By John Mauldin
The payroll tax, as a way to pay for Social Security, has been 12.4% since 1990, with half paid by workers and half paid by business. Late last year a temporary payroll tax cut of 2% was enacted. This saved an average family of four about $1,000 per year and affected 160 million taxpayers. It is not peanuts. It also "cost" about $120 billion in revenue (best estimates). This is about 0.8% of GDP. Remember that number.
Let's review the economic implications of tax policy. Depending on which academic study you want to use, tax increases or cuts have a "multiplier" effect of anywhere from 1 times (Harvard and Italy) to 3 times, the latter from Obama's former head of the council of Economic Advisors, Christina Romer, and her husband, both at the University of California Berkeley (not a hotbed of conservatism). Let's use 2 times as an average for our discussion, but you can adjust to suit your favorite academic study (you have read all those papers, haven't you?). Various studies show that spending cuts exert an effect for about 1 year before they are "absorbed" into the economy, and tax cuts take a little longer to have their full effect.
I think it likely that we will see that the US economy grew less than 2% in 2011, and probably closer to 1.5%. If there is a 2 times multiple on tax cuts, then the stimulus was worth anywhere from 1% to 1.6% of growth in 2011 (depending on your favorite academic paper), which is much of (and maybe most of) the growth we had in the US this last year.
As I write early Saturday morning, it looks like the payroll tax cut extension will only be for two months. This would mean that taxpayers may see a roughly $100 per month cut in take-home pay, starting in March. This means that the economy will take a growth hit starting in March. So why not extend it for a year? Or even two? Why not wait until the economy is stronger?
The problem is that the US fiscal deficit is about 8% of GDP. We already have a debt-to-GDP ratio of between 80% to 98%, depending on how you count intergovernmental debt and nonfederal debt. But let's use the lower number.
That means, if we do nothing about the deficit, in three years we are over 100%. We know (Rogoff and Reinhart and the BIS studies) that potential growth decreases above the level of 90% debt-to-GDP. We also know that as the debt grows, so does the cost of interest to pay the debt.
Let's run a thought experiment (for the purposes of simplification) on a country with a large debt of, say, 80% of debt-to-GDP and a deficit of 8%, with interest costs of about 2%. Revenues are 16% from taxes, and expenses are 24%.
First, that means that the debt carries an interest rate cost of about 1.6% of GDP, or around 10% of revenues. If the debt rises to 100% of GDP, then the interest costs will rise to about 2% of GDP, or about 12.5% of revenues. This will force spending cuts or tax increases if the deficit is not allowed to rise.
But wait. If we cut spending (also known in Europe as austerity), then we will see a negative tax multiplier of about 1.5% of GDP over that time period. That means it will be harder to grow our way out of the problem, especially if the economy is growing at less than 2% annually. Debt at the levels we are talking about makes it much harder to grow yourself out of debt.
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