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Fix Payroll Tax Cut for Low-Income Workers

The New Tax Framework Needs an Easy Adjustment

SOURCE: AP/Gerald Herbert

President Barack Obama signs the American Recovery and Reinvestment Act, Tuesday, February 17, 2009. As part of the recently announced tax framework agreement between the president and Republicans in Congress, the Making Work Pay credit, originally passed as part of the Recovery Act, will be allowed to expire as scheduled at the end of this year, raising taxes for about 25 million working people.

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The recently announced tax framework hammered out by President Barack Obama and Republicans in Congress contains some rather detestable elements. Slashing the estate tax, which benefits just the biggest 5,000 estates in the country, and forcing the federal government to borrow another $120 billion to finance special tax cuts for the wealthiest 2 percent are not pleasant pills to swallow. But this was the price demanded by Republicans in exchange for desperately needed assistance to job seekers, for middle-class tax cuts, and for vital tax incentives for business to invest and expand.

Conservatives were willing to accept nothing less than billions of dollars in giveaways to the rich or else they would force higher taxes on everyone—and there appears to be little anyone could do to convince them otherwise. But there is one revolting aspect of this deal that still could be fixed—an unintended tax increase on low-income workers.

As part of the deal, the Making Work Pay credit, a $400 tax credit ($800 for couples) originally passed as part of the American Recovery and Reinvestment Act, will be allowed to expire as scheduled at the end of this year. A 2 percent reduction in the Social Security payroll tax paid by employees will take its place. In many ways, this is a good switch. The payroll tax cut, like the Making Work Pay credit, will help nearly every working person. Overall, it will actually be a bigger tax cut. And economists argue that a payroll tax cut is a relatively good way to create growth and jobs.

But there is one big huge caveat: about 25 million working people who will actually have to pay more in taxes next year because of this switch.

The Making Work Pay credit was a flat $400 per person. The new payroll tax cut, by contrast, amounts to 2 percent of a person’s earnings below $106,800—the current cap on the Social Security payroll tax. So for someone earning $100,000, this new payroll tax cut is going to be worth $2,000, much more than the Making Work Pay credit. But consider the case of someone making $15,000. They will only get a tax cut of $300, or 25 percent less than they would have received with Making Work Pay.

The math here is actually pretty simple. Any single person making less than $20,000 will face a tax increase next year, as will any couple making less than $40,000. To put that in perspective, a family with two parents working full time at the minimum wage will earn $29,000. After switching out Making Work Pay for the payroll tax cut, that couple will pay $220 more in total federal taxes next year.

The good news is that fixing this problem is easy and, compared to the cost of the entire package, pretty cheap. The best solution would be to implement a “stop-gap” credit that makes up the difference between their payroll tax cut and the value of the Making Work Pay credit. This would actually be easier and simpler than the current Making Work Pay structure, and it would hold harmless all 25 million people. This fix would cost less than $7 billion—less than one-tenth the cost of extending the bonus Bush tax cuts for the rich, and less than the cost of cutting the estate tax.

Over the past several months, conservatives were fond of saying that no one should have to face a tax increase in these difficult economic times. Well, under the current framework, about 25 million people will see their federal tax bill rise next year. Making sure that doesn’t happen would improve the deal substantially, at relatively little cost to the federal bottom, but it would sure mean a lot to those 25 million people.

Michael Linden is the Associate Director for Tax and Budget Policy at the Center.

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