The muddled economics of the payroll tax cut

The current debate over extending the payroll tax cut well demonstrates that policymakers often mean different things when referring to policies that “help” or “expand” the economy.

Here’s a blog post of mine just published over on Concord’s blog, The Tabulation; I’m cross-posting it here:

The current debate over extending the payroll tax cut well demonstrates that policymakers often mean different things when referring to policies that “help” or “expand” the economy. I often hear the words “stimulus” and “growth” used interchangeably, but when economists use them, we typically are making a distinction between different economic goals that apply to different circumstances.

“Stimulus” usually refers to short-term policies to increase demand for goods and services in an economy  operating at less-than-full capacity — i.e., an economy with high unemployment. In such a recessionary economy, the problem is not a lack of productive resources (capital and labor), but a lack of demand for the goods and services that those resources produce. Under such conditions, public sector deficits — whether through tax cuts or direct spending — can be an effective way to increase demand (consumption) and the level of economic activity.

“Growth” usually refers to the long-term expansion of the “supply side” of the economy — that is, the supply of capital and labor. When the economy is at “full employment,” the binding constraint on it is not the demand for goods and services, but the supply of inputs to production. Fiscal policies that are good at growing the economy over the longer term are therefore those that encourage greater educational attainment, labor force participation, and saving. Instead of the recessionary goal of increasing consumption, we want the opposite over the longer term: We want to increase saving. Reducing tax rates is often emphasized as a good “supply side” policy because raising the net-of-tax return to working or saving can improve the private sector’s incentives to supply these resources. But any deficit-financing of such policies is counterproductive in dollar-for-dollar reducing the public sector’s contribution to national saving.

In the debate over the payroll tax cut, we are hearing arguments from both sides that muddle the distinctions between short-term, demand-side stimulus and longer-term, supply-side growth. Many Republicans argue that the payroll tax cut is not an effective way to expand the economy, but they are probably measuring it against their favored supply-side yardstick. The Congressional Budget Office (CBO) shows that a payroll tax cut is one of the most effective tax cuts in stimulating demand for goods and services in a recessionary economy — not as effective as direct spending on unemployment benefits but still far more effective than high-end income tax rate reductions.

Both Democrats and Republicans seem torn about paying for the payroll tax cut, for probably different, yet both valid, reasons. Democrats don’t want to offset the cost with immediate spending cuts that could largely negate the short-term stimulative effect of the tax cut. If spending cuts are fairly immediate and significantly affect lower-income households, they would likely offset the stimulative effect of the tax cut. Republicans don’t want to offset the cost with other tax increases because they worry that supply-side incentives would worsen. These concerns are legitimate when the offsetting tax increases stretch into the longer term (after the economy gets back to full employment) and to the extent that the tax offsets adversely affect the returns to working or saving.

As the Concord Coalition has emphasized many times before, it is possible to effectively stimulate the short-term economy while being fiscally responsible about the longer term. Deficit financing should ideally be limited to short-term policies that have high “bang per buck” in increasing demand for goods and services. Longer-term policies designed to grow the supply side of the economy when it is back to full employment ought to be paid for in ways that protect the incentives  to work and to save. And any offsets to the cost of stimulus policies should be designed to have minimal damage to short-term demand — by steering the burdens toward higher-income households or stretching the offsets over the longer term.

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Postscript:  To these issues of the stimulative effect of the payroll tax cut and whether and how the costs are offset, I’ll be adding the additional confusing issue of how the payroll tax cut affects the Social Security program–short answer, “not”–in my next Tax Notes column.