Understand Why A Temporary Payroll Tax Cut Extension Is A Mistake

A temporary payroll tax cut extension or a temporary tax cut anything is a mistake.  The important issue to understand is what people do with their money during a temporary tax cut. If you know that a tax cut is temporary, you aren’t going to spend your tax savings because you know a tax hike is coming.

Given you aren’t spending your extra income, you are doing nothing to stimulate the economy. In fact, not spending your income is hurting the economy more than if there were no tax cut since we are robbing from Social Security in the future.  Giving tax revenue to the government would at least be wasted on some social programs.

A non-reaction to temporary benefits is as clear as day. We are taught this phenomena in high school economics, college economics, business school economics and observe our own actions in the work force.  Here are some examples to help illustrate:

Example 1: You won’t stop training your hardest if your next opponent after Peewee Herman is Mike Tyson.

Example 2: You won’t stop studying after your open book mid-term if your final exam is closed-book and accounts for 30% of your grade.

Example 3: Samsung Electronics won’t stop innovating its smartphones just because Apple didn’t release its iPhone 5.

Given you agree with the three examples, why would you ever spend your payroll tax cut income when you know you’ll have to pay more payroll taxes in 2013?

WHAT ABOUT THE REALLY POOR?

Let’s say you earn $20,000 a year in San Francisco or Manhattan.  There’ no doubt that you are poor.  With a 2% temporary payroll tax cut, you are saving $400 a year, or $33.3 a month, or $16.75 per bi-weekly paycheck in taxes.  Because you only earn $20,0000 a year, you live at home with the parents or rent an apartment with a couple roommates.  To spend much more than $500 a month on rent doesn’t really work.

$16.75 more income a paycheck should provide a boost to consumption since someone making $20,000 likely spends all their money on necessities.  However, if we look at it from a economic stimulus angle, given the bottom 50% of income earners account for just 12.75% of all income, there won’t be as big of a stimulus as desired.  Given payroll taxes go up to $106,800 in income, one might be tempted to think that a bigger impact would occur.  Again, after a certain subsistence level, people just save any temporary tax cuts for the inevitable increase later on.

One can argue though that the poor would have an even higher propensity to save the temporary tax cut because money is that much more valuable.  Sock away for a rainy day and do everything possible to increase one’s income.

A bigger issue lies in those who live outside their means.  At every income level beyond poverty, one should be able to spend less than they earn.  We must adjust our lifestyles accordingly.  Hence, to those who crave a temporary 2% payroll tax cut extension, ask yourself really why this is?

SOLUTION TO THE PROBLEM

We cannot blow a $100 billion+ hole in Social Security for temporary relief when the system is already underfunded. Would you rather pay for this payroll tax cut extension by charging a surtax on income over $1 million like Democrats want?  Or would you rather pay for the payroll tax cut extension by freezing salaries of Federal workers and firing more government employees like the Republicans want?

Since I neither make over $1 million a year or am a Federal Government employee, I am objective in saying do neither. Instead, implement a permanent Federal tax decrease for all levels while increasing the breadth of people who pay Federal taxes. A permanent tax decrease until the next President comes along will provide a tremendous signal for companies to start hiring again, and people to spend even more of their disposable income.

For those who make $100,000 or more, have you noticed a $2,136 increase in disposable income since the payroll tax was cut to 4.2% from 6.2%?  For those who make under $100,000, have you noticed any increase in disposable income?  Are you willing to hurt Social Security more since you don’t think it’ll be around anyway?

Note: My definition of “temporary” is one to two years.  The best definition of “permanence” is four to eight years max given the term limits.

Recommendation: I’ve been doing my own taxes with H&R Block At Home for the past ten years. H&R Block is so easy to use, anybody can do their own taxes with their step by step guide with audit protection. The program has consistently found thousands of extra dollars in tax savings I did not realize I could have. Why bother paying an account hundreds of dollars when you can learn more about your financials, find extra tax savings, and do it all from the comfort of your own home? Get the H&R Block At Home Online Free Edition!

Regards,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

You can sign up to receive his articles via email or by RSS. Sam also sends out a private quarterly newsletter with information on where he's investing his money and more sensitive information.

Subscribe To Private Newsletter

Comments

  1. says

    Sam this logic doesn’t work for those who live paycheck to paycheck. They notice the increase in pay. I work with a fellow ( who earns well into six figures ) whose cash flow is so tight that he for example notices when the payroll tax cap ends (its about 104k). He Certainly notices the extra 2k per year.

    If you are cash flow poisitve ( spend less each month than you earn) you may not notice it as much. Thats the beauty of withholding and why govts like it so much. Many people may not even notice it. The main reason i dont like this idea is that payroll tax cuts dont lower your future earned ss/medicare credits (these are based upon taxable payroll not actual taxes paid).

    Sfi

      • says

        Sam, my consumption doesn’t change for things like this because my income varies each year
        each year so I spend below what I conservatively expect as income. Also, my
        consumption is much lower than what I earn. My reaction to this tax cut was
        to direct more money each month to automated investing accounts.

        • says

          Sounds good. Are you really directing a max of ~$180 a month more in investment accounts?

          The crux of this post is figuring out who actually benefits from this tax cut extension of such a small amount on an income cap. I don’t think behaviors change, while budgets get crushed.

          Those who keep spending more than they should need to fix their own spending habits first.

  2. says

    I did notice the increase. It allowed me to accomplish some of my goals a bit faster. These goals involved investing in various assets so technically it spurred the economy a bit. Some people will save the money, but some will invest it accordingly so more money in your pocket temporarily does work.

    The democrats are arguing for this because the republicans are the no tax party. How can you argue to extend the bush tax cuts but hem and haw at the payroll tax cut? But, I’m with you. in the long run temporary anything doesn’t work. Since, temporary doesn’t invoke permanent change in the populace.

    My solution.. End 2001 bush tax cuts, stop the war, extend social security tax / payroll tax beyond 106,800.

    P.S… Tax cuts should never occur during war time. 2001 it happened, 2003 it happened, then the payroll tax cut should have never happened.

    • says

      I actually agree with you on the idea that tax cuts shouldn’t occur during war time. However, if we use that logic, we’ll never get a tax cut since we are, it seems, always finding new enemies to destroy.

    • says

      YFS,

      The payroll tax is setup to fund future earned benefit credits. If you increase the payroll cap above 106K, SS will have to pay higher benefits to those people in the future. There’s no free lunch, liabilities will increase.

        • says

          Social security benefits are already capped in a sense. If you make over a certain amount you will be taxed on your social security income.

          “You will have to pay federal taxes on your Social Security benefits if you file a federal tax return as an individual and your total income is more than $25,000. If you file a joint return, you will have to pay taxes if you and your spouse have a total income of more than $32,000.”

          Also,

          “If you increase the payroll cap above 106K, SS will have to pay higher benefits to those people in the future. There’s no free lunch, liabilities will increase.”

          This is not necessarily true. Social Security benefits are provided based on a formula. With the increase in revenue by increasing the tax base you adjust the formula accordingly. Also, Security tax are only captured from employment taxes. You do not pay Social security and Medicare taxes on portfolio income. See sections 1401, 3101, and 3111 of the internal revenue code. So an alternative to simply removing the 106,800 cap is to levy the social security tax across the board on all income received.

          But, we are going off course from the original question of payroll tax cut being effective. My answer is still a resounding yes.

  3. says

    It’s all political. Republicans supported this tax cut before the midterms that were good for Republicans. Democrats were against it. Now, Democrats support this temporary extension and Republicans oppose it.

    It’s all kinds of stupid, really. I ran the numbers and the amount of money works out to roughly .88% of GDP. Kill it and you keep growth weaker. Extend it and you can claim that the good times will roll for another year or two. Stupid headline stuff.

    At the end of the day, I really think that FICA needs to be rolled into a simple tax structure. If you simplified the code so that there were no deductions or credits, the government could take more out of the economy and logical people would still conclude it’s a better deal. Not only is FICA horrendously regressive, but any intellectual infrastructure is regressive – you have to invest serious resources to ensure that you don’t pay Uncle Sam too much. I’d much prefer pay a higher tax rate if I didn’t have to invest hours and hours into investigating credits, keeping all my ducks in a row, or working to pay for a CPA. I’m sure I’m not the only one.

    Unfortunately, any overhaul will be impossible. Half the voting electorate – those who vote Republican no matter what – think getting rid of a credit is a “tax hike,” even if it’s the removal of a subsidy. The other half of the voting electorate doesn’t understand how marginal tax brackets work, and thus concludes that 90% income taxes are the best thing since sliced bread – this Democratic talking point is as annoying as the above Republican line.

    • says

      You are right, which is why there needs to be a revolt on the hill. Politics are screwing up progress. It is so incredibly divided I can’t stand it. Obama and the leaders need to find a common ground.

      They are hurting the middle class the most.

    • says

      I agree with you JT. Too much politics involved. Also, do away with credits, exemptions and subsidies. But, I truly think we should have mechanisms in place to take care of our poor, old or disabled rather than let them rot in the street. The problem is that middle/wealth people want the same treatment as a seriously poor person so it’s dragging down the system.

      • JR says

        I have a working theory that (generally speaking) even the poor could work themselves out of poverty smartly. Additionally, that our older generations could have themselves set to be worry-free by the time they retire. I realize that ~90% of this theory is the psychology of the individual to make it operational.
        I have always been under the basic premise that our system should treat everyone the same, regardless of socio-econonmic status. Whether that be in judicial, medical or any other system. The founding documents I read and learned stated a right to “Life, Liberty…Pursuit of Happiness.” Anything else is essentially a comfort that must be earned, bought or traded.
        I agree that Politics are dragging us down in modern times. I think we could add some other advancements as well. But that is another story.

        • says

          JT I agree with you. But, the system is set up to make people believe they are entitled. I feel that only the extremely poor should get help. Even that help should be limited to 1 or 2 years then you’re off the proverbial government teet to fend for yourself. The problem is no politician will ever go for this because, he/she will not get elected.

  4. says

    I am ineligible, but my wife gets the break! It does not change anything for us and I want Social Security there for my future retirement. Although I want to be in the highest tax bracket, I would not mind a cut in income taxes (sales tax, state income taxes & property taxes too).

  5. says

    I haven’t paid much attention on this one but it doesn’t sound like a very good option to me. It sounds like it’s going to make things a lot more complicated by changing the rates temporarily and businesses having to figure out when to put in the changes, what to change them to, etc. The tax system is so complicated I wish they would just simplify the whole process.

  6. Michael says

    Sam, to answer your question, I have noticed, but I’m not spending it. It’s added to my savings. My wife is doing the same. I wouldn’t miss the credit if it expired, but I wouldn’t complain if was extended either. I’m not counting on SS when I retire – there is a good chance it will be spent on something else within the next 30 years. I’ll consider SS a bonus when the time comes.

  7. tommytebco says

    Please stop saying that social security is underfunded!!

    The system is fully funded. The current negative cash flow was foreseen during Carter’s presidency and contributions were raised at that time.

    Unfortunately, the government doesn’t want to or can’t meet it’s obligations as the government bonds that the ss fund were invested in are redeemed.

  8. says

    I kind of forgot about the tax decrease. Things seem to change so much year to year that when one thing drops, another thing takes over. We increased contributions to our HSA this year and changed our deductions and employee stock purchase plan. So it seems each year, there is something that impacts our bottom line one or way or another. If the tax was the only difference in our check though, I would have noticed a difference though because that money would have been put away somewhere.

    Since I talked about myself, I can talk about others now. :) Where I grew up, I can guarantee that temporary money would have been spent, no doubt about it! Some people that live in lower income areas live there because they can’t stop from spending every dime they have (and even dimes they don’t have). Of course, some truly don’t make much money and are doing the best they can. Maybe they take the extra money and put it toward a savings account to be used so they can move one day. In essence, I think lower income people would be MORE apt to spend the money than those who are better off. It may not be today, but in the not-too-distant future.

  9. JR says

    Sam,

    You present the issue as if the greater part of us are reasonable and rational enough to see this extension in the same light. I think that those of us who read this blog probably do have similar enough views. However, I do think that in the larger population many will not see things the similarly.

    This is a contributing factor to the current state of affairs in which we find ourselves. Too many people walking away from responsibilities w/ little to no consequence. In the case of this tax extension, it is Politicians looking to keep themselves where they are- in thier elected office. The more they quibble, the more they keep the masses distracted. Maybe even more polarized.

  10. says

    I’m not American, so I can’t comment on the wisdom, or lack, of your tax cut. Our tax system is quite different, as far as I can tell.

    However, we are a family of four with an income considerably below the Low Income Cut Off, and it’s my belief that the poor should be *more* interested in saving every extra penny (although, unfortunately, most are not). We save about 25% of our income and an extra $16/week would get socked away.

  11. says

    I never noticed it. I spent it all. Of course, that was before I started paying attention to my finances. I was being an irresponsible, financially reckless person. I think I would notice it now, but I can’t guarantee that I wouldn’t spend it anyway. I’m trying to stop the cycle of living paycheck to paycheck, but changing a lifestyle takes time.

  12. USsquid says

    I run a tight ship when it comes to my finances so I definitely noticed. However since Im financially independent, the extra doesnt really affect me. I live on way less than my investments kick back so thankfully, I’m well off. Now as far as social security, if people had to fund their own retirement, they wouldn’t be so quick to spend all that money on useless crap (useless scrap is stuff you buy but never use). My retirement is already funded and my daughter’s trust fund is in good order. Im very frugal and live a happy, fulfilled life, and yes, Im a republican :)

  13. says

    The critique of the temporary payroll tax cut is sound, but the proposal for a “permanent” income tax cut suffers the same problems because it is not credible. The Feds can’t keep spending over 24% of GDP and also keep cutting taxes in ways that deliberately lose revenue (like Bush’s 10% tax rate, Obama’s making work pay tax credit and the “temporary” payroll tax cut). We will then end up paying more taxes, not less, because of the rising interest bill. Taxpayers know the national debt is their debt (not their grandchildrens’), and it can get ugly when the bill come due.

  14. says

    I thought it was a silly move back when they did it, and I think it’s worthless now too.

    I think the government should focus on real problems instead of Mickey Mouse solutions…

Leave a Reply

Your email address will not be published. Required fields are marked *