Why a Payroll Tax "Holiday" Is Such a Bad Idea

Lately you may be hearing lots of people from the Right and even some advisors to former President Clinton such as Robert Reich and Laura Tyson proposing a payroll tax holiday in order to boost hiring. I do not believe, based on the evidence I've seen, that this will have the effect they claim yet it will have severe repercussions damaging institutions that millions of Americans rely on. It is also somewhat telling that the Clinton era economists that came up with the idea of killing Glass-Steagall are the ones proposing this.

Some Quick Background

On every paycheck you receive, you will see some tax deductions: federal income tax, state income tax, maybe a municipality or county tax, Social Security and Medicare. It's those last two that make up your portion of payroll taxes also known as FICA taxes. Your employer (if you're not self employed) also pays an equal amount of Social Security and Medicare taxes for you. This adds up to 7.65% of your income below $90,000.

This money is then used to fund current beneficiaries of these systems with the promise that future workers will pay for you to collect benefits. Most years, the money being paid in is more than what is paid out to beneficiaries so the money is saved (in treasury bonds for the most part) in order to pay out in worse years. Unfortunately, as I'm sure you've heard, more workers are due to retire in the next several years than new workers entering the workforce. Also, during the current recession, more people are taking early retirement and fewer people are working, which has caused the Social Security Administration to pay out more this past year than it took in. Overall though, it is projected that the trust fund will be able to afford full benefits for at least the next 25-30 years.

Medicare on the other hand is not in quite as good a shape. Health care costs have been rising quickly and again the ratio of workforce to beneficiaries has been steadily shrinking. This has left the Medicare trust fund (PDF) at about 1/7th the size of Social Security.

What a Payroll Tax Holiday Will Mean for Business

Currently, the average worker earns about $32,000 a year which means each business pays less than $2,500 per worker per year in payroll taxes. Just to equal the salary of a minimum wage worker (a little more than $15,000 per year), it would take more than six other employees' payroll taxes. It would take 13-14 employees' payroll taxes to equal a new average worker. That new employee would also require training and time to get up to speed in the new job, not to mention any other benefits the company offers. Then in a year or so, when the "holiday" expires, that average employee will suddenly cost almost $35,000 and all the other employees start to cost $2,500 more as well.

What a Payroll Tax Holiday Will Mean for Workers

In general, most workers won't immediately notice anything. Depending on how it's done, workers may see those FICA deductions no longer in their paycheck, giving them an extra $2,500 per year, but most plans that I've heard about only discuss the holiday in terms of removing it on businesses, since the intent is to get them hiring. However, long term, workers will see significant harm. A retiree's benefits are based on how much they paid into the system and how long they paid. Remove a couple years' payments in and most workers will see a significant drop in projected benefits, ask any woman who has taken an extended maternity leave. Add this on top of the 30-50% drop most people have seen in their invested retirement funds and the drop in home values and you have a significant portion of the population unable to afford retirement, even at 70 or 75.

What a Payroll Tax Holiday Will Mean for Social Security and Medicare

Put simply, these already strained systems may collapse. Unless the funding is replaced by government spending, Medicare could lose $250-500 billion, nearly or completely bankrupting it (their current trust fund is $381 billion). Social Security has a bit more of a cushion, but it too would lose $400-800 billion. This could shave five or more years off of it's trust fund easily. If someone wanted to kill these programs, I can not think of an easier way.

What Would Most Likely Happen

I want to preface this by saying I am not an economist and have nothing on Reich or Krugman when it comes to big economic questions (I'm happy when I can keep my own budget in order). But I can look at what people have done and have been doing and put two and two together. Right now, people aren't buying: many don't have jobs, many more are afraid of losing their job and other have lost sometimes considerable wealth when their home value plummeted and credit dried up. This means companies aren't selling as many products and so don't need as many people on their factory floors or behind their cash registers. If a payroll tax comes through, companies will have more money, but they still won't be selling products and so still won't need workers. Thus, as they have already been doing, most corporations will instead pay their CEOs bonuses for "earning" the company more money and wealthy investors will get a dividend. Meanwhile, unemployment will hardly be affected and workers retirement funds will get that much smaller.

What Should Be Done

As I said above, the problem companies are facing is a demand problem. Same store sales have fallen or are flat for most retailers. Home prices are still falling. 50% more businesses rate sales as the most important problem than any other issue, including taxes. What we have is a catch-22: businesses won't hire because they aren't getting sales, consumers aren't buying because the job market is in the toilet. The thing that will get the most companies hiring again is increasing demand and the only organization willing or capable of doing so is the federal government. This has already been started and had great effect, but what was done was too small for the pit we were put in. When $2-4 trillion worth of wealth has been destroyed, spending $300 billion a year isn't going to replace the demand lost.

Obama has proposed some things that will lead to increasing demand: tax credits for business investments will get companies buying equipment (unlike employees, equipment doesn't cost more each year) increasing demand and creating jobs for equipment manufacturers. A $50 billion infrastructure investment fund, while small, will put people back to work directly and as proposed will pull in private investment, getting money moving again. Tax credits directly related to new hires are already working.

There are ways, both with targeted tax policy and direct government spending to increase hiring. The stimulus act was able to create at least three million jobs (or at least prevent people from getting fired, like police and teachers). But it can't be done with half measures by people who are afraid of a bunch of self absorbed know-nothings.

Congress, get out there and do your job. Go big or go home.