As a key piece of President Obama’s signature tax-cut package begins boosting paychecks this month, American workers will confront a critical question that could determine the pace of country’s economic recovery: Spend or save?
One of the most visible components of the $858 billion plan passed by Congress is a 2-percentage-point reduction in the federal payroll tax for all workers that will last through the year. The administration hopes the increase in take-home pay — about $1,000 for an average family, according to White House estimates — will boost consumer spending, which in turn drives the nation’s economy.
But how much of that money will actually be spent rather than saved or used to pay down debt remains a hotly debated topic among economists. Many consumers will not even notice the increase because it is spread over the course of a year, rather than distributed as a lump sum. Critics also note that the payroll tax cut will leave the lowest-income workers with a smaller paycheck than last year, even though they are the most likely group to spend the money.
“We know that people are sitting on bundles of cash,” said Roberton Williams, a senior fellow at the Tax Policy Center. “Giving them more money is not necessarily going to make the economy grow any faster.”
Americans have ramped up their savings rate during the economic downturn to 5.3 percent, up from a negative rate during the headiest days of the of the boom years, as consumers worry about job security, home prices and stock market volatility. And though spending the extra money from the payroll tax cut may benefit the country, financial experts say the best strategy for individuals is to save as much of it as possible.
Joe Wilson, a wealth management adviser at TIAA-CREF, said workers should put the money toward retirement, particularly if they are eligible for a matching contribution from their employer. And because the payroll tax is used to fund Social Security, using the money for retirement could prove useful down the road.
“The writing is on the wall. . . .It means that we will be getting less or later, or both, from the government,” said Eleanor Blayney, consumer advocate for the Certified Financial Planner Board of Standards. “We have to be looking to our own future.”
Still, consumers’ best intentions often go awry at first sight of a Groupon. After similar tax cuts and stimulus plans in recent years, workers spent roughly two-thirds of the money within six months of receiving it, said Mark Zandi, senior economist with Moody’s Analytics. The remaining one-third went toward savings, investments or paying down debts.
According to Zandi’s analysis, the payroll tax cut will boost economic growth by 0.5 percent for the year, with most of the growth occurring in the first half. Low- and middle- income households are expected to benefit the most, as the payroll tax is only assessed on the first $106,800 in earnings. The tax cut is likely to create 1 million new jobs, he said.
But a crucial difference between this tax cut and previous rebates is the method of distribution: lump sum vs. over time.
That’s because consumers play psychological games with themselves. Some economists think the smaller payments will increase the likelihood that the money will be spent because it seems negligible or perhaps even goes unnoticed.
An oft-cited study conducted by behavioral economist Richard Thaler in the 1990s argues that consumers divide their money into three buckets — income, assets and future income. Money that falls into the first bucket is most likely to be spent. The second bucket is a mixture of spending and saving, while the money in the last bucket is almost always saved. Small increases to Americans’ paychecks are more likely to be considered income, while larger disbursements become assets, his research found.
But a more recent analysis by the National Bureau of Economic Research examined how consumers intended to spend the 2008 stimulus checks issued under former President George W. Bush and the 2009 Making Work Pay credits that appeared in each paycheck. It found that 25 percent of people said the stimulus checks would lead to increased spending but that only 13 percent planned to spend more when getting paycheck raises.
In fact, some data suggest that consumers prefer lump-sum payments. For years, the government offered low-income workers the ability to receive their tax refund throughout the year instead of all at once. But that program was discontinued this year because only 3 percent of eligible workers signed up.
Even if consumers do spend all of the extra money, the lowest-income workers’ paychecks will be smaller than they were last year. That’s because the payroll tax cut is a flat percentage: Those who make less money will get less money. For single workers earning less than $20,000, the tax cut will amount to less than the $400 credit they received last year under Making Work Pay.
“Money given to people at the bottom end of the distribution goes out of the door almost immediately,” the Tax Policy Center’s Williams said. So although the payroll tax cut is much bigger than last year’s credit, “it’s not as effective in the bang for the buck.”
In a final wrinkle, some employers have not had time to update their payroll systems to comply with the law since it was passed in late December. Scott Mezistrano, senior manager of government relations for the American Payroll Association, a trade group, said 30 percent of participants in a recent webinar on the new tax rules did not expect to implement them in time for the first affected paycheck.
That could delay the impact of the tax cut by several weeks or even months. Employers have until March 31 to handle final adjustments.