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End to Payroll Tax Holiday May Weigh on Economy

John W. Schoen
Monday, 22 Oct 2012 | 4:18 PM ET

A tax break that's added about $19 a week to many paychecks for the last two years looks like it's going away in January. While most taxpayers may not notice the difference, it's a good bet the economy will.

Mike Kemp  | Getty Images

To help offset the income lost during the surge in unemployment following the 2007, Congress and the White House gave American households a small "tax holiday" starting in 2011 and followed it up again this year.

While unemployment remains high, consumer spending has perked up strongly in the last few months. That extra spending power could take a big hit if, as now appears likely, the Obama administration's payroll tax holiday expires at the end of this year.

(Read More: Democrats Threaten Payroll Tax Cut Consensus)

"The payroll tax holiday was intended to be temporary and there is strong bipartisan support to let that tax provision expire," said Sen. Orrin Hatch of Utah, the top Republican on the Senate Finance Committee. "The continued extension of a temporary payroll tax holiday has serious long-term implications for Social Security and, frankly, it's not even clear that it has helped to boost our ailing economy."

Enacted in 2010, the tax holiday was designed to help pull a stagnant economy out of the doldrums by boosting consumer spending, which accounts for roughly 70 percent of gross domestic product.

The money came from taxes paid to fund Social Security, half of which is paid by employers and the other half by workers. For 2011 and 2012, Congress and Obama cut the share paid by workers from 6.2 percent to 4.2 percent.

That meant someone making the median income of about $50,000 saved $1,000 a year, or a little more than $19 a week.

The Deficit Abyss

The extra money diverted into consumers' pockets, though, is money that isn't going to shore up the Social Security trust fund, which is already creaking under the actuarial weight of a large influx of aging baby boomers. With Congress already staring over the edge of a "fiscal cliff" into a budget deficit abyss, the idea of underfunding Social Security has lost a lot of its appeal.

"I think there's a growing consensus that Congress and the president can't continue to divert such a critical revenue stream from Social Security," said Rep. Kevin Brady of Texas, a senior Republican on the tax-writing House Ways and Means Committee. "I think more and more Americans understand that that payroll tax cut, while politically appealing, is endangering Social Security."

Technically, the tax cut hasn't robbed money from Social Security. When the law was enacted, Congress agreed to reimburse Social Security for the lost revenue, estimated at $103 billion in 2011 and $112 billion in 2012. But Congress didn't cut spending or raise other taxes to offset the lost revenue, so the payroll tax cut is being financed with borrowed money, adding to the national debt.

That has raised concerns that borrowing from Peter to pay Paul will only make it harder to get the trust fund back on a sound footing.

"Further extension of the payroll tax holiday would undermine confidence in Social Security and put at risk the program's dedicated funding stream and the hard-earned benefits of millions of Americans and their families," AARP CEO A. Barry Rand wrote in a letter to Congress and the White House Friday.

It's also far from clear just how much good the tax cut did to revive the economy, and whether whatever stimulus it did provide is needed. Economists are divided on how much of that was spent, how much was saved and how much used to pay down debt.

Healthier Household Economies

Even if it did help boost spending, the tax holiday windfall pales in comparison to the money consumers have freed by paying down the mountain of debt they accumulated during the height of the borrowing binge of the 2000s.

At the start of the decade, American households spent about 17 percent of their disposable income to cover payments on a list of financial obligations tracked by the Federal Reserve, including mortgage and consumer debt, car leases, rent, homeowners' insurance, and property taxes. After peaking at 19 percent in 2007, that burden has fallen to 15.8 percent of disposable income.

Some of that drop is the result of a wave of credit card defaults and mortgage foreclosures. Some is from households' efforts to pay down debt. But a large measure of the debt relief has come from the Fed's unprecedented effort to drive interest rates to the floor, which has sparked multiple waves of mortgage refinancing.

Altogether, the cash freed up by the falling debt burden, thanks in part to the Fed's low-rate policies, is roughly four times as much as the money diverted from the payroll tax holiday.

The savings from low interest rates on debt payments, of course, are offset by the lost interest on savings like money market funds. But the improvement in American household finances has undercut a major argument for extending the tax cut holiday for another year.

Still, lopping some $125 billion from consumer paychecks with what amounts to a tax hike won't help the sluggish economy recover any faster, especially if the money is cut all at once. Based on estimates of how much flows directly into spending, ending the tax holiday would represent about a $100 billion hit to consumer spending, according to JPMorgan chief U.S. economist Michael Feroli.

"Even if the adjustment is spread out over the first two quarters of the year, which seems more consistent with past experience, the headwind to growth should be noticeable," he wrote in a recent research note.

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