Why Everyone's Payroll Taxes Are Going Up Next Year

The payroll tax cut, slated to expire on January first, is doomed. Although the fates of so many other fiscal provisions are unclear as the government approaches the fiscal cliff, the payroll tax cut's is not, as been more or less abandoned by both Republicans and Democrats.

At first glance, there is little reason for the measure to lack support. Put into place in the 2010 deal between President Obama and Republicans that also extended the Bush tax cuts, it lowers the payroll tax by two percentage points, saving the average worker $1,000 a year. Ending the holiday will mean taking about $100 billion out of workers' pockets and into the federal coffers next year. Proponents of the bill argue that, with the Treasury facing negative real interest rates, it should be a no-brainer to exchange debt for taxes. In that case, the government would get paid to borrow, and workers, especially lower-income folks, would have more money to spend now, stimulating the economy.

So why does neither side have any real interest in extending the payroll tax cut? Because doing so would hasten the day when a major decision about the future of Social Security would be unavoidable.
Here's how it works. Payroll taxes are dedicated to the Social Security trust fund. When the payroll tax was reduced in 2010, the government replaced the trust fund's lost revenue with funds from the general budget.

The problem is that there's a long-standing disagreement about whether or not the Social Security trust fund is a useful concept or an accounting trick, one that disguises the federal government's inability to meet its Social Security promises. By replacing some of the Social Security trust fund's dedicated revenues with general fund revenues, the payroll tax holiday helps blur the distinction between Social Security's resources and the general budget's resources - a distinction Social Security advocates try hard to maintain.

As Social Security trustee Charles Blahous argued in a brief for Economic Policies for the 21st Century, one more year of the payroll tax holiday "may in short order put an end to the longstanding conception of Social Security as a benefit earned by worker contributions." Blahous noted that, if the cut were extended, general revenue subsidies would surpass net payroll tax revenues as a share of the trust fund balance by the middle of next year. At that point, the decades-long debate over the role of the Social Security trust fund - with its implications for whether the program is cut - would be more or less pre-empted. Most of the program's non-interest funds would be coming straight out of the general budget.

David Dayen gives a straightforward explanation of the Democrats' worries about that particular situation:

The reason Democrats won't [extend the holiday] is because of the impact on the Social Security Trust Fund. The payroll tax cut takes money that would go to that Trust Fund and distributes it to workers. Then the General Fund pays back the Trust Fund.

And this has worked; the Trust Fund indeed has been paid back. But the rhetorical threat of attacks to Social Security based on a strain on the actual budget has been too much for Democrats to bear. They have a good argument to make about how Social Security doesn't affect the budget, and the mechanism of the payroll tax cut undermines that.

Democrats don't want to forfeit the Social Security debate, and Republicans aren't looking to add Social Security reform to the list of big-ticket items that need immediate attention. As a result, everyone's taxes are going up next year.