Political Hay

The Payroll Tax Trap

Republicans know there is no "trust fund." So why play footsie with the left instead of arguing for permanent cuts?

By 9.12.11

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The Hill is reporting that "President Obama's push to extend a payroll tax cut has united a rare combination of conservative Republicans and liberal Democrats in opposition." In particular, Pete Sessions (R-TX), chairman of the NRCC, suggests that a payroll tax cut risks the solvency of Social Security.

This is the wrong argument and Republicans are falling into a trap by accepting it.

The case against extending the tax break due to impact on the "trust fund" is misleading at best. There is no trust fund, at least not in a way that anyone other than a politician would understand one, because Congress has spent 100% of the prior decades' Social Security surpluses rather than actually saving the money.

In other words, the Social Security system's operating deficit, which occurred in 2010 for the first time since 1983 and is likely to occur every year in perpetuity, will require the gap to be filled in by any tax revenue the government collects, such as federal income tax, corporate income tax, estate tax, etc. The so-called "trust fund" simply holds government bonds which the government will have to tax citizens (again) to convert into actual cash. (This is why you should disagree vociferously when a Democrat tells you that a government bond is the same as cash.)

If we had a public education system that actually taught American history, people might not be surprised to learn of the few major cases related to the constitutionality of Social Security, particularly the 1937 case of Helvering v. Davis in which the Supreme Court ruled that the program is not a contract, not insurance, and not investment; payroll taxes are general revenue like any other income tax and it is only political realities which make Social Security seem like an "entitlement" in the literal sense of that word. In theory, government could end Social Security without citizens having a legal leg to stand on to save it. In practice, it's been government's piggy bank, masking what would have been even larger federal deficits.

Therefore, a cut in the payroll tax is no different than the same cut in the income tax rate except for issues of caps on how much income is subject to which parts of the payroll tax. It may look different on the government books with a cut in the payroll tax reducing the income to the Social Security system and increasing its apparent deficit, but if the choice is reducing the payroll tax or the income tax, then you're just choosing which deficit you want to increase because the government's total revenue and total liabilities are the same. If there were an actual Social Security Trust Fund, the situation might be different. But today what we're dealing with is nothing more than shady accounting practices for which a public company CEO would go to jail.

Republicans should make this point very clear, even though they have culpability as well: There is no trust fund, and government cannot be trusted to maintain one. This is why Social Security must be reformed into personal accounts with property rights.

The choice of implementing a payroll tax cut rather than an income tax cut is a political choice, not an economic one. It simply "plays better in Peoria." Or it used to, until Peorians awoke to the devastating reality of short-term Keynesian thinking. Yes, this tax cut is Keynesian, not supply-side, because it is temporary.

The argument should be, must be, about temporary versus permanent tax reform. Short-term tax breaks do not change people's behavior, and it's only today's Keynesians who believe they do...because they, like other Progressives, believe people are stupid.

Milton Friedman understood, as he described in his 1957 paper "A Theory of the Consumptive Function," that people don't make important economic decisions based on temporary changes in their income. His theory, called the Permanent Income Hypothesis, says that "Men do not adapt their cash expenditures on consumption to their cash receipts..." In other words, despite the fondest hopes of Keynesians, people realize that our lives are longer than a temporary tax cut. We weight the value of that tax cut over a longer time period than the policy itself lasts and simply save some of that money, or pay off debt, leading to much lower aggregate demand than Barack Obama and other economic naifs expect. (It takes a particular sort of mind and ego to continue to expect what they expect after episode after episode of Keynesian policies proving that their ideas simply don't work, thus what Hayek termed "The Fatal Conceit.")

Therefore, the economic benefit of any short-term policy, whether tax cut or cash-for-clunkers, will be muted at best, though the latter is much worse than the former because it incentivizes the public to spend money in less efficient ways than they otherwise would in pursuit of a free lunch, or at least a free appetizer. This means that short-term policies will have a minuscule "multiplier," the effective economic value of $1 of policy change because of the follow-on effects of the policy. Indeed there are good reasons to believe that cash-for-clunkers sorts of policies have a multiplier that is not only less than one, but perhaps even less than zero over a slightly longer term.

In order to get people to change their economic behavior, policy changes must be permanent, and permanently in the direction of lower taxes and regulation, now and later. (More deficit spending now means more taxes later.) Yes, Americans realize that one Congress cannot bind the next, and that there's no such thing as "permanent" in American politics. But we know that a tax cut with an expiration date will either expire or lead to political turmoil, the prospect of either causing us to be less aggressive in our investing and business start-ups than we otherwise would be.

If a tax is like a ball and chain on an ankle, a temporary tax cut is like removing the ball but not the chain: we're less restricted than we were before but constantly reminded of what's likely to be coming soon. And we behave accordingly.

Perhaps, with the right outcome in the 2012, we can even prove wrong the aphorism that "there is nothing so permanent as a temporary government program." This was, of course, also stated by the late great Milton Friedman; being proven wrong in this case would probably make him smile.

Republicans must get away from the argument that a payroll tax cut harms the Social Security system. It's an argument that plays directly into the left's hands, making further cases for reform much more difficult. Instead, they should argue that temporary policies of all sorts are much less beneficial than their proponents predict, and they should point to every single week of the Obama Administration as evidence.

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About the Author
Ross Kaminsky is a self-employed trader and investor and is a senior fellow of the Heartland Institute. He is the host of The Ross Kaminsky Show on Denver's NewsRadio 850 KOA on Saturday mornings from 6 AM to 9 AM. You can reach Ross by e-mail at rossputin(at)rossputin(dot)com.