The deal negotiated by Vice President Biden and Senate Minority Leader Mitch McConnell (R-Ky.) and approved by the Senate early Tuesday addresses a separate tax — the income tax — and would prevent tax rates from increasing for all but the wealthiest Americans. But both sides have decided to leave the payroll tax out of the agreement.
Unlike income taxes, which rise along with a worker’s income, the payroll tax is a fixed percentage of an employee’s salary. Allowing the tax cut to expire increases taxes on salaries by 2 percent for every American worker. Up to $110,100 a year in salary is subject to the tax.
This jump in payroll taxes, combined with other tax increases affecting the very wealthy as a result of the deal, would make for the largest increase in taxes in about half a century.
With the country going over the fiscal cliff for at least a day because both houses of Congress did not approve the deal before the year-end deadline, a wide range of taxes went up Tuesday, although perhaps only for a matter of hours. If lawmakers ultimately fail to approve the tentative agreement, it would mean thousands of dollars would come out of the pockets of average workers, the largest tax increase on Americans since World War II.
But support continued to mount Tuesday for the deal, which would extend lower tax rates for families earning less than $450,000. At the same time, higher-income earners would face steeper income taxes and potentially fewer tax breaks, as well as an already enacted new tax to pay for the Affordable Care Act health-care legislation.
For most American workers, the expiration of the payroll tax cut would be the only increase they experience.
With the end of the payroll tax holiday, a worker earning $50,000, for instance, will pay $1,000 more in taxes this year; a worker earning less than $20,000 a year will pay about $100 more. Someone in the upper fifth of households, making $150,000 a year, will pay about $2,200 more.
The increase in taxes on workers means that “the era of asymmetrical tax policy — where taxes can only go down — is over,” said Jared Bernstein, a former White House economic adviser. “What’s been weird is in this history of taxation in America, there’s been this long period when it’s been forbidden to increase taxes at all.”
While the Obama administration fought for the payroll tax cut in previous years to goose a weak economic recovery, the White House has been more ambivalent this year. Before the election, even as prominent Democratic economists and lawmakers argued in favor of extending the tax cut, the White House declined to call for its renewal.
Then, during its post-election talks with congressional Republicans, the Obama administration requested an extension. But Republican lawmakers were skeptical, viewing the payroll tax holiday as contributing to federal deficits because the Treasury had borrow money to replace payroll tax revenue, which ordinarily would go to fund Social Security. The administration quickly dropped the payroll tax cut from negotiations.
“I know for a fact that the White House economists think about it much the same way I do — as a very important part of stimulus in 2013 — but I think they just judged they couldn’t get it,” said Bernstein, who served as a top adviser to Vice President Biden.
The tax increases come after a period of tax cutting that began in 1997. That year, President Bill Clinton trimmed rates on investment income. President George W. Bush cut a wide range of taxes in six of his eight years in office, first as a response to projected budget surpluses and later in an effort to stimulate the economy.
President Obama continued the trend, cutting taxes in 2009 and then even more deeply in 2011, largely in response to the deep recession.
As a result, nearly half of American workers probably have never experienced a tax increase.
“We haven’t seen broad-based individual tax increases at the federal level in the last 30 years,” said Owen Zidar, an economist at the University of California. “In the 1960s through the 1980s, payroll tax increases affected most taxpayers, but the vast majority of broad-based tax changes have been cuts rather than increases.”
When considered as a percentage of the size of the nation’s overall economy, the increase in taxes set to occur Tuesday is likely to be largest in about 50 years, according to a study of previous tax policy changes by Jerry Tempalski, a tax analyst in the Treasury Department.
Payroll taxes last went up in 1988, when they increased by 0.72 percentage points.
Some very small tax increases have taken effect in recent years, including an increase in levies on cigarettes to pay for expanded health care for children and a tax on tanning salons to pay for Obama’s health-care plan. Clinton raised taxes in 1993, but that mainly affected the wealthy. (By contrast, state and local taxes have been increasing over the years, in part to make up for budget shortfalls caused by the recession.)
Middle-class Americans will not only be wrestling with higher taxes this year; they will also be earning less than they did just five years ago.
“Many more households are living paycheck to paycheck than just a few years ago given the very tough economy and the decline in real incomes. This amplifies the negative fallout from the expiration of the payroll tax holiday,” said Mark Zandi, an economist with Moody’s Analytics. “The still very weak consumer confidence, due in part to lower real incomes, also reinforces the negative impact of the end of the holiday.”
Economists say the expiration of the tax cut will be a major drag on the economy this year. Estimates suggest it could cost between 500,000 and 1 million jobs, leaving the unemployment about 0.4 percentage points higher than it otherwise would be.
Tax increases on the wealthy, by contrast, are expected to have much less of an effect on the economy.