Why The Payroll Tax Cut Is a Good Idea Even if it Won’t Create Much Stimulus

The volume of pixels I’ve spilled arguing that the cut in payroll taxes will not create much economic stimulus has apparently created the impression that I’m against the cut.

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So let me clear that up right now—I’m not against the tax cut.

My critique has always aimed at the assumption that Americans will spend most of the slight and temporary increase in take-home pay that results from a 2% cut in payroll taxes. The central planners in the Obama administration may wish that Americans could be counted on to respond so mechanically to turning the tax dial this way or that—but wishing doesn’t make it so.

In reality, the spending and savings habits of people are based on their plans and expectations. If they believe they’ll need savings to finance desired future consumption, they save more. If they think that future income will provide enough wealth to finance future consumption, they’ll save less. A temporary tax cut may provide extra-income, but workers still buried under a mountain of debt and facing an uncertain economic future are likely to use that extra-income to deleverage or save for a rainy day.

But just because the Obama administration’s economic theory behind the payroll tax cut is wrong, that doesn’t mean the payroll tax cut itself is wrong. Increased savings and decreased household debt is certainly a positive result. It will make American households more robust and better equipped to deal with future downturns. That’s a great—albeit unintended—result of the payroll tax cut.

If cutting payroll taxes is such a good idea, why have I been making such a big deal about the flaws in the theory that encouraged the Obama administration to push for the tax? Two reasons. First, I think it’s important to get these things right—even if the truth is inconvenient or may discourage others from adopting policies I support. More importantly, businessmen and investors need to know that they shouldn’t expect a jolt to economic growth or consumer spending from the payroll tax cut. If they get this wrong, a lot of resources will be misallocated.


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