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Bloomberg News - Cut in Payroll Tax is Bad Policy

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By Amity Shlaes

Liberal Democrats attacked not only the rates in the White House-Republican tax-cut compromise, but also the plans for Social Security. The deal trims the employee side of the payroll tax from 6.2 percent to 4.2 percent for one year.

This reduction is supposed to stimulate growth. These Democrats don't care. They don't want to mess with the retirement program.

"This is a grand plan of starving Social Security so you can then privatize Social Security," Rep. Jackie Speier, a California Democrat, said last week. "I'm very disappointed. He's out-Bushed Bush."

She is right, though not in the way she means. The payroll tax break of 2011 encapsulates what's wrong with our entire tax system. This one piece of the compromise plan also explains why growth after next year is likely to be weaker, not higher, than the current optimistic predictions.

In the past century both parties and the economists behind them have focused on the business cycle, their theory being that for the country to grow, that cycle must be managed, preferably by them. But economic growth requires something else: trust that deals and contracts will be honored by all, including governments. Pensions are contracts, even public pensions like Social Security.

When a showcase contract like Social Security is compromised, citizens' faith in other contracts, public or private, begins to fray. Their willingness to invest or hire weakens.

Franklin Roosevelt and others doubtless believed that the Social Security contract complemented their plans to make the business cycle less bumpy. After all, in the 1930s, millions of elderly languished in poverty. Feeding them was smoothing the business cycle in the most crucial way.

But in 1937, the first year of Social Security's implementation, that strategy was challenged. That's when Americans began making payments into the system; the government's take amounted to 2 percent when you include the employer side. As Francois Velde, an economist at the Federal Reserve Bank of Chicago, pointed out in a paper published in the fourth quarter of 2009, the amount taken represented 10 percent of all federal receipts that year.

Next, came the Depression within the Depression of 1937 and 1938, in which industrial production dropped a third in six months and unemployment moved into the high teens. Other forces were far more important in causing that Double Dip. One was monetary and banking policy, another was Washington's hostility to business. (Roosevelt actually told the country that he would prove to Wall Street that he was "their master.")

But the sequence of the Social Security tax followed by recession made a deep impression. American leaders' takeaway from the mistake of 1937 was that the payroll tax was a nifty tool for demand management. They liked the thoughts of Marriner Eccles, the Fed chairman. Eccles believed that Social Security's payment schedules should be flexible so that authorities might raise it during strong growth, to prevent "overheating," and lower it during recessionary periods.

That playing with the heads of taxpayers in this way might be disconcerting didn't seem to occur to anyone. The payroll tax cut for 2011 takes the idea of Social Security as fiscal tool to Eccles-level extremes.

One might argue that Social Security is already a joke to most Americans. Younger people expect no payout. So, the argument goes, the policy should be to get the economy growing through reform, tax and other changes to the retirement system, and only later to rebuild American trust in our institutions. But that is backward. Enduring growth comes when there is more trust in contracts. Certainly foreign investors, who buy bonds and currency, view the U.S. that way.

Social Security is a relatively easy fix, as contracts go; it could be put back in balance in an afternoon. To do that would be to send an important signal that other imbalances will be addressed.

The latest tax-rate compromise sends no such signal. It therefore jeopardizes U.S. growth in the longer run.

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