As the COVID-19 pandemic rages on, America continues to struggle with the dual questions of how to safeguard public health and how to revive an economy that has been put on emergency hold. As a way to both ease suffering and stimulate economic growth, President Trump and others have suggested declaring a payroll tax holiday for the remainder of 2020.
Skeptics have been swift to question whether a payroll tax cut will work. Exploring that question requires first defining what it actually means for any tax cut to “work.” A 2020 tax holiday might be considered successful if it achieves any one of three goals—helping those most in need, stimulating general economic growth and/or stabilizing businesses now so they can fully reopen more swiftly when the time comes—without breaking the federal budget.
I will break down the major pros and cons of a 2020 payroll tax holiday based on these criteria in a moment. Let’s start, however, with a quick review of what payroll taxes are and why cutting them is a separate matter from any other coronavirus tax relief plan.
What Are Payroll Taxes and Why Declare a “Tax Holiday”?
Many people vividly remember receiving their first paycheck as a teenager. The image often carries strong recollections of two distinct feelings: immense pride, and sheer outrage upon seeing a large pay deduction for something called FICA. For low-wage workers, FICA takes a much larger bite out of paychecks than ordinary income tax withholding.
Officially, FICA stands for the Federal Insurance Contributions Act. FICA taxes directly support the Social Security and Medicare trust funds. The tax rates applied are usually 12.4% for Social Security and 2.9% for Medicare, both split evenly into an employee share and an employer share. Employee wages above a specified limit ($137,700 in 2020) are exempt from the Social Security tax, but the Medicare portion is assessed across all salaries. (In fact, in most cases, the Medicare tax rate increases by 0.9% for single filers with incomes above $200,000 and joint filers with incomes above $250,000, as of tax year 2020.)
Whereas a tax cut involves either reducing tax rates or refunding taxes already collected, a tax holiday is simply a temporary suspension in collection. In the case of payroll taxes, the holiday could entail halting collection of the employee tax share, the employer share or both. At the end of the holiday period, tax collection would resume as usual, with no need for new legislation. In this regard, tax holidays offer the apparent advantage of simplicity. Of course, the fact that something is easy to do in no way answers the question of whether it should be done.
Would a Payroll Tax Cut Help Those Most in Need of Help?
Many elected officials suggest a payroll tax holiday would bring immediate relief to those who have suffered the most during the economic shutdown. The idea here is that the largest benefits of suspending payroll tax collection go to low-wage workers, small businesses and other companies with large payroll costs in comparison to general overhead expenses like rent.
Pro: Because of the Social Security tax wage cap, payroll taxes are effectively regressive; those at the low end of the economic spectrum lose a significantly higher proportion of their incomes to FICA taxes than high-income taxpayers. The burden is greater still for low- and middle-income self-employed individuals, who must pay both the employee and the employer share of these taxes. Therefore, in theory at least, temporarily reducing or eliminating payroll taxes would provide greater assistance than other tax relief programs to those with the greatest need.
Con: In order to benefit from a payroll tax holiday, an individual or entity must be either earning or paying wages. While many essential low-wage workers (such as warehouse crews and meat packers) are still on the job, millions of others considered nonessential—including restaurant servers, hair stylists and retail floor sales staff—have been laid off or furloughed. Neither unemployed people nor the companies that found it necessary to let them go would immediately gain financially from the elimination of FICA taxes on wages that do not exist.
In evaluating the con here, it is of course worth bearing in mind that as soon as workers can safely return to their jobs, they would start benefiting from a payroll tax holiday that extends through 2020, or even beyond. What the holiday cannot do, at least not on its own, is save these individuals from defaulting on rent, mortgage or car payments in the meantime.
Demand-Side Economic Stimulus Potential
Many tax relief programs center on the goal of stimulating consumer spending, driving economic growth from the demand side. Note that for this effect to materialize, two things must happen: Consumers must have more money, and they must spend it.
Pro: Although establishing any direct connection between specific tax policies and economic performance is supremely complex, history has provided some evidence that ongoing paycheck increases provide a greater consumer demand boost than one-time payments. If this trend holds, then a payroll tax holiday could provide a significantly stronger demand-side economic stimulus than the Economic Impact Payments (EIPs) the IRS is currently sending out.
Con: Many of the workers best positioned to continue earning something close to their usual incomes during a shutdown are middle- and upper-income taxpayers who can readily work from home. Historically, these groups have shown a tendency to turn paycheck bumps into savings, not spending. Therefore, any potential demand-side economic impact of a payroll tax suspension may not be realized until millions of currently idle Americans can get back to work.
Supply-Side Benefits and Economic Stimulus Potential
A 2020 payroll tax holiday could provide desperately needed liquidity to struggling businesses, forestalling the business failure domino effect that can occur in a recession. Here, it is critical to remember the current situation is not a recession in the usual sense. It is more a period of forced dormancy due to noneconomic factors, like the shuttering of a city due to a hurricane.
Pro: For some small businesses trying mightily to avoid letting workers go, lifting the burden of the employer FICA tax share from their shoulders might enable them to keep a few more people on the payroll. While this benefit alone probably would not generate a significant economic stimulus, it would at least allow these businesses to stay afloat so they can hit the ground running when things improve. In fact, there already is a payroll tax holiday of a sort in effect for small businesses, as I will explain momentarily.
For businesses actually experiencing growth due to the unusual circumstances of life during a pandemic (for example, delivery services and online meeting portals), a payroll tax cut could provide a strong incentive to continue and even expand hiring. While such staff expansions would not necessarily produce a supply-side stimulus in the usual sense (companies might not rush to replace equipment or expand facilities), they could contribute to a demand-side activity boost.
Con: Again, a payroll tax holiday provides no clear help to a business that has already been forced by economic realities to furlough or lay off personnel. In the case of employers falling far short of the revenues needed to keep staff on board, the small amount of relief offered by such a holiday would not be nearly enough to flip a furloughs-vs.-paychecks decision. These realities do not mean a payroll tax holiday would utterly fail to deliver any benefits, however. The tax break just cannot replace more direct efforts to help employers continue making payroll.
One program already serving that purpose, the Employee Retention Credit, actually is a payroll tax holiday of a sort. Under the program, affected companies can receive a tax credit of up to 50% of the first $10,000 paid in wages to each employee during any quarter of the coronavirus crisis. Businesses can take the credit instantly by reclaiming money withheld from paychecks or otherwise set aside for the employee and employer payroll tax shares. They can also request advance payment of the credit from the IRS if payroll tax reserves are insufficient to cover it.
As well intentioned as the Employee Retention Credit is, its complex qualification and payroll processing requirements have scared many business owners away. Fortunately, a program that is both much simpler and significantly more generous followed swiftly on its heels. Through the Paycheck Protection Program (PPP), many business owners can continue paying personnel with what amounts to free money.
Although the first round of the PPP had well-publicized problems, a second round has made the money available to a wider range of taxpayers, particularly local businesses and self-employed individuals. Many of these taxpayers have been especially hard hit by the coronavirus economic lockdown but were shut out during the first PPP round due to their lack of banking connections.
In essence, the program offers ultra-low-interest loans (usually 1% APR) to these entities so they can keep paying employees and contractors. Better, in many cases, the loans will be completely forgiven if the funds are indeed used for their stated purpose. I would urge any business owner suffering losses due to COVID-19 to consult a business tax and finance pro about this program.
Potential Federal Budget Impacts of a Payroll Tax Break
Responsible leadership requires considering the long-term budgetary impacts of both new government expenditures like the PPP and new tax relief plans that reduce revenues. After all, if free money were easy to come by, economics would be taught in preschool. A thoughtful review of the fiscal implications of a 2020 payroll tax holiday reveals yet another double-edged sword.
Pro: Since payroll taxes go into trust funds dedicated for specific social safety net programs, a pause in their collection would not have an immediate impact on the general federal budget. Together with the possibility of rapidly helping those most in need, this theoretical budget neutrality is often put forth as one of the strongest arguments in favor of payroll tax holidays.
Con: Underfunding of the Social Security and Medicare trusts is a constant worry as the U.S. population ages. Benefits paid out under these programs represent an enormous government obligation, amounting to more than one-third of federal expenditures. If the trust funds fall short, it might become necessary to raid the general budget in order to distribute promised benefits. Thus, a payroll tax suspension’s apparent budget neutrality might amount to merely kicking the can farther down the fiscal road. Perhaps the piper will only show up with invoice in hand during more prosperous times, but it would be quite a gamble to count on such favorable timing.
Any Plan Must Be Grounded in Sober Analysis
As with the disease itself, there is no single cure for the economic hardships COVID-19 will leave in its wake when it finally retreats from America’s shores. Whether a 2020 payroll tax suspension would ultimately do more good than harm is beyond anyone’s ability to predict in the midst of these unprecedented times.
The best starting point would be a continuing, eyes-wide-open evaluation of the impact of programs already in place, such as EIPs, enhanced unemployment benefits, the Employee Retention Credit and the PPP. It may be that a payroll tax holiday, if intelligently woven in, strengthens this overall tapestry of recovery efforts. Or it could prove to be the seam along which the entire plan frays apart. Only a detailed accounting of the dollar value of each pro and con can ultimately provide the answer.
This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
Harvey Bezozi is a CPA and CFP. More information can be found at YourFinancialWizard.com