Payroll Tax Political Theater

When it comes to political posturing, the current fight over extending this year’s payroll tax cut is a classic.

While they differ on the details, Democrats and Republicans both favor the proposed extension. Leaders of both parties claim that the reduced payroll tax, which saves the average family about $1,000 a year, will stimulate the economy. And, as is usually the case, they are wrong.

All the squabbling makes for amusing political theater but distracts from the real problems America faces. Nothing in any of the proposals for extending the tax “holiday” addresses America’s fundamental economic problems, nor will any of the proposals do much to speed the economic recovery.

Temporary tax cuts may modestly and temporarily increase spending, but they do little to grow an economy. The reason is simple: People make serious spending and investment decisions based on long-term expectations. If your employer tells you that you are going to get a $10,000 salary increase, you are far more likely to change your spending behavior—finance the purchase of a new car over the next six years, perhaps, or apply for a home equity loan so you can redo your kitchen—than if he gives you a one-time $10,000 bonus. The increase is permanent; the bonus is transient.

The same logic applies to tax changes. A permanent tax reduction that individuals and investors can count on over many years will generate much more economic activity than a temporary reduction.

But nobody in Congress is proposing a permanent cut. Besides, such a promise wouldn’t be credible because such a permanent cut would merely put us further in the hole.

Remember: The payroll tax funds Social Security. According to the 2011 Social Security and Medicare Trustees Report, Social Security is already operating in the red, with a $49 billion deficit last year (excluding interest income), an expected $46 billion deficit this year and “deficits … expected to grow rapidly [after 2014] as the number of beneficiaries continues to grow at a substantially faster rate than the number of covered workers.” Cutting the tax that funds Social Security would make the deficits larger and would increase the likelihood of future tax increases.