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Stimulus Report Card

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“MAKING WORK PAY” TAX CREDIT

Key Points

·        Each worker not claimed as a dependent on someone else’s tax return could receive an income tax credit equal to 6.2 percent of earned income up to a maximum credit of $500.

·        The credit could start quickly if implemented through reduced withholding. Otherwise, taxpayers would likely not benefit until they file their tax returns the following year, in which case the stimulus effect would be significantly delayed.

·        Delivery in small increments through reduced withholding—rather than in a lump sum as a tax refund—might encourage recipients to spend the credit rather than save more or pay down debt.

·        A temporary credit induces less additional spending than a permanent credit.

·        The credit could induce some low-income people to work and partially offsets the regressivity of the payroll tax.

·        JCT estimates that the proposal would cost $145 billion over 10 years, more than one-half of the $275 billion cost of all the tax provisions combined. (If made permanent, the long-term costs would be very large.)

Current Law

The “Making Work Pay” tax credit is a new credit.

Stimulus Proposal

The “Making Work Pay” (MWP) tax credit would make good on President Obama’s promise to offset part of the Social Security taxes paid by low- and middle-income workers.

MWP would provide a refundable tax credit in 2009 and 2010 equal to 6.2 percent of earnings (the employee share of the Social Security payroll tax), up to a maximum credit of $500 per worker. Those claimed as dependents by other taxpayers are not eligible for the credit.

The credit would phase out at a rate of 2 percent of income over $150,000 for married couples filing joint tax returns and $75,000 for others. Therefore, couples with income above $200,000 and others with income above $100,000 would not get the credit.

The legislative language does not specify how workers would receive the credit, but the Ways and Means summary says that withholding would be adjusted to advance the credit to many workers soon after the bill is enacted. If the Internal Revenue Service (IRS) adjusts withholding tables, recipients would quickly benefit from the credit through larger paychecks.


Discussion

Assuming that taxpayers receive the credit over time through reduced withholding, the new credit could quickly boost take-home pay. The IRS could adjust withholding tables to reduce the amount withheld from workers’ checks by about $10 a week and thus deliver the $500 over the course of a year. Because each payment would be small, recipients might be more likely to spend the added income rather than saving it or paying down credit card or other debts. Evidence from behavioral economics suggests that taxpayers view small increments to after-tax pay as income, to be spent, whereas they tend to view lump-sum payments as wealth, to be saved. (James Surowiecki summarizes this point in “A Smarter Stimulus.”) Thus, the reduction in withholding would likely be an especially effective way to deliver stimulus.

If, alternatively, the IRS left withholding tables unchanged, most workers would get the credit only when they file their income tax returns the next year. In that case, the 2009 credit would not arrive until 2010, delaying any stimulative effect. Furthermore, because they would typically get the credit as a single large payment, recipients would be more likely to save it or use it to pay down their debts, which would not stimulate the economy. In addition, the fact that the credit disappears after two years makes it less likely that recipients will increase their spending. Permanent tax cuts can affect behavior more than temporary ones do.

The credit could begin quickly because employers could readily reduce withholding. Workers who hold multiple jobs and high-income workers for whom the credit would phase out would require special treatment to avoid under-withholding.

The credit would have some beneficial effects beyond the stimulus because it would partially offset the regressivity of payroll taxes and encourage low-income people to work. However, because it would not be limited to low-income workers, the credit would substantially reduce federal tax revenues. If it were made permanent—as President Obama proposed during the campaign—the credit would continue to reduce revenues even after the economy has turned around and when the country will need to restore fiscal balance.

Grade: B+

This proposal gets high marks for timeliness, assuming it is implemented as an adjustment to tax withholding, and that mechanism would also maximize the chances that the credit would be spent rather than saved. As a refundable tax credit, the proposal would aid many low-income workers who are most likely to spend the money. However, the credit would also be available to many higher-income workers who are less likely to spend the additional income. Were the credit better targeted, it would have been graded an A.

 

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