"The Payroll Tax Holiday - A Bad Idea"

Sydney M. Williams

Thought of the Day

“The Payroll Tax Holiday – A Bad Idea”

September 21, 2011

Of all the stimulus measures taken, the one that received the most bi-partisan support was the temporary reduction in the portion of the pay roll tax paid by individuals from 6.2% to 4.2%, in a bill passed last December and which terminates at the end of this year. The President is urging its extension; this time, though, doubts are being expressed. It should not be a surprise that the original bill was endorsed by both the President and Congress, because its positive impacts would be felt immediately, and because no one in Washington (apart from a select few) give a damn about the longer term consequences of their actions. From my perspective, it is a good thing that its merits are now being debated. Curiously, detractors now include such disparate politicians as Republican Paul Ryan of Wisconsin (author of “A Roadmap for America’s Future”) and Independent Bernie Sanders of Vermont, a self described democratic socialist.

The President has proposed reducing the payroll tax for individuals from the current 4.2% to 3.1% for 2012, and doing the same for corporations on the first $5 million in wages paid. The tax is imposed on the first $106,500 of an employee’s wages. Its purpose is to fund the Social Security System, a fund badly in need of shoring up. The reduction of the tax this year – from 6.2% to 4.2% for individuals – is expected to cost $112 billion in 2011. A further cut, as the President proposes for 2012, would cost an additional $240 billion in 2012. Liberal Democrats fear that it jeopardizes Social Security, meaning that its funds would be exhausted by 2021, instead of 2037. They are right to be fearful. Fiscal conservatives are concerned about the negative economic consequences of restoring the tax in 2013. They are also right to be concerned. Temporary tax relief is never a good solution.

In March of 2010, Mary Williams Walsh wrote a piece for the New York Times in which she reported that the Congressional Budget Office said that Social Security, for the first time, would pay out more in benefits in 2010 than it would take in. Stephen Goss, chief actuary for the Social Security Administration concurred with that opinion. The timing was auspicious, as Ms. Williams wrote, for it would be the “first step of a long, slow march to insolvency, unless Congress strengthens the program’s finances.” When the Simpson-Bowles deficit commission issued their report in November 2010, they recommended three steps toward achieving solvency: Gradually raise the retirement age to 70; lower the cost of living adjustment, and change the formula for calculating benefits. Instead, as we all know, the President chose to ignore the recommendations of his Commission. He then further denuded the System by depriving it of badly needed cash – a fiscally irresponsible decision, in my opinion. The situation has become worse. Fox Business reported in April of this year that “U.S. households are now getting more in cash handouts from the government than they are paying in taxes for the first time since the Great Depression.”

The retirement problem is as daunting as any we face. Ten thousand baby-boomers retire every day and will continue to do so for the next seventeen years. Collectively, they represent 75 million people. For the forty years following World War II many retirees relied on a combination of Social Security and the defined benefit retirement plans of the companies for which they worked. It was an age of big business and big factories. There was an assumed efficiency in size. An ever expanding body of employees eased funding requirements. Rising stock prices (during many of those years) added value to the funds. Demographics favored the retirees, with 5.1 workers supporting every Social Security recipient in 1960. Today that number is closer to three. The numbers were similar for private pension plans, most of which have been terminated.

Beginning in the 1960s, and then accelerating over the next two or three decades, automation began replacing people. “Productivity improvement” became the words “du jour.” Technology proliferated and companies downsized personnel. By the 1980s, with smaller workforces supporting a growing number of retirees, companies, seeing the “hand writing on the wall,” either altered or cancelled their defined benefit plans, replacing them with defined contribution ones. The golden age for retirees was coming to an end.

The problem of inadequate retirement assets was masked by the bull market of the 1980s and 1990s. For the twenty years ending December 31, 2000 the compounded return to the Dow Jones Industrials was 12.83% before dividends. (To put those returns in perspective, the twenty-year return coming off the absolute low in the DJIA in 1932 was 9.9%. Similarly, twenty-year returns to that index following the December 1974 low was 9.8%.) Unsurprisingly, many companies, for actuarial purposes, assumed those rates of return would persist into the ‘00s. They did not. Equity prices are lower today than they were at the end of 2000. As a result, many of those companies that still have defined benefit plans are generally underfunded. More serious though, employees, left to fund their own plans, have not made the necessary contributions, and what contributions that have been made have seen very little, if any, price performance.

As a result, most people are woefully unprepared for what will prove for many to be a third of their life. Social Security was always meant to be a safety net, not a means of providing a comfortable retirement. Nevertheless, the system is already on life support. Changes will be necessary, such as upping the retirement age, conducting a means test, or increasing the level of income on which benefits are collected. If this is not done, there will be no safety net. Providing a “Holiday” for employees (and employers) does not make sense, as it exacerbates what is already a shortfall.

However, ever the optimist, I believe answers will arise. Mitch Daniels, Governor of Indiana, recently said, Americans have a “built-in capacity for self correction.” He is right. Fixing Social Security will involve altering the formula, as indicated above. A combination of easing immigration regulation and increasing birthrates would ease the pressure. Bryan Caplan, in the introduction to his book, Selfish Reasons to Have More Kids, writes: “Parents who have more kids aren’t just doing future retirees a favor; they’re also making the tax burden on future workers a little more bearable.” Just because answers are not apparent doesn’t mean they don’t exist. But that is no excuse for depriving the Social Security System of the money it needs today. There has to be a better way; one that involves reforming the tax code and entitlements. Reducing payroll taxes makes little sense.