No Extension for Payroll Tax Cut! Yes!!

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Headshot of Alicia H. Munnell

is a columnist for MarketWatch and director of the Center for Retirement Research at Boston College.

According to the New York Times, neither party has any interest in extending the cut in the payroll tax used to fund Social Security when it expires at the end of December.  If true, that is wonderful news.  Messing around with Social Security’s finances was always a bad idea.  And while no one wants the country to fall off a fiscal cliff, one small step towards sensible fiscal policy probably won’t hurt the economy very much and will greatly reduce the risks to the Social Security program.

As background, the payroll tax cut emerged in 2011 as a compromise when Congress refused to extend the Making Work Pay Tax Credit.  The cut reduced the employee contribution to Social Security from 6.2 percent to 4.2 percent.  The cut was supposed to expire at the end of 2011.  It never seemed realistic, however, to think that politicians of any stripe would let the tax cut expire in an election year.  And indeed, Republicans and Democrats, who cannot agree on the day of the week, voted to extend the cut through December 2012.  My fear was – and maybe still is – that they would not let it expire as planned.

The Social Security program, which is financed primarily by the earmarked payroll tax, has not lost any money over the past two years.  While payroll tax revenues were down about $110 billion per year, the trust funds have been reimbursed from the general fund of the Treasury.  So if the cut does indeed turn out to be temporary, it hasn’t done any harm. 

But if the cut does not expire, the reduction in payroll tax revenues could be used to make Social Security’s long-term financing shortfall look much worse than it is.  Absent the payroll tax cut, the Social Security financing story is one where the average cost rate for the next 75 years is 16.7 percent and the scheduled income rate is 14.0 percent, producing a deficit of 2.7 percent.  That figure means that if the payroll tax were raised immediately by 2.7 percentage points – 1.35 percent each for the employer and employee – the government would be able to pay the current package of benefits for everyone who reaches retirement age through 2086.  

A 2-percentage point cut in the employee payroll tax changes the story.  The deficit becomes 4.7 percent of payrolls.  Yes, general revenues are being credited to the trust funds to make up for foregone revenues in the short run, but restoring balance to Social Security, which in 2010 looked trivial, now appears daunting.  The expiration of the payroll tax cut makes eliminating the shortfall a manageable exercise.

Restoring balance to Social Security is crucial for the well-being of every worker, because Social Security provides the base of retirement income.  The benefits are not large – about $1,240 per month on average – but they are indexed for inflation and continue as long as people live.  The only other retirement income for most households will be that produced by assets in 401(k) plans.  The Federal Reserve’s recent Survey of Consumer Finances shows that these assets are modest – $120,000 for households approaching retirement.  If a couple purchases a joint-and-survivor annuity with this amount, they will receive $575 per month.  This $575 is likely to be the only source of additional income, because the typical household holds virtually no financial assets outside of its 401(k) plan. Thus, everyone who cares about retirement security should welcome the restoration of the payroll tax cut.  The economy appears to be bottoming out and should be able to absorb a tax increase of this magnitude.  Once the payroll tax cut expires, it would be a good time to begin a conversation about how we are going to restore long-run financial balance to the program.