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The New Payroll Tax Holiday Has Kicked In -- Did You Notice?

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By this point in the year, almost everybody with a job has gotten a paycheck. Did you notice the latest tax cut brought to you by President Obama?

The tax deal cut during the lame duck session of Congress included a provision to provide a payroll tax cut for 2% on the amount that normally is allocated to the Social Security program. Previously, both employees and employers contributed 6.2%. This year that level is going down to 4.2% for workers, while the employer contribution remains the same. The Social Security Trust Fund will be credited with full contributions, so long-term financing issues won't be altered. But it does lower the taxes collected from almost every single paycheck.

The administration's idea was to replace the Making Work Pay Tax Credit (MWPTC), which expired at the end of the year. Without a replacement, everybody would see their taxes go up and their take home pay go down. Did you notice?

The deal came together pretty quickly and accordingly was not particularly scrutinized. It certainly was one way to get more money in the economy for the upcoming year. This may have been a decent political route for the Obama administration to take since they probably had their doubts about what kind of fiscal policies they could get through Congress in the coming year to help the sluggish economy.

Perhaps this reality in and of itself justifies the approach. Having more money in the hands of families during the next year seems like a good idea on a number of fronts. For some, this will help them get out from under their debts and deleverage. For other, it provides a bit more money to spend on necessities and in the aggregate increase consumer demand. And for other families, it will help jumpstart their savings process and accumulate the necessary resources to invest in their future. I think all of these are important and don't believe it is the responsibility of working families to solve our national economic woes and increase their spending regardless of their circumstance.

But I have two main concerns about this approach. First, I'm not sure people will actually see this as a windfall, which may actually blunt its impact. Sure, the classical economists tell us that utility maximizing people will it figure out in the end. But I think the behavioral economists are helping uncover the value of "salience." What people see and know can make a difference. That is why I am not sure that the small tweak to the paycheck deductions was the best way to get the most bang for the proverbial buck. Increasing tax refunds or one-time cash back infusions may be more effective for the objectives at hand.

Second, for many families the new policy is much less significant for families on the lower half of the income scale. This is because it is worth less to them than the value of the MWPTC. Workers earning under $40K a year will actually see their overall take home pay go down and not up.

The MWPTC was a flat credit ($400 for individuals and $800 for the married among us). It did have income restrictions and phaseouts that kicked in once incomes got well up the income ladder ($75K for individuals and $150K for couples). In contrast, the payroll tax holiday is based on a percentage. And it goes all the way up the wage scale until the Social Security cap kicks in at roughly $100K per worker. This means the holiday is still quite valuable for a higher earner. Anyone pulling down that six figure salary would benefit around $2,000. If you earn less, the benefit is way less too. A married couple making $30K a year and filing jointly would save only $600 under the new scheme instead of $800 under the MWPTC. For those with lower wages, the deal is worse than the one they got last year. And it's worth keeping in mind that the percentage of families making under $40,000 a year is 45%, which means that a pretty high number were given the short end of the stick. Meanwhile, once again, life looks a bit different for those with higher incomes.

And while I think that increased saving and deleveraging are fairly high priorities for many families in addition to maintaining their spending and consumption, the payroll tax holiday approach may be less effective as a stimulus for the broader economy. If we want the money to circulate in the economy, it would be better to give it to people who will spend it, which is more likely to be those on the lower half of the income distribution.