Examining the Payroll Tax Cut

| Wed Dec. 8, 2010 11:22 AM EST

Part of Obama's tax deal is a cut of two percentage points in the employee share of Social Security taxes. Employers will continue to pay 6.2% of wages, but starting January 1 employees will pay only 4.2%. Greg Mankiw argues that this is backward:

An alternative would have been to reduce the employer's share of the payroll tax, at least to some degree. Given a sticky wage, this policy would have reduced the cost of hiring and, to the extent labor demand curves slope downward, increased employment. It would also have increased business cash-flow and, to the extent that firms are cash-constrained, increased business investment.

I have a hard time seeing this. If the tax cut were permanent, it might have the effect he describes. But a temporary 12-month reduction would, I think, have virtually no effect on hiring decisions as long as consumer demand stays weak. Conversely, the employee-side tax cut will probably have some genuine stimulative effect. It won't be huge since much of the money will be saved, but it will be something.

None of this is to suggest that this is why the cut was structured the way it was. I have no doubt that it was mostly done this way so that lots of registered voters would notice an increase in their take-home pay. Still, given the small and temporary nature of the cut, it really does seem as though it's probably more effective on the employee side than the employer side.

POSTSCRIPT: And just a note, since I think a few people are still unaware of this: the payroll tax cut is being paid for out of the general fund, so it has no effect on the future solvency of Social Security's trust fund.