Fiscal Cliff Ahead: The Party's Over for the Payroll Tax Holiday

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Payroll tax cutA month ago, we mapped out the fiscal cliff America is hurtling toward, and the torturous trail of automatic budget cuts and unhindered tax increases that could send the economy screaming into the abyss.

Pundits and analysts have largely focused their attention on the big-ticket items: the expiring Bush tax cuts that will add to tax burdens across the economic spectrum, and the automatic budget cuts that will disembowel most government programs.

But while these problems will be more vexing in the longer term, their immediate impact pales beside the expiration of the payroll tax holiday, which will also occur on Jan. 1. For most working families, the expiration of this benefit will cause an immediate, significant cut in their spending, which will rapidly slice into the revenues of the companies that rely on their consumer patronage.

A Hard Hit to the Middle Class

Initiated in 2010, the payroll tax holiday was designed to goose the economy by giving workers a quick influx of cash. The 2% cut in employee contributions to Social Security immediately put money into the pockets of working families. For a household making the national average of $50,000 a year, it translated into a $1,000 tax cut -- or about $20 more per week.

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Unlike most of the fiscal cliff changes, which will affect people across the economic spectrum, the payroll tax holiday will primarily hit middle class families, because it was so precisely targeted to help them. Relatively speaking, it doesn't benefit wealthy households much, since Social Security taxes are only taken out of earnings up to $110,000.

Nor was the payroll tax holiday all that great for working families at the lower end of the income spectrum. It superseded the Making Work Pay Credit, which gave a lump sum of up to $400 to individual taxpayers. Most individuals making less than $20,000 and households making less than $40,000 actually got a marginally smaller tax break with the payroll tax holiday.

The result that the payroll tax holiday was most generous to the middle class was no coincidence. As many analysts have noted, a strong middle class is vital for a robust economy. The reason is simple: When households on the upper end of the economic spectrum get more money in their paychecks, they are more likely to invest it. The middle class, on the other hand, is more likely to spend that extra cash on goods and services. As middle class households pour more money into the economy, companies hire more employees to create and sell goods and services, creating a virtuous cycle of economic growth.

Virtue aside, the payroll tax holiday has become somewhat controversial. Earlier this summer, some Senate Democrats suggested that the benefit should be allowed to expire, due to the long-term threat it poses to the solvency of the Social Security Trust Fund. However, given the tepid pace of the economic recovery, many were loath to let the holiday end. In fact, House Republicans voted in February to extend the payroll tax holiday until the end of the year -- despite their hard-line approach on most tax breaks targeted at the middle class. Then again, in an election year, no party wants to be labelled as the Grinches who voted to increase taxes on 160 million struggling middle-class workers.

That is why -- brinksmanship aside -- the payroll tax holiday may well be renewed before January. Right now, both Democratic and Republican lawmakers seem inclined to allow the nation to slide closer to the fiscal cliff, as both sides hope the results of November's election will put them in a better position to get their spending and tax priorities passed afterward. But regardless, any party that forces struggling families to make do without that extra $20 a week will have a lot of explaining to do.

Quiz: The Economy and the Tax Gap in the United States
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Fiscal Cliff Ahead: The Party's Over for the Payroll Tax Holiday

A. 30%
B. 27%
C. 19%
D. 13.9%

Answer: C. Thanks in large part to the exceedingly generous 15% capital gains and dividend taxes, most of the super-rich pay a lower tax rate than middle-class filers making $69,001 per year.


A. The top 1%
B. The Bottom 20%

Answer: B. Taxpayers in the bottom 20% pay, on average, 8.8% of their income into Social Security. Those at the top pay, on average 1.6% of their income into Social Security.


A. The top 1%
B. The bottom 20%

Answer: B. Depending on the state, the bottom 20% of earners pay between 6.7 and 1.1 times as much of their paycheck in state taxes.


A. 28%
B. 50%
C. 62%
D. 71%

Answer: B. While he has become the patron saint of tax cutters, for most of Ronald Reagan's presidency, the top tax rate was much higher than it is today.


A. 50%
B. 41%
C. 70%
D. 91%

Answer: C. Under President Nixon, there were also up to 33 tax brackets. Today, there are six.


A. 27%
B. 39%
C. 73%
D. 91%

Answer: D. The first big drop in the top tax bracket -- to 77% -- happened under John F. Kennedy.


A. $50,000
B. $375,000
C. $5.12 million
D. $10 million

Answer: C. In 2001, the estate tax exemption topped out at $675,000, and the top rate was 55%. Today, the exemption is $5.12 million, and the top rate is 35%. Side note: $5.12 million represents the average yearly earnings of over 103 households – none of whom would get a 100% exemption on their taxes.


A. 27.3%
B. 49.3%
C. 37.8%
D. 51.7%

Answer: B. The period right before the Great Depression witnessed one of the biggest income distribution gaps in U.S. history.


A. 25.3%
B. 32.3%
C. 41.7%
D. 50.3%

Answer: B. In the 1950's, America's thriving middle class was flush with cash. Their free spending further increased employment, creating a virtuous economic cycle.


A. 21.2%
B. 30.7%
C. 37.5%
D. 49.7%

Answer: D. In other words, income distribution in the U.S. today is more unbalanced than it was before the Great Depression.



Bruce Watson is a senior features writer for DailyFinance. You can reach him by e-mail at, or follow him on Twitter at @bruce1971.

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