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  • Abiye Alamina

Payroll Tax Cuts?

As markets tumbled today continuing their dismal reaction to the ongoing coronavirus and the sharp fall in oil prices as Saudi Arabia slashed its oil price in reaction to Russia's decision not to cut production of oil, President Trump announced that he will be asking Congress to pass a payroll tax relief, in a desperate bid to calm markets.

A few days ago Congress had passed an $8.3 billion package aimed at addressing the coronavirus, which President Trump quickly signed that into law, but markets unfazed continued their weeks long retreat. A payroll tax cut, it is hoped, would provide much needed relief to stop the stock market bleeding and stimulate the economy.

What is a payroll tax?

A payroll tax is a tax paid on the wages and salaries of workers, and in the US it takes the form of social security and medicare taxes that are withheld by employers from workers' paychecks and are also paid by employers as part of a 50-50 sharing process: In the US the social security tax is 12.4% and Medicare tax is 2.9%, but employees pay half of both in the form of FICA (Federal Insurance Contribution Act) tax withholdings from their paychecks, while the employers pay the other half.

So while the tax actually helps to finance benefits that accrue to workers in the form of social security earnings upon retirement including medicare payments to cover health insurance when one qualifies for them, it constitutes a present reduction in disposable income, which is the income that a worker has available to spend today. So a payroll tax cut is simply a re-allocation of future earnings into the present - akin to tapping into one's savings to meet a pressing current expenditure.


Tax cuts are a part of the fiscal policy tool kit that governments can potentially draw on to stabilize their economies when they are contracting or in a recession. The argument for tax cuts instead of explicit increases in government spending is premised on the belief that tax cuts puts money directly into the hands of households - the consumers that drive 70% of the US economy.

Perhaps facing huge losses from falling stock prices households might become depressed and want to cut back on spending, but with bigger paychecks as a result of the tax cuts, they would continue spending as though their financial investment losses were fully covered by the tax cuts.

Generally, any policy action that helps to keep household spending from falling by restoring consumer confidence, which is currently being rocked by the uncertainty associated with the spread of the coronavirus and its upending of our normal way of life - school and work closures, quarantines, product scarcity, cancelation of public events - including its impact on oil prices and the stock market, is considered to be providing an economic stimulus.

Will this policy help? The main criticisms of tax cuts as a fiscal policy stimulus have to do with two related arguments, one fairly theoretical and the other more practical.

The theoretical argument first points out that tax cuts come at a price - the government has to make up the lost revenue by borrowing since it cannot cut its own spending, as that would adversely affect its stimulus objective.

Social security and medicare costs make up a huge component of the mandatory portion of government spending, and because these are funded by current payroll taxes, the government has to increase its borrowing to cover these. As the theoretical argument continues, we, the beneficiaries of the tax cuts, understand that if the government increases borrowing today, taxes have to go up in the near future in order to pay back the debt, so we are more likely to save the "rebate" so as to keep our spending profile constant over time - a concept known as consumption smoothing.

The practical argument is one that looks really hard at how we feel about the situation of things. If we feel things are really bad then the tax cuts will not encourage us to keep spending but rather to save in order to weather what we believe might be a storm on the horizon.

A reason for this has to do with the fact that we don't act in concert thinking about the economy, but instead we make personal choices based on our perception of things. The tax cut helps our personal circumstances by enabling us to replace lost spending, but if we believe the future to be really dire, we might instead choose to save than spend.

So let's think about the nature of the problem facing the economy. There is as yet no cure for the coronavirus. The virus continues to spread on a daily basis, and while the way too early and possibly flawed mortality rate associated with the virus suggests it is milder than the seasonal flu, the seeming indiscriminate spread of the virus, and its global reach, including media reports of death tolls and of communities being put into mandatory quarantine etc. continue to fuel fear whether real or imagined in the general public. Governments in both advanced and developing countries are spooked, markets are spooked, it is therefore unlikely that payroll tax cuts will move the needle on the consumer confidence scale to encourage continued economic activity.

For sure the government has to act. The spending bill that was passed was a step in the right direction, and the tax cuts perhaps would contribute to propping up incomes where households are seeing their other financial investments being decimated on a daily basis, but perhaps this is a problem where the resolution of certainty is what will bring it to an end. Perhaps as well, the size of the tax cuts might also matter, after all we assumedly all have a price. To require that we act normally in uncertain times is akin to being asked to assume risk. For the right price we just might all be willing to do so.


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