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Doubling Down on the Payroll Tax Holiday is a Bad Bet

2 min readBy: William McBride

The center piece of the President’s jobs proposal is to extend and expand the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. holiday for another year. This would cut the rate employees pay in half, from 6.2 percent to 3.1 percent, and also cut in half, to 3.1 percent, the rate employers pay on the first $5 million of their payroll. Additionally, businesses that increase their payroll in 2012 would be exempt from paying any payroll taxes on the increase in payroll, with a cap of $50 million.

According to the White House, the total cost to the Treasury is estimated to be $240 billion, with $175 billion going to employees and $65 billion going to employers.

Why won’t this work? For much the same reasons the first version has not worked. It is temporary, and unlikely to substantially change economic plans, particularly the hiring plans of businesses which are multi-year gambles. So, for the most part, it won’t directly address the unemployment problem.

It will put money in the pockets of those already employed, and this is certainly a relief. The hope is that much of this money will be spent on consumption and thus contribute to short term GDP growth. Confidence fairies abound.

Let’s assume all $240 billion is spent on consumption and adds $240 billion to GDP in 2012. This would add $240 billion to the national debt as well. By my calculations, this adds almost 1 percentage point to the debt to GDP ratio, which is expected to hit about 70 percent by the end of the year. So, it’s going in the wrong direction in terms of debt consolidation.

More dangerous, in terms of budgetary concerns, is that it cuts deeply into the largest stable source of federal revenue. As the following chart shows, payroll taxes are the second largest source of revenue, and more stable than personal and corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. revenues which fluctuate with the economy.

The chart also reveals that corporate income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. revenues are a relatively small share of total revenues. In fact, the corporate income tax could be eliminated for less than the cost of this payroll tax holiday. Now that would add jobs. According to the OECD, the most harmful tax to economic growth is the corporate tax. Gordon and Lee estimate that lowering the corporate rate by 10 percentage points adds 1 to 2 percentage points to growth.

Eliminating the corporate tax would create an unprecedented economic boom. I’m afraid this president has missed a golden opportunity, and put the country in danger of further downgrades.