What About The Payroll-Tax Holiday Idea?

It’s interesting that tax cuts have taken a central role in the fiscal-stimulus debate.

(We really should be debating whether a massive fiscal stimulus is even the correct approach to the current economic, housing and financial crises. But since conventional wisdom has already hardened around that, forget about it.)

In orthodox Keynesianism (perhaps last seen during the Kennedy Administration), tax cuts were the accepted way of generating demand in economies deemed to be performing below capacity. (Of course, it turns out that giving consumers more money to spend without giving producers an incentive to produce more, generates not stimulus, but rather inflation. Forget about that, too.)

And the other big problem with taxes (as the Keynesians in the Johnson Administration learned, quite to their surprise) is that taxes are easy to cut, but not easy to raise. So they leave something to be desired as an instrument of economic policy.

Nonetheless, Obama’s bold, aggressive experiment in economics (“Borrow Big! Spend Big! Get Happy!”) has included proposals to “cut taxes” by about $300 billion dollars. What does he have in mind?

The cynic in me thinks as follows: For one thing, there really aren’t enough pork-barrel projects on state governors’ wish lists to consume the kind of money he wants to spend. So he needs to fill up the hole with something, and tax cuts are an easy way to do that.

For another thing, Obama’s whole model is to lead by being unthreatening. He’d rather have someone else make the tough decisions and take the political heat, and he figures that tax-cut proposals will work like catnip on Republicans in Congress. And therefore, they’ll have the big fights with the Congressional Democrats that Obama would prefer not to have.

Congressional Republicans should examine carefully what’s being offered here.

It’s generally held by people who still think that economic freedom is a good idea, that private people and businesses, rather than government, should decide how we spend our resources. (Yes, there still are a few of us left.) This is why conservative orthodoxy holds that tax cuts are a good idea.

But let’s be very clear about why conservatives, in general, like tax cuts: because they’re a way of limiting the size of government. The goal isn’t lower taxes per se (although there is much experience to suggest that lower marginal tax rates do make economies more efficient). Rather, the goal is to keep the government small.

But we’re debating a Keynesian stimulus package here. Smaller government isn’t even in the room, much less on the table. Obama still intends to borrow all the money that would be used for the tax cuts. This doesn’t make the government smaller at all. It’s a bait-and-switch, and all conservatives should be very suspicious of the idea for that reason.

The question Republicans should be asking Obama is: If a $300 billion borrow-and-rebate plan is such a good idea, what’s wrong with just reducing the overall size of the stimulus package by $300 billion? Let’s go from $850 billion down to $550 billion and forego that much of the borrowing, instead.

Democrats will have an interesting time answering this question. Obviously, they’d love to be able to jump up and say that they’re for the little guy, and that America needs tax cuts, dammit, because after all didn’t Obama promise one to 95% of Americans?

But their own economic experts, led by the redoubtable Paul Krugman and echoed by Obama aide Christina Romer, are telling them that tax cuts are the wrong way to stimulate the economy.

Why? Because when you cut people’s taxes, they save the money. And the whole point of Keynesianism is to increase demand (which in turn increases spending, which in turn increases economic growth, which in turn THEORETICALLY reduces unemployment).

So to the Democrats, tax cuts aren’t even the solution to the problem. Those Democrats who are more secure about their jobs (like Charlie Rangel) are saying that the final amount of tax cuts in the mix is going to shrink. And Obama can then furrow his brow thoughtfully, tug his chin professorially, and say “I proposed, Congress disposed.”

That’s why I think the major reason that Obama is pushing tax cuts is NOT to solve the economic problem, but rather to fool Republicans into biting off on supporting the biggest and most inchoate expansion of government that anyone can remember.

But look, there’s another really critical question: Why are we having an economic recession in the first place?

Unlike nearly every postwar American recession, this one is being led not by overinvestment, or too-high inventories, or any of the standard stuff. This one is being led by deep reductions in consumer demand. And why did that happen?

The conventional wisdom coalescing around this question is that people became so frightened by the news reporting of the acute financial crisis of last September, that they decided to pull in their horns and stop spending so much on discretionary purchases. In short, the media caused the recession.

I don’t think so. I think there’s a lot more going on here. We’ve now had three months in a row in which sales of cars and trucks have fallen by one-third or more from the corresponding levels of a year earlier. One-third. That’s a tremendous amount of demand reduction, and it shows no sign of being a short-term problem.

I think that if you take the combined effects of reduced stock-market values and reduced housing values, there’s been a tremendous reverse-wealth effect that is causing consumers to recalibrate their spending. This effect is pervasive and durable.

And it’s not something you can solve with a trillion dollars in new government spending. If a consumer’s problem is that she’s worried about paying her kid’s college tuition and still have enough to retire, she’ll think long and hard about buying a new car or a new washer-dryer, or even about going to the movies this weekend. Giving her a brand, spanking-new bridge to drive over, isn’t going to make her less reluctant to go to the movies.

The only way to resolve the hole in consumers’ balance sheets is to give them time to save up enough money so they feel they’re on sound financial footing again.

And that’s the only way to make the economy get any better on a permanent and sustainable basis.

So let’s look at a totally different idea which the Republicans might propose, in lieu of borrow-and-spend:

How about eliminating the payroll tax?

I don’t mean a tax holiday, or tax credits for lower-income people. I mean, let’s zero out the payroll tax altogether.

What would be the effect of this? Well, by my very rough count, this would reduce Federal revenue by about $700 billion. (I’m still crunching the numbers.) Obama is talking about an $850 billion plan over two years, so my idea is a little less than twice as big.

Let’s go out and borrow the same funds that would be used to fund stimulus, and hand it right back to the American people. If you cut the payroll tax entirely, everyone would see an immediate reduction of half of the FICA levy. It would look like a several-percent raise, instantly. The other half of the levy would disappear from the cost structure of business, so it would immediately reduce the cost of producing goods and services. The latter is a direct and instantaneous stimulative effect.

If you made the elimination of the payroll tax permanent, then it would change people’s behavior. Yes, there would be a paroxysm of saving as everyone stuck money in the bank to make them feel more financially sound. After some time went by, however, consumption levels would rise and the economy (and tax collections) would start growing.

What are the downsides? First, a sharp and permanent increase in Federal deficit spending. But as long as the world’s savings are being held uselessly in the form of central bank reserves, they have little or no investment value. Let’s displace the world’s savings onto the balance sheets of American consumers, where they can usefully rebuild the world economy’s biggest demand driver.

The second downside is the finances of states and localities. They would be forced to raise taxes in order to make up for their current budget shortfalls, which result from economic weakness. So some of the payroll-tax abatement would still be spent on public goods (assuming you consider it good, what governors spend money on). But again, the eventual recovery which would be set in motion will take care of that problem.

I’ll save for another post the Democratic argument that infrastructure spending is the best stimulus because it employs people at unionized Davis-Bacon wages. This argument (“inflation is actually good for you”) actually dovetails with some of the more sophisticated theory about the financial crisis. But I’m never in favor of lower productivity, which is the entire point of trade unionism.