Photo: cliff1066 via flickr
One of the biggest questions facing the economy in 2012 is the fate of the payroll tax cut and whether it will be extended into next year.In a note out today, Goldman’s Alec Phillips does a Q&A on this and other fiscal matters.
Here are two big questions Phillips answers on the matter.
Q: Will the payroll tax cut be extended?
A: It is much less certain in light of the super committee failure, but extension still appears possible. Several Republican lawmakers have recently stated that they view the current payroll tax cut to be an ineffective form of stimulus. That said, many Republican lawmakers are nevertheless cautious about the prospect of allowing a tax increase to occur through inaction. This caution probably stems from two factors: first, blocking the extension could be seen as contributing to economic weakness next year; second, blocking this tax cut on grounds that it is too expensive would presumably make extending the 2001/2003 tax cuts, which are set to expire at the end of 2012, more difficult to justify.
Q: What are the obstacles to extending the payroll tax cut?
A: The greatest obstacle to extension is the fiscal cost and how to offset it. Apart from general political disagreement, the most important obstacle facing the payroll tax cut its $110bn annual cost. Extension of the payroll tax cut ultimately hinges on reaching a political agreement on how much, if any, of this cost should be offset by enacting new deficit reduction policies in other areas of the budget. One potential option is to use the less controversial of the spending cut options discussed by the now-defunct super committee, involving changes to various programs in the mandatory budget unrelated to the large entitlement programs. This might appeal to some lawmakers, particularly Republicans, who are wary of simply adding the cost of extension to the deficit. Alternatively, congressional leaders could opt to extend the tax cut without any offsetting policies to cover the cost, which would avoid controversy regarding specific ways of paying for the payroll tax cut extension, but could make House passage difficult.
To increase the likelihood of agreement under either scenario, Democratic leaders might accept some Republican priorities as part of a broader package, though it is not obvious what these would be. Some recently discussed options include a repatriation tax holiday or a postponement of the defence portion of the automatic spending cuts set to take effect in 2013. However, both have substantial costs; the Joint Tax Committee has estimated a repeat of the 2005 repatriation tax holiday would cost $78bn, while delaying the defence cuts would raise the deficit by $55bn for each year they are delayed unless the cost is offset elsewhere in the budget. Changes to the defence cuts that raise the budget deficit could also have negative ratings implications. The House is debating a number of smaller jobs-oriented bills dealing with regulatory changes, but these are not on the same scale as the payroll tax cut.
The upshot is that in a typical year, particularly in a weak economy, the payroll tax cut is the type of provision that would normally be extended in a year-end fiscal agreement. Indeed, this is what happened last year, when extension of the 2001/2003 tax cuts were paired with the payroll tax cut and extended unemployment benefits in a package that suited both sides. However, the fiscal debate thus far this year has been far from typical, and although both sides would appear to have something to gain from a compromise, the recent super committee failure demonstrated that this is not always enough to produce agreement. (Of course, the consequence for inaction on the payroll tax cut is much more immediate than the automatic spending cuts that take effect in 2013 as a result of super committee failure.)