Lending a Hand to the Maxed-Out Consumer

Congress Should Continue the Payroll Tax Holiday

Congressional Republicans are dithering on critical assistance for America’s middle class—a temporary payroll tax holiday—at a time when families and the economy are in dire need of help.

A House GOP bill scheduled for a vote today does extend the payroll tax cut for a year. But it also cuts funding for health reform, freezes federal employee pay for another year, curtails the length of emergency unemployment insurance, blocks environmental protections from moving forward, and forces the president’s decision on a controversial oil pipeline project. Those provisions all but guarantee the bill’s defeat in the Senate and render the Republican proposal unserious.

That’s a tragedy for American families still suffering from crushing debts. They are putting off consumption, and in turn firms are holding back business investment because they can increase sales slowly without increasing capacity. Economic growth and job creation are slow as a result.

This column examines how continuing the payroll tax holiday, along with maintaining extended unemployment-insurance benefits, is the most effective way to allow families to reduce their debt burden and thus return consumption, investment, and economic growth to better health.

Low consumption is holding back economic growth

Consumption is the single-largest component of the economy. Consumer spending, outside of spending on owner-occupied housing, makes up about 70 percent of the entire economy. [1] Consumption, however, has grown by only 5 percent in inflation-adjusted terms from June 2009, when the economic recovery officially started, to September 2011. This is the slowest consumption growth for any economic recovery of this length since World War II. [2]

The most recent quarter, from July to September 2011, highlights consumers’ struggles with maintaining even modest consumption growth. Consumption grew at an annualized, inflation-adjusted rate of 2.3 percent in the third quarter of 2011, well below the long-term historical average growth rate of 3.5 percent before the Great Recession. [3]

This subpar performance required households to substantially decrease their saving. The personal saving rate dropped from 4.8 percent of after-tax income in the second quarter of 2011 to 3.8 percent in the third quarter in 2011. This was the lowest saving rate since the fourth quarter of 2007, just before the Great Recession.

Consumers cannot cut their saving much more to support consumption growth.

How to deal with heavy debt burdens that are weighing down consumer spending

Lack of consumption is partly driven by consumers having other priorities to worry about. Chief among them is a still-massive debt burden. Households owed a record-high 129.9 percent of their after-tax income in September 2007 but only 114.2 percent of their after-tax income in September 2011. [4] This reflects an unprecedented drop in the ratio of debt to after-tax income, but the total debt burden in September 2011 was still higher than at any point before the middle of 2004, dating back to 1952.

There are three options to reduce household debt burdens further.

One is for banks to write off more debt by continuing a massive wave of foreclosures and by agreeing to allow more short sales where homeowners sell their homes for less than they owe. Banks are reluctant to incur even larger losses than they already have, so debt write-offs are unlikely to grow.

Alternatively households could refinance their existing debt into lower-interest rate debt, but banks are still holding back on extending new loans, so refinancing opportunities are few and far between.

This leaves boosts to after-tax income growth to lower the household debt burden since more after-tax income will make it easier for households to repay their debt.

How extending the payroll tax would cut debt burdens, boost spending, and help grow the economy

A hypothetical example helps illustrate how faster after-tax income growth can cut households’ debt burdens.

Household debt stood at 114.2 percent of after-tax income in the third quarter of 2011, but as I pointed out earlier that is still too high. The average debt-to-after-tax-income ratio for the late 1990s, when the economy and the labor market were strong, was 89.2 percent.

It will take until June 2017 before households reach this level of debt again, if after-tax incomes continue to grow at the low annual rate of 2.9 percent and if debt continues to drop at the unprecedented annual rate of 1.5 percent that has occurred during the recovery so far. [5]

Households, however, will get to sustainable debt levels six months earlier for each year that personal after-tax income grows 3.1 percentage points faster. Increasing after-tax income by 3.1 percent for one year—which would happen if Congress continues the payroll tax cut for another year—means that households will get to sustainable debt levels in late 2016 instead of the middle of 2017.

Continuing the payroll tax holiday and the extended unemployment insurance benefits will thus accelerate the return to a healthier economy no longer held back by crushing middle-class debt burdens.

It’s important to point out that this income growth will not happen fast enough on its own. Income growth generally comes from job creation for most households. But economic growth is currently too slow to create a lot of jobs. As I mentioned earlier, businesses are holding back on investment and hiring since they can fill their slowly growing orders with much of their existing capacity. Economic growth and job creation stay low as a result, further holding back household-debt reduction, consumption, and investing. At this point only policy interventions to boost after-tax income can break this vicious cycle.

In short, strengthening middle-class after-tax incomes with the tax holiday is both expedient and efficient in returning the U.S. economy and the labor market to better health.

Christian E. Weller is an associate professor, department of public policy and public affairs, University of Massachusetts Boston, and Senior Fellow, Center for American Progress, Washington, D.C.


[1] Author’s calculations based on Bureau of Economic Analysis, “National Income and Product Accounts” (2011).

[2] Ibid.

[3] Ibid.

[4] Author’s calculations based on Board of Governors, Federal Reserve System, “Release Z.1 Flow of Funds Accounts of the United States” (2011).

[5] Ibid.