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"MAKING WORK PAY" TAX CREDIT

Key Points

 

·        Workers can receive an income tax credit equal to 6.2 percent of earned income up to a maximum credit of $400 ($800 for couples).

·        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 $116.2 billion over 10 years, making it by far the largest tax provision. (If made permanent, the long-term costs would be very large—an estimated $640 billion more through 2018.)

 

Current Law

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

Stimulus Proposal

The “Making Work Pay” (MWP) tax credit would implement part of President Obama’s campaign proposal 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 $400 for individuals ($800 for couples). Neither nonresident aliens nor people claimed as dependents by other taxpayers are 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 $190,000 and others with income above $95,000 would not get the credit.

The credit would be reduced by the amount of any economic recovery payments made to recipients of Social Security, Veterans Administration payments, or Railroad Retirement and by the amount of the temporary refundable tax credit provided to certain government retirees.

The legislative language does not specify how workers would receive the credit, but the conference report says that the Internal Revenue Service (IRS) should adjust withholding tables to advance the full amount of the credit to workers evenly over the rest of 2009. As a result, 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. If implemented for the last six months of 2009, IRS adjustments to withholding tables would reduce the amount withheld from workers’ checks by about $15 a week and thus deliver the $400 by the end of the year. (Weekly paycheck increases would be half as large in 2010 because they would apply throughout the 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.

Workers with little or no withholding now could not get the full credit through reduced withholding and would receive some or all of 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. In addition, because the credit for married couples is based on joint earnings, it would be difficult to adjust withholding tables to get the right result for both single- and dual-worker couples. The income caps will complicate withholding tables further by making it hard to know which couples will have too much income to claim the credit. Depending on how the IRS implements withholding changes, married taxpayers may find that they have the wrong amount of tax withheld.

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—by an estimated $640 billion between 2011 and 2018—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 the IRS implements it quickly by adjusting tax withholding tables. 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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