Payroll tax debate has 2012 implications

The Signal

The debate in Congress over an extension of the payroll tax reduction has large implications for the 2012 election.

The payroll tax, which pays for Social Security, is currently 4.2 percent for employees and 6.2 percent for employers. The permanent rate for employees is 6.2 percent, but it is under a temporary reduction. Democrats have put forward a bill to lower the payroll tax for employees to 3.1 percent. Employers would pay 3.1 percent of the first $5 million and 6.2 percent of the portion over $5 million.

The income tax is the most prominent of American taxes. As recently as this spring, presidential hopeful Rick Perry called for the repeal of the 16th Amendment, which enables the federal government to impose an income tax. In response to Occupy Wall Street's slogan emphasizing the wealth and income of the top "1%", conservatives organized a response emphasizing the "53%". This slogan refers to the fact that 47 percent of American families no longer pay income taxes. Starting in 2002, the Wall Street Journal began calling those people "lucky duckies." In reality, they are not very fortunate: About half of them are paying no income tax because they earn too little income; the other half receive specified deductions for being elderly on a fixed income, being a student or other similar reasons. More to the point, most are still paying payroll taxes and other federal taxes.

As the effective income tax rate has lessened, the payroll tax is an increasingly large share of the median American family's tax bill and thus has become increasingly salient to many Americans. The chart, constructed from Congressional Budget Office data, shows how taxes have changed in the past few decades for the middle quintile of American households (i.e., those are between the 40th and 60th income level). In 1979, payroll and income taxes were about the same percentage of the median family's tax burden. Now the payroll tax is approaching 70 percent of the median family's tax burden and the income tax is closer to 20 percent.

Not only is the payroll tax increasingly meaningful to many Americans, the payroll tax rate has a very direct impact on the U.S. economy; the chief economist for Moody's predicts that returning payroll taxes to 6.2 percent for employees and employers would shave about 1.7% percent off of GDP. The current payroll tax deduction provides about an additional $1,000 per median American family; the proposed payroll tax deduction would provide 50 percent more, or $1,500 per median American family. Since most American families do not have excess income right now, they would spend much of the extra money stimulating the economy, the argument goes.

This increased impact on American families is a main reason that the extension of the payroll tax reduction is likely to pass. Unemployment insurance is even more direct in its stimulus of the economy, because nearly everyone with unemployment insurance needs to spend all of the money they receive, while a portion of the money in a payroll tax reduction goes to higher income families that will save, not spend, the extra money. Yet, it is a much more narrow group of Americans that collect long term unemployment benefits compared to those who pay payroll taxes.

Further, the payroll tax reduction fits into the narrative that the Democrats want to introduce in 2012--that they care about the "99%" while the Republicans care about the "1%". The Democratic proposal actually calls for a 3.25 percent tax on income over $1 million. This is either a bargaining chip or a stunt, but it demonstrates how they want to categorize this debate. While there needs to be negotiations on the details of how to offset the reduction, the tactic is scaring the Republicans who have been showing signs that it will pass, despite initial opposition.

Passing this extension will have a minimal impact on the likely outcomes of different 2012 elections, because it is expected. Goldman Sachs noted to its investors that the extension of the payroll tax deduction will pass. This is similar to the muted impact of the failure of the "super committee"; the market assumed that the "super committee" would fail to compromise on the budget, so there was no movement in the likely outcomes of election when the likely outcome of super committee occurred.

If Congress does not pass the reduction in the payroll tax, our 2012 predictions will realign considerably, although it could move in either direction. The likely negative short-term impact on the economy will hurt Barack Obama, since, rightly or wrongly, the electorate often blames the president for poor economic conditions. At the same time, Democrats would have new ammunition for their argument that Republicans protect tax cuts for the ultra-wealthy at the expense of the vast majority of Americans. For these reasons, we expect Democrats and Republicans to reach a compromise and pass a payroll tax reduction before the end of the year.

David Rothschild is an economist at Yahoo! Research. He has a Ph.D. in applied economics from the Wharton School of Business at the University of Pennsylvania. His dissertation is in creating aggregated forecasts from individual-level information. Follow him on Twitter @DavMicRot and email him at thesignal@yahoo-inc.com.

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