2013 Payroll Tax Increase Is a Blessing in Disguise For the Economy

Many Americans are receiving their first paychecks of the new year. The timing couldn't be better: January is a time of financial belt-tightening for many coming off the holiday gift-buying season. This year, that phenomenon may be particularly pronounced with higher-than-expected consumer spending at the end of 2012.

What many people are not noticing as they are paying off their credit card bills and socking away their paychecks is that those paychecks are smaller. That's right: payroll taxes increased in 2013. But wait, wasn't the whole point of the fiscal cliff compromise that taxes weren't going up except for the wealthiest of Americans? Yes, that was the point. But that doesn't make it true.

It turns out that one of the elements of the fiscal cliff that Republicans were not able to successfully negotiate (and Democrats are none too eager to advertise) is that the Social Security tax rate for all individuals is increasing from 4.2% to 6.2%. Technically, this is not a tax increase. It's the expiration of a temporary tax decrease that was in effect throughout 2011 and 2012. However, that doesn't change the fact that the taxes Americans pay on the money they earn is increasing by 2 percentage points this year. This means that the average working American will take home $15-$20 less per week in 2013 than they would have in 2012.

While the lack of transparency and attention on this issue both in Washington and in the media is questionable, the end result may be a good thing. The additional tax revenue to the federal government in 2013 may be in the range of $100 billion from this 2% tax increase. In this world of trillion dollar deficits, the federal government needs every additional dollar that it can get. The problem with most traditional tax increases is that they have a negative impact on the economy (bad in its own right) and therefore overall tax revenue. Because the 2013 payroll tax increase is not getting much mainstream attention, this negative effect may be somewhat mitigated.

Goldman Sachs economic models estimate up to a 1% hit to the U.S. economy in 2013 due to the payroll tax increase. Assuming their estimates are accurate, that would mean a reduction of federal revenue of around $20 billion. The net impact on federal revenue is still an increase of $80 billion.

Of course, this is a significant simplification of a complicated issue and ignores the ramifications of the broader impact on the economy. However, if you assume that consumer spending decreases by 2%, you see slightly less than a 1% impact on the economy (personal spending accounts for only 40% of GDP). On top of that, it is unlikely that consumer spending will actually fall that sharply. Why? Because this issue is not receiving much attention and consumers are unlikely to substantially change their spending habits if they don't realize that they're taking home less money.

The overall impact of the payroll tax increase on the economy is not yet clear. It remains to be seen if consumers will respond negatively and cut their spending sharply. However, regardless of their reaction, this is a step in the right direction in the battle against federal debt.