Whatever form the new normal of life in the U.S. might take as the COVID-19 pandemic continues, an economic recovery likely will not come as swiftly or easily as we would all prefer.

As leaders continue to ponder ways to coax the American economic machine back into gear, the idea of a payroll tax holiday keeps cropping up as one potentially useful fiscal tool.

We know much more about both economics and medicine than our ancestors who endured the great influenza pandemic a century ago, but we are far from having all the answers on either front. Just as no one can reliably predict the arrival date for a coronavirus vaccine, no one can say for certain what economic impacts a particular government program will have.

Nevertheless, thoughtful analysis does reveal some clear pluses and minuses of a 2020 payroll tax holiday.

What Payroll Taxes Fund and How They Work

Unlike changes to tax rates or deduction rules, a tax holiday does not necessarily require updating the tax code. It is simply a temporary suspension of tax collection. The payroll tax proposal many leaders favor is a collection holiday through the end of 2020. To understand the potential impacts of such a policy, it is first necessary to review what these taxes are.

Payroll taxes are assessed on all wage earners, including those who earn too little to be subject to federal income tax. The primary payroll taxes fall under the heading FICA (Federal Insurance Contributions Act), and they fund Social Security and Medicare. Both taxes are split into employee and employer shares. However, the large Social Security portion is only assessed on the first $137,700 of an individual’s earnings (as of 2020). As a result, low-wage workers pay a significantly higher percentage of their income in FICA taxes than high-salary employees.

To oversimplify some rather elaborate bookkeeping a bit, revenue collected through FICA taxes first goes to paying out Social Security and Medicare benefits. Any leftover revenue is devoted to replenishing the trust funds for these programs, primarily through investments in treasury bonds.

During years when revenue falls short of the government’s benefit obligations, these bonds can be cashed in to cover the payouts. The rose-colored hope is that good and bad revenue years will occur with roughly equal frequency, ensuring the ongoing solvency of the trusts. The reality tends to shade away from rosy and more toward budgetary red, but more on that a little later.

Since payroll taxes serve such specific fiscal purposes, suspending their collection would not directly affect defense, transportation, or other essential government functions. In this regard, a payroll tax holiday makes more budget sense than discontinuing income tax collection.

How a Payroll Tax Holiday Could Stimulate the Economy

From the standpoint of fiscal policy, the hoped-for benefit of any tax cut is increased movement of capital through the markets, stimulating economic growth. The economic stimulus can come either from the demand side (increased consumer spending) or the supply side (expansion of business activity). Since both employees and employers pay shares of FICA taxes, a payroll tax holiday could, in theory, give the economy and upward nudge from both directions.

Demand Side

By putting extra money into the pocket of every wage-earning American over an extended time period, a payroll tax suspension could have a substantially greater demand-side impact than one-time direct stimulus payments. Moreover, the tax reduction would be most dramatic for those toward the lower end of the wage scale. Since these workers presumably have the most pressing need to replenish supplies during the crisis, the demand increase could be substantial.

Supply Side

With the burden of paying the employer’s share of FICA taxes removed, many businesses would experience a notable uptick in liquidity. For business sectors experiencing growth during the COVID crisis (video conferencing services, online stores, etc.), the added cash could spur additional hiring or even facilities expansion, bringing new rental income to owners of currently idle properties.

For the many companies currently digging in their fingernails and just hoping to survive the slowdown, a payroll tax holiday will not end their struggles, but might reduce the need for layoffs and furloughs. In these cases, the effect would not be so much an economic stimulus, as a reduction in the intensity of economic contraction forces.

How the Tax Break Could Fail to Stimulate the Economy

The principle that reducing taxes spurs economic activity rests on two critical assumptions:

1. As a result of the tax break, individuals and/or businesses will, in fact, have more cash.
2. People and companies will actually spend the extra money at their disposal.

Unfortunately, neither of these outcomes would be guaranteed for a 2020 payroll tax holiday.

Demand Side

As the staggering unemployment numbers released each week constantly remind us, tens of millions of Americans are not working at all right now. Since unemployed workers do not pay payroll taxes, they would receive no direct benefit from the tax holiday. The good news is that for workers who can return to their jobs relatively soon, a tax suspension through December 31, 2020 could still provide them with meaningful extra income. Unfortunately, many jobs, such as positions at large sports and concert arenas, may not come back for many months.

A second problem might exist with the spending half of the formula. Employees who can work from home have a distinct advantage these days with regard to keeping their jobs. These employees tend to have salaries in the middle and upper ranges. Data from past payroll tax cuts (such as a reduction in the employee share during 2011-2012) suggests that individuals at these income levels are more likely to save the extra money than spend it.

Supply Side

Just as individuals must be working in order to benefit from a payroll tax cut, a business must actually be paying wages. For small businesses that have been forced to shutter completely and furlough their entire workforces, the limited relief provided by a tax holiday might not be enough to enable them to reopen.

Every idle business drags the economic supply side downward, often bringing other companies with it. For this reason, it is critical to encourage small business owners to avail themselves of every form of help available. A payroll tax holiday can only serve as one small component of a much broader business rescue strategy.

More Direct Help Exists for Businesses to Keep Employees

Arguably the most important program for the survival of small businesses nationwide, the Paycheck Protection Program (PPP), has already helped many companies with little or no current revenue to keep paying employees. It is the closest thing to free money that most of us will ever see.

Officially, the money a business receives from the PPP is a loan at the bargain-basement annual interest rate of 1%. However, if the company uses the money for payroll (and rent, utilities, and other allowable expenses) and can demonstrate lost revenue due to COVID-19, the loan will be forgiven. I urge all struggling business owners to reach out to their bankers, financial advisors, or local small business associations to learn more about this extraordinary opportunity as soon as possible before the funds are depleted again.

Because of the restrictions on how PPP money may be used, the program will not generate a supply side economic stimulus in the usual sense. However, it could do much to prevent a rash of business failures, while helping out the demand side by keeping more people on payrolls.

Who Would a Payroll Tax Holiday Help Most (and Least)?

Regardless of whether they immediately spend it, lower- and middle-income workers who have stayed on the job would see a considerable increase in their paychecks during a payroll tax break. Unfortunately, those currently not receiving wages would be left out in the cold, and so would need other forms of assistance.

On the supply side, a FICA tax holiday could mean significantly more liquidity for small businesses with payroll as a primary expense, such as many service companies. Meanwhile, companies with small staffs and large overhead expenses (like many industrial supply warehouses) would receive relatively small slices of the tax savings pie. Like the unemployed, these entities must not be ignored when the potential economic impacts of the tax holiday are assessed.

When Will the Bill Come Due?

Whatever the economic positives of a 2020 payroll tax holiday might be, one unavoidable negative is that the Social Security and Medicare trust funds will take a major revenue hit. It would be ideal if the trusts currently held enough treasury bonds to cover the temporary shortfall without jeopardizing the programs’ long-term financial health. Unfortunately, this is exactly where the picture turns decidedly more red than rosy.

According to the best current estimates, both trust funds will run dry as soon as the early 2030s. The same projections show that at that time, FICA tax revenues will fall far short of the benefits promised to retirees and disabled workers who spent decades paying into the trusts. If new revenue sources do not materialize, the only choice will be to reduce benefits. Pity the politician who has to make that announcement to the American public. He or she might want to wear a mask for entirely different reasons than preventing the spread of a virus.

The surest way to avoid that budgetary nightmare would be to increase payroll tax rates during the coming years. Of course, such a move might promptly undo whatever economic gains could result from a tax holiday this year. By no means should these considerations put a payroll tax suspension completely off the table, but they serve as a stark reminder that great economic challenges seldom have easy solutions.

Decision Making in an Era of Trial and Error

Exasperating uncertainty stands alongside physical, emotional, and financial suffering as one of the great stressors of this era. Modern economies simply did not exist the last time a pandemic ravaged the world. Political leaders must make economic decisions without the benefit of past examples to show the way.

Nevertheless, careful review of all the potential positives and negatives of a 2020 payroll tax holiday will at least prevent the mistake of acting in haste with unrealistic expectations. In economics as in medicine, effective solutions come from a combination of analysis and hope.

This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.

As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com