The Payroll-Tax Holiday from Hell
Had an American taxpayer fallen into a deep slumber in January 2011 and awakened 11 months later, he might have thought he had been teleported into an alternate universe. “Extension of Tax Cut Stalls in House as G.O.P. Objects,” ran a December 18 front-page headline in the New York Times. “Republicans in House Reject Deal Extending Payroll Tax Cut,” announced the December 21 Times front page. Our hibernator would have begun his sleep following the GOP triumph at the end of December 2010, when the resurgent Republicans in the House of Representatives compelled Barack Obama to agree to a two-year extension of the lowered federal-tax rates that had been the significant domestic political legacy of George W. Bush. So what happened in 2011 to alter the GOP’s standing as the party of tax cuts?
Why were the most conservative Republicans, the ones in the House of Representatives, standing in stout opposition to a payroll tax cut—which had been part of that heralded December 2010 deal to extend the Bush cuts?
Therein hangs a tale of an emerging tension within the Republican Party and the conservative movement. That tension led to a standoff followed by total capitulation, both of which handed Obama a much-needed political victory on an issue that has been a huge liability for him—and an ignominious defeat for those who had decided to take their stand against the payroll tax cut.
The payroll tax supposedly funds the Social Security entitlement programs by placing the dollars raised through it into a special trust. The 2011 cut in the employee’s share of the payroll tax, to 4.2 percent from 6.2 percent, was designed to provide ready cash to struggling American workers—cash that, it was hoped, they would immediately spend on consumer items, thus bolstering the economy. It was designed to stay in place for a year and was therefore originally dubbed a holiday.
Such a holiday is a problematic form of tax cut for several reasons. First, it is temporary, and many conservative economists, following the theory that made Milton Friedman’s reputation, believe a tax cut must be permanent to have a significant impact on the economy. Second, the payroll tax is supposed to collect funds for Social Security; remember Al Gore’s drumbeat in 2000 about the “lockbox” he would use to guarantee the safety of that money? Using it instead as a consumer piggy bank is a clear violation of the social compact governing these programs.
And yet the payroll-tax holiday is a tax cut, pure and simple, and Republicans are supposed to support tax cuts; indeed, the late columnist Robert Novak once famously said that “God put the Republican Party on earth to cut taxes.” So, in part, what we have is a conflict between the belief that government should take less money from citizens and the conviction that the payroll tax cut is neither an effective nor sensible way to do it.
That accounts for the divergent views of the Republican presidential candidates as the payroll-tax-cut issue began to dominate the political discussion. Newt Gingrich, in a November 9, 2011, debate, had backed extending the payroll-tax holiday into 2012. “I’m not prepared to raise taxes on working Americans in the middle of a recession that’s this bad,” Gingrich said. In the same debate, Mitt Romney took a similar position, saying, “I don’t want to raise any taxes anywhere.” But a third candidate, Michele Bachmann, in a December 18 appearance on NBC News’s Meet the Press, gave three reasons for opposing the payroll tax cut: “It’s put senior citizens at risk by denying the $111 billion to the Social Security trust fund,” she said. Also, “there isn’t one shred of evidence that that created jobs,” and “all it’s doing is adding to the debt.” Rick Santorum and Rick Perry also opposed extending the payroll tax cut for another year, while Ron Paul favored the extension.
The picture among congressional Republicans was no clearer than among those on the campaign trail. In a preliminary vote, Senate Republican leader Mitch McConnell and 38 other Republicans joined Democrats in voting for a two-month extension of the payroll tax cut. Among the seven Republicans who opposed it were Jim DeMint, of South Carolina, and Ron Johnson, of Wisconsin—the former the acknowledged leader of the conservative rump in the Senate and the latter one of the candidates ushered into office in November 2010 by the Tea Party. Johnson issued a statement: “I believe reducing funding for Social Security by extending the payroll-tax holiday is bad policy. It has not helped boost economic growth, and it replaces Social Security revenues with more borrowing.” He warned: “We will bankrupt Social Security, and we will bankrupt our nation. It is long past time to act responsibly and begin to seriously address and reduce our debt and deficits.”
House Republicans echoed the substantive concerns voiced by the Senators and resisted both the short term of the extension—just two months, rather than a full year—and some of the way that the “cut” was “paid for,” or not, under the internal logic, or illogic, of budget rules. “If you talk to employers, they talk about the uncertainty,” House Speaker John Boehner said. “How can you do tax policy for two months?”
President Obama, meanwhile, seized the opportunity to portray House Republicans as blocking a tax cut—and effectively raising taxes. The White House website featured a clock counting down the hours and minutes until a tax increase would take effect unless Congress acted. A Twitter hashtag, #40dollars, dramatized the amount an American worker would lose in a weekly paycheck if the tax holiday expired. “If you’re a family making about $50,000 a year, this is a tax cut that amounts to about $1,000 a year,” Obama said. “That’s about 40 bucks out of every paycheck….$40 means dinner out with a child who’s home for Christmas, a new pair of shoes, a tank of gas, a charitable donation. These are the things at stake for millions of Americans. They matter to people. A lot.”
Faced with the power of the president’s argument—which is, at least in recent history, a Republican one—that ordinary Americans could spend the money better and needed it more than the government did, Republicans found it prudent to relent. The House passed without objection, and the Senate passed by unanimous consent, the Temporary Payroll Tax Cut Continuation Act of 2011, which extended the payroll-tax reduction for two months.
The IRS press release announcing the change was newsworthy in at least two respects. First, it claimed, optimistically but unverifiably, that “this reduced Social Security withholding will have no effect on employees’ future Social Security benefits.” Second, it called attention to the little noticed but still significant fact that the two-month extension law included a brand-new special tax—a tax increase, compared with 2011—on those earning more than $110,100 a year. “This provision imposes an additional income tax on these higher-income employees in an amount equal to 2 percent of the amount of wages they receive during the two-month period in excess of $18,350,” the memo stated. “This additional recapture tax is an add-on to income tax liability that the employee would otherwise pay for 2012 and is not subject to reduction by credits or deductions.” For some large number of Americans, then, this “Temporary Payroll Tax Cut Continuation Act” was not a continuation of a tax cut but the end of one.
And so Barack Obama managed to champion a tax increase while he came across as a tax cutter—and the Republicans came across as though they opposed giving $40 a week back to the American worker.
So the politics were fairly disastrous for the GOP and rather pleasurable for Obama and the Democrats. But what about the substantive question of whether such a tax cut is a good idea? Steven Hayward, a fellow at the American Enterprise Institute and the author of a multi-volume study of the leadership of Ronald Reagan,1 addressed the question in an essay published in Breakthrough Journal. He quoted Reagan approvingly likening the curtailment of government spending through tax cuts to the reduction of a child’s allowance. Hayward argues that Reagan got this wrong:
Long-term evidence indicates that the starve-the-beast strategy not only fails, but may make the problem of unrestrained spending growth worse, suggesting that a “serve the check” strategy might be a more effective means of curbing the growth of government spending. The simple explanation for this seeming paradox is that the starve-the-beast strategy currently allows Americans to receive a dollar in government services while only having to pay 60 cents for it.
Hayward cites the late William Niskanen, a member of Reagan’s Council of Economic Advisers who was a longtime chairman of the Cato Institute: “[Niskanen] found that lower taxes correlated with higher levels of federal spending. As a result, Niskanen argues that raising taxes may be the most effective way to reduce government spending.”
The second debate is over Social Security. One of the heated exchanges of the Republican presidential nominating cycle came in September 2011, when Rick Perry called Social Security a “Ponzi scheme” and “a monstrous lie.” Mitt Romney criticized Perry while pledging to “save Social Security.” President George W. Bush’s major second-term domestic-policy initiative was an unsuccessful attempt to reform Social Security to include personal accounts for younger workers. Not for nothing is Social Security described as a third-rail issue—touch it and die. Republicans seem torn between trying to touch it themselves and the temptation of accusing President Obama and Congressional Democrats of touching it by pushing payroll tax cuts that will weaken the program’s funding.
The third, and related, debate is over fundamental tax reform of the sort being proposed to help avoid the long-term budget disaster facing the federal government—and to clear the regulatory brush and thereby make economic growth more achievable. One question is whether such a reform would replace the current payroll tax system, originally established by the Social Security Act of 1935, or leave it unchanged on the grounds that, as defined by the 1939 amendments to the Social Security Act, the taxes are “insurance contributions” more than taxes under the Federal Insurance Contributions Act, which appears on pay stubs as FICA. Another question is whether such a reform would be “revenue neutral” or whether it would contribute, either through growth or through some static analysis, to deficit reduction.
All these debates are playing out in an election year, in a context of slow growth, high unemployment, large federal deficits, and federal debt at about 100 percent of GDP. It is clear that the Republicans who chose to make a principled stand against the ineffectuality of the payroll tax cut were doing so at the wrong time and in the wrong way—even though they were surely correct on the merits. Dealing with the payroll tax on a one-year or two-month basis, without addressing these bigger issues of the future of Social Security, the rest of the tax system, or the imbalance in the federal budget, is nonsensical. But that is the way the politicians have proceeded, in part because the payroll-tax holiday is relatively easy and popular, while those other problems are complex and hard.
On Social Security, the most rational solution to a long-term fix would be a transition to a system of individually owned, privately invested accounts of the sort George W. Bush advocated as a presidential candidate in 2000 and 2004. Such accounts would foster individual responsibility and choice instead of government dependence. They would also expand the “investor class” of those with a direct interest in policies that increase corporate profits. Alas, the tumble the stock market took in early 2008 and early 2009, and the volatility since, together with the backlash against the financial-services industry that would have a role in managing the accounts, means that this solution is unachievable. Or will be, until politicians and voters truly confront the unattractive alternative options of either tax increases or benefit cuts that would turn Social Security into more of a means-tested welfare program, with all the attendant perverse incentives.
On tax reform, we are past due for a simplification that would lower rates and broaden the base by reducing the complexity of the code. Interest groups that fiercely defend certain tax breaks have prevented such a simplification from moving forward so far. Such a tax reform, properly formulated, should have some growth effects that would be beneficial to the federal fisc, but using such a reform as camouflage for a big tax increase would, and should, surely sabotage it. So would entangling tax reform, hard enough on its own, with Social Security. The politics of each is sufficiently difficult that pairing them is a guarantee that neither would be accomplished.
As for the broader picture of the budget, polling shows that the public already basically understands it is a spending problem, not a revenue problem. In the dramatic face-off before the conflict over the payroll taxes, the one in the summer of 2011, it was the Congressional Republicans who prevailed against President Obama’s insistence on a “balanced approach”—i.e., tax increases—to deficit reduction. The Republicans prevailed notwithstanding Obama’s aggressive use of the White House communications arsenal. Focusing on spending cuts runs the genuine peril of dangerous reductions in the defense budget, but at least it avoids one hazard of a revenue-driven approach, which is that rather than using the tax dollars to reduce the deficit or debt, the politicians will just spend more.
That hazard, in turn, is a point that brings us back to the outcome of the payroll-tax fight. In a more reasonable world, before lawmakers started fiddling with the payroll tax on either a two-month or a one-year basis, they’d tackle tax simplification, move toward a balanced budget, and overhaul Social Security. A payroll-tax holiday, or cut, and especially one accompanied by a “recapture” tax increase for some Americans, is no substitute for any of those things.
1 Hayward’s article, “The Liberal Misappropriation of a Conservative President,” appeared in the October 2011 issue of COMMENTARY.