Basit Zafar, Max Livingston, and Wilbert van der Klaauw examine the impact of the payroll tax cut in 2011 and 2012, and its subsequent reversal:
My Two (Per)cents: How Are American Workers Dealing with the Payroll Tax Hike?, by Basit Zafar, Max Livingston, and Wilbert van der Klaauw, Liberty Street Economics, NY Fed: The payroll tax cut, which was in place during all of 2011 and 2012, reduced Social Security and Medicare taxes withheld from workers’ paychecks by 2 percent. This tax cut affected nearly 155 million workers in the United States, and put an additional $1,000 a year in the pocket of an average household earning $50,000. As part of the “fiscal cliff” negotiations, Congress allowed the 2011-12 payroll tax cut to expire at the end of 2012, and the higher income that workers had grown accustomed to was gone. In this post, we explore the implications of the payroll tax increase for U.S. workers.
The impact of such a tax hike depends on two factors. One, how did U.S. workers use the extra funds in their paychecks over the last two years? And two, how do workers plan to respond to shrinking paychecks? With regard to the first factor, in a recent working paper and an earlier blog post, we present survey evidence showing that the tax cut significantly boosted consumer spending, with workers reporting that they spent an average of 36 percent of the additional funds from the tax cut. This spending rate is at the higher end of the estimates of how much people have spent out of other tax cuts over the last decade, and is arguably a consequence of how the tax cut was designed—with disaggregated additions to workers’ paychecks instead of a one-time lump-sum transfer. We also found that workers used nearly 40 percent of the tax cut funds to pay down debt.
To understand how the tax increase is affecting U.S. consumers, we conducted an online survey in February 2013. We surveyed 370 individuals through the RAND Corporation’s American Life Panel, 305 of whom were working at the time and had also worked at least part of 2012. ...
After a presentation of the survey results, and a discussion of what they mean, the authors conclude:
Overall, our analysis suggests that the payroll tax cut during 2011-12 led to a substantial increase in consumer spending and facilitated the consumer deleveraging process. Based on consumers’ responses to our recent survey, expiration of the tax cuts is likely to lead to a substantial reduction in spending as well as contribute to a slowdown or possibly a reversal in the paydown of consumer debt. These effects are also likely to be heterogeneous, with groups that are more credit and liquidity constrained more likely to be adversely affected. Such nuances may be lost in the aggregate macroeconomic statistics, but they’re important for policymakers to consider as they debate fiscal policy.
In response to arguments that tax cuts wouldn't help because they would be mostly saved, I have argued that there are two ways that tax cuts can help (see Why I Changed My Mind about Tax Cuts). One is to increase spending, and the other is to help households restore household balance sheets that were demolished in the downturn (i.e. the cure for a "balance sheet recession"). The sooner this "deleveraging process" is complete, the sooner the return to normal levels of consumption and the faster the exit from the recession (rebuilding household balance sheets takes a long time and this is one of the reasons the recovery from this type of recession is so slow, tax cuts that are used to reduce debt can help this prcess along). It looks like both effects are present for payroll tax changes (and work in the wrong way with a payroll tax increase).