Senate Republican leaders introduced a bill that would keep the payroll tax rate at its current level for another year. The cost is roughly $120 billion. Senate Republicans would offset most of the cost by freezing the pay of federal employees through 2015 and gradually reducing the federal work force by 10 percent.
The marginal propensity to consume for reductions in payroll taxes maybe be high but it is still less than unity. So if we reduce government purchases by the same amount as reduce payroll taxes – this proposal would be contractionary. I guess the good news here is that some of the reduction in government purchases would be deferred.
I guess in a world of PAYGO, however, we should ask how the Democrats propose to offset the loss in payroll taxes revenues:
Senate Democratic leaders want a deeper temporary reduction in Social Security payroll taxes. They would provide payroll tax relief to employers as well as employees. And they would offset the cost with a 3.25 percent surtax on modified adjusted gross income in excess of $1 million.
In other words, raise taxes on households who are not liquidity constrained which means if there is anything left to Barro-Ricardian equivalence, perhaps the marginal propensity to consume for changes in taxes on the very well to do is less than the marginal propensity to consume for reductions in payroll taxes. So if the goal is to increase aggregate demand – then the Senate Republican idea is awful whereas the Senate Democrat idea makes sense.