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Yes, Your Paycheck Was Smaller Last Week…

robin anderson

After the fiscal-cliff deal, the payroll tax rate – income withheld from our paychecks for social security – went up from 4.2% to 6.2%.  For the last two years, American employees were paying a little bit less in social security withholding and the jig was up last week. This rate increase is an effective increase in taxes of about $16 per week  (or about $850 per year) for the average American worker.

What does this reduction in income mean for economic growth for 2013?  A lot of retailers are concerned that, with less money in their pockets, Americans will spend less. In line with economic theory (taxes increase, demand goes down), many economists forecast that the payroll tax cut will have drag on consumer spending for the year (J.P Morgan expects 0.6% drag on growth, Goldman expects the same drag, Credit Suisse expects consumption spending to move from 2% in Q4 2012 to 1.5% in Q1 2013).  We also think the payroll tax cut may have a bit of drag on consumer spending (here and here) in the first half of the year, along with the other changes in tax policy and uncertainty surrounding sequestration and the debt ceiling. 

To understand how the payroll tax increase may affect consumer spending, we need to understand how the payroll tax affects different levels of earners at different parts of the income distribution, and how those people used the payroll tax cut. The payroll tax is regressive—incomes up to $110,100 are taxed at the same rate (now 6.2%), while incomes above that amount are taxed at a generally lesser amount.  The regressive nature of the payroll tax cut is why a lot of people viewed the payroll tax cut as being a successful stimulus.  A lot of empirical work shows that tax cuts targeted at the lower end of the income distribution (the bottom 90%) are more effective at helping the economy than tax cuts target at the wealthy—( review of academic work , CBO work ).

The regressive nature of the payroll tax cut also explains why a lot of people expect the increase in it to hit households at the lower end of the income distribution more.  However, this group’s spending makes up a relatively small share of total consumption. Consumption spending (like income and wealth distributions) is pretty unequal. According to the latest Consumer Expenditure Survey data:

  • the bottom 20% of households’ spending make only 8.8% total expenditures;
  • the bottom 40% make up 21.7% of expenditures;
  • the top 40% of households’ spending makes up 61.2% of spending;
  • the top 20% of households generate 38% of all spending.

So even if people earning less money (let’s even say to the bottom 80%) spend less, if people at top continue similar spending habits that could at least partial buffer the lower income households’ reduced spending.

We actually do know what people did with 2012 payroll tax increase thanks to new paper from economists at the New York Fed.  A lot of people used that extra cash to pay down debt—so the payroll tax cut helped consumers continue to delever.

Here the details (taken from Table 4 of the paper):

  • a lot of people used that money to pay down debt,  more low-income people than high income did so  –32% of high income people and 51% of low-income people;
  • more high income people saved the money (27%) than low-income people (19%);
  • ditto for spending – 41% of high income people and 30% of low-income people.


So, without that extra money in their paycheck, as FT’s alphaville and Fed paper speculate, people will move money away from spending to pay down debt  and that’s why we would see a reduction in consumer spending. Another scenario (and this may be more likely for households that can only pay for necessities) is that some households will be forced to move money that was used to reduce debt payments back to expenditures, thus delaying their deleveraging process. The payroll tax cut will no doubt make all of us feel a bit lighter in the wallet and that will likely roll up to a bit of a drag on the economy, holding all else equal.

However, in the macro economy, it is hardly ever the case that “all else is equal.”  As we discuss and also noted by Alphaville, there are positive forces at work in the economy, putting consumers in a better place starting off 2013 compared to 2012. Home prices started to turn around last year – better home values translate into more wealth for consumers. 2012 was also a good year for stocks, which also adds to consumer wealth. Gas prices are quite low too, and that boosts spending power. In addition, while the job market is still pretty tepid, it may be better than the monthly jobs reports suggest.

Until this year, for most of the last 20 years, tax rates had been had been stable or decreasing;  now taxes are going up.  That will be modest drag on spending with some consumers being more affected than others. But there are positive forces at work to dampen the blow.

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