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Would a payroll tax holiday boost the economy?

As the April 15 tax deadline approaches, two freshmen House members are offering a new version of a hardy tax code perennial: a six-month “holiday” from payroll taxes that they say would benefit both small businesses and the working poor.
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As the April 15 tax deadline approaches, two freshmen House members are offering a new version of a hardy tax code perennial: a six-month “holiday” from payroll taxes that they say would benefit both small businesses and the working poor.

Under the bill offered by Rep. Aaron Schock, R-Ill., and Rep. Walt Minnick, D-Idaho, employers and employees of businesses with 50 or fewer workers would pay no Social Security and Medicare taxes for six months. Currently, both employers and employees are required to pay the 6.2 percent Social Security tax and the 1.45 percent Medicare tax throughout the year.

According to the congressional Joint Committee on Taxation, payroll taxes are a bigger burden than income taxes for more than four out of five tax filers.

Lower-income workers would especially stand to benefit from a suspension of the taxes: according to the Joint Committee on Taxation, more than 60 million tax filers with incomes under $40,000 had tax returns in which their payroll taxes were greater than their income taxes.

A way to help low-income workers?
And according to the Tax Foundation, a nonpartisan think tank, more than 45 million tax filers had no income tax liability at all. A payroll tax cut is one of the few ways to reduce such workers’ federal taxes.

The tax holiday proposal would affect about 5 million firms and 34 million workers, according to Bill Rys, the tax counsel for the National Federation of Independent Business, which is backing the idea.

(The federation also backed Schock in his House race last year with a contribution of $2,000 of the total of $2.6 million which Schock raised.)

The payroll tax hiatus has been proposed in past recessions. Joel Slemrod, the director of the Office of Tax Policy Research at the University of Michigan Business School, says in his book "Taxing Ourselves" that “some Democrats responded to Republican income tax proposals in 2001 and 2003 by advocating temporary cuts in the Social Security payroll tax instead” as a way to help low-income people.

Among those supporting the idea of temporarily suspending the payroll tax in 2003: then-presidential hopeful Sen. John Kerry, D-Mass., and Sen. Mary Landrieu, D-La.

The Schock-Minnick bill would require small-business owners to invest the savings from the payroll tax holiday in hiring new workers or buying machinery or other investments to make their firms more productive.

How to enforce reinvestment
The bill would require the Internal Revenue Service to determine whether a firm’s increased employee compensation or capital expenditures during the payroll tax hiatus was at least equal to the money it was saving by not having to pay payroll taxes.

If, for instance, the tax timeout saved the firm $60,000 in taxes, and if the firm used only $40,000 for employee compensation or capital expenditures, then it would have to pay taxes on the $20,000 not used for those purposes.

Rys acknowledged that there would be “some challenges as to exactly how you enforce” the reinvestment requirement in the bill. But he argued that many small firms are so hard pressed right now that “any tax saving would more than likely be put back into the business to keep people on the payroll and keep the business operating.”

Democrats such as House Speaker Nancy Pelosi have voiced worry in the past is that a payroll tax pause would drain money from the Social Security and Medicare programs, even though the bill would replace revenue lost from the Social and Medicare funds by transferring money from the general tax revenues.

The tax holiday “could easily be paid for by canceling the spending in the stimulus package after 2010,” said Minnick spokesman John Foster. (Minnick was one of only 11 House Democrats to vote against the stimulus bill in January.)

In 2001, the liberal policy think tank The Center for Budget and Policy Priorities attacked the payroll tax holiday proposal then percolating in Washington.

“At first blush, this proposal may sound quite attractive. Upon closer examination, however, the proposal turns out to be problematic. Although costly, it is likely to be relatively ineffective as a stimulus measure,” the CBPP report said.

“Half of its tax breaks would essentially amount to a windfall to businesses. It is unlikely that much of this half of the tax cut would be spent quickly.”

Interestingly, the co-author of that CBPP study was Peter Orszag, who is now director of the Office of Management and Budget for President Barack Obama.