A better way to cut the payroll tax rate

With a possible recession looming, the Trump administration is reportedly considering a temporary payroll tax holiday to boost the economy. A temporary cut to the payroll tax rate – which should only be considered if the economy deteriorates significantly – may help combat the next recession by reducing layoffs and giving workers more money to spend, as it did in 2011 and 2012.

But a better plan would be to enact a permanent cut in the payroll tax rate and to apply the employer side of the payroll tax to a broader base that includes all compensation, not just covered wages. Replacing the employer payroll tax with a compensation tax could boost both short- and long-term economic growth, making the payroll tax more efficient and progressive and helping to shore up the Social Security trust funds.

First, some context. Currently, the federal government taxes 12.4 percent of wages to cover the cost of Social Security benefits. This payroll tax is divided evenly between a worker and her employer so that each pays 6.2 percent. It applies only to cash wages and only up to a maximum of about $133,000 of earnings per year, otherwise known as the taxable maximum.

In 2011 and 2012, policymakers temporarily reduced the employee-side Social Security payroll tax by 2 percentage points as a form of economic stimulus. This tax holiday helped to support the then-fragile economy by leaving workers more of their income to spend on goods and services. But it did so at a cost of $225 billion, which was added to the national debt and then transferred from the general fund to avoid weakening Social Security’s finances directly.

Given that we’re already headed to trillion-dollar deficits, we shouldn’t expand federal borrowing unless absolutely necessary. But if the economy goes into recession and stimulus is needed to support an economic recovery, policymakers should consider a permanent reduction in the payroll tax that is paid for and actually raises revenue over time.

For example, lawmakers could cut the worker’s rate and employer’s rate by 1 percentage point each – 2 percent total – in order to accelerate economic growth. Cutting workers’ tax rate will boost economic activity by increasing consumer spending, while cutting employers’ rate will support the economy by helping businesses to keep prices low and retain or hire workers. Making the rate cut permanent will assure these economic gains are sustained over time, encouraging work and supporting wage growth by increasing the financial benefits of working more, especially for the middle class. 

Of course, permanently cutting the payroll tax on its own would be disastrous for Social Security’s finances — even current payroll taxes are only enough to cover three-quarters of benefits; a further tax cut would hasten the program’s looming insolvency. Thus, any rate reduction must come with a plan to offset the costs as the economy recovers.

I suggest policymakers make up for the lost revenue by gradually replacing the employer-side payroll tax on middle-class wages with a new tax on all compensation.

The current payroll tax only applies to about two-thirds of all compensation. The 15 percent of pay that goes to those making above $133,000 per year is mostly exempt from the payroll tax, as is the other 20 percent paid in the form of fringe benefits like health insurance and stock options.

Instead of matching workers’ payroll tax contributions as under current law, employers should pay a simple 5.2 percent tax on the total cost of compensation paid to workers — including on earnings above the taxable maximum and on the value of other health care and other fringe benefits. This reform would be far more progressive and more efficient than the current payroll tax. It would encourage employers to control health care costs and boost middle class wages rather than dedicating a growing share of compensation toward fringe benefits and pay for companies’ highest earners.

By my estimate, transitioning the employer payroll tax to a compensation tax over five years would fully offset the cost of a 2 percent payroll tax cut within a decade and close about a fifth of Social Security’s long-term financial shortfall. A slight increase in the rate could further improve solvency.

Of course, some details would need to be worked out. These include how to treat self-employed workers and contractors, what do to about the Medicare payroll tax, how to prevent income reclassification and where exactly to set the rate in order to best promote growth and improve solvency.

In an ideal world, this policy would be paired with other pro-growth Social Security solvency measures to encourage work, savings, investment, delayed retirement and productive aging.

The right policy design can boost near- and long-term economic growth while also increasing progressivity, strengthening retirement security and lifting wages for ordinary Americans. But doing so will require a little bit of creativity and a little bit of political will. Sadly, we haven’t seen much of either from Washington recently.

Marc Goldwein is the senior vice president and senior policy director for the Committee for a Responsible Federal Budget.