points out very few people will spend this money. Everyone else knows that we are in the midst a downturn that pretty much nobody predicted, that’s been worse than anyone predicted, and is greatly affecting their own personal bottom line. They’re gonna take that 3%, and if we’re lucky, they’ll put it into a bank.

    The only people who won’t spend it are those having no trouble making ends meet. I can promise that folks living paycheck to paycheck will spend it. Further folks who haven’t lost their jobs and think the recession is over will spend at least some of it.

    As to predicting this downturn, pretty much no one predicted it except Peter Schiff. He might not be right with his predictions now ( I pray he isn’t), but he was right then. About a right as person could possibly be about something this big. I watched this clip again, and every time I watch it I am astonished how blithely idiotic and wrong everyone else was.

  12. Mike A. Says:

    “I watched this clip again, and every time I watch it I am astonished how blithely idiotic and wrong everyone else was.”

    …and arrogant and dismissive of Schiff’s analysis.

  13. Nick Benjamin Says:

    @kk
    Most of the people I know who are actually having trouble making ends meet don’t pay payroll taxes because they aren’t employed, or they’re self-employed so they pay all their taxes in April. Most of the rest pay very little in payroll taxes because they’re underemployed.

    Payroll taxes are by and large paid by people like who have good-paying jobs. In this economy those folks would have to be extremely stupid to buy anything. Just look at what happened to Saturn’s employees. In early December last year they worked for one of the best-known companies in the world, which was in some trouble but seemed to be stable. By February they were in bankruptcy and Penske was their only hope for continued employment and/or a pension.

  14. kranky kritter Says:

    Payroll taxes are by and large paid by people like who have good-paying jobs. In this economy those folks would have to be extremely stupid to buy anything. Just look at what happened to Saturn’s employees. In early December last year they worked for one of the best-known companies in the world, which was in some trouble but seemed to be stable. By February they were in bankruptcy and Penske was their only hope for continued employment and/or a pension.

    Your Saturn anecdote is interesting. But I doubt whether anyone working for any domestic auto manufacture had strong reasons to believe their company was “stable.” Not when the entire domestic industry was on the ropes.

    Your notion that anyone with a good paying job would be stupid to spend money seems strange to me. I suspect that there are plenty of people who have good reason now to think their job is stable. I am not saying all or most or even the majority. But plenty. Gov’t workers for starters, though not all pay all payroll taxes.

    Further I simply doubt whether your opinion about the wisdom of spending will be predictive of actual behavior.Those who have survived this serious downturn without losing their jobs can be expected to vent some of their pent-up demand. And I’m not just saying this to be sanguine about the economy. As you know, I am pessimistic about our prospects over the short and intermediate terms. I simply think that people who haven’t lost their jobs and who have lived below their means due to economic fear will start to spend.

    I do question how much a payroll tax holiday would lead to new jobs.C ompanies do of course need a means to add employees if they want to expand their productive capacity. But no enterprise expands its productive capacity simply because it can. They need to believe that they can profit from the additional capacity. Arguably that’s missing these days.

    But I do think that Americans with jobs who find extra money in their pockets due to a tax holiday will spend a substantial portion of that money. As you believe, prudent folks may indeed view that spending as folly. Doesn’t mean it won’t happen anyway.

    You would have had to be crazy to take out a $500,000 adjustable rate mortgage if you had a weekly income of $1000 to $1500. But look how many folks did something like that. We both know that “you’d have to be crazy to do x” is different from predicting that no one would do x, right?

  15. kranky kritter Says:

    @ Mike A:

    Laffer and Stein were I think the most annoying in their arrogant dismissiveness. IIRC, it was Laffer who acted dumbfounded when Schiff said that the wealth growth of home and stock owners wasn’t real and would disappear when inflated valuations burst. How could he not understand the plausibility of this?

    And Stein’s blithe “you’re simply wrong” was pricelessly embarassing.

    But wasn’t the most comical that long perm-haired blond real estate guy? The one who looked like he was probably an aerobics instructor or infomercial salesman who lucked into the real estate boom and probably had no clue. What a f%^%king moron. He called 10% annual growth in real estate prices normal. NORMAL! I guess because it was normal for his vast 8 years of experience. Makes me so mad!

  16. Mike A. Says:

    @KK

    Yea, the clip is truly an embarrassment for everyone but Schiff. I’m amazed Stein has the audacity to open his mouth and give any financial advice publicly.

  17. Nick Benjamin Says:

    @kk
    Before the financial crisis the auto industry actually looked like it was recovering from it’s last downturn largely because the UAW had agreed to take a $multi-billion cut in health benefits. Then the financial crisis hit, nobody would approve car loans for a few months, which meant GM couldn’t sell cars, and nobody would give GM a bridge loan. Saturn workers in particular must have felt safe because they made small cars, and the company was designed to avoid Detroit problems. That’s why it was in TN.

    As for your crack about government workers it may be true if they’re Federal employees. But state and local employees are in big trouble. One of the few positive results of the stimulus was the fact that it allowed states to fire fewer people.

    Economically the rational decision for most people to make, if they received a payroll tax cut, would be to spend money. It looks like the economy is gonna recover, which means prices will go back up. But most people aren’t gonna be thinking that way until they know the economy’s recovering for sure.

    A payroll tax cut would do some good. I just don’t think it would do enough because most potential recipients are in a very frugal mood.

    Personally I’m leaning towards a second stimulus that’s free money to states. Get the accountants to figure what every state would need to not fire cops if it were well-run, and then give that much to every state. I’d also love it to include a more efficient jobs program. Just gives states $50,000 a job, and tell them to hire people to do whatever.

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