MINITER: Payroll-tax problem

OPINION:

A central component of President Obama’s economic plan is an extension of the payroll-tax holiday, which is set to expire in the coming weeks. But is it really a holiday for taxpayers - or is it a holiday from the type of sound economic policy required to build a strong foundation for America’s future?

Republicans have struggled to defend their opposition to the president’s approach. Some even have criticized the payroll-tax holiday from an unlikely angle, complaining that it undermines a protected social entitlement program. Granted, there is some merit to the point that by taking money out of the Social Security system, the president is adding to the national debt. But there is a broader and deeper problem to the payroll-tax holiday that supply-siders understand well.

The president’s payroll-tax holiday took effect at the beginning of 2011. It reduced the Social Security withholding rate to 4.2 percent from 6.2 percent, giving the typical family an extra $40 per paycheck, according to the administration. The rationale is that people will spend this money and, in turn, increase the demand for goods and services, requiring companies to ramp up production and create new jobs.

Yet through 2011, the U.S. economy continued to muddle forward at a sluggish pace, and joblessness is still relatively high at 8.3 percent.

While in principle it’s good when the federal government lets Americans keep more of their own money, trying to stimulate consumer demand with a temporary tax holiday is misguided. Because consumers know they can’t count on this money in the future, the extra cash won’t induce them to go out and sign up for a new monthly car payment or mortgage.

The larger problem with the president’s approach is that it seeks to stimulate demand, when the real driver of economic growth is productivity. The classic way to increase productivity is to innovate, or develop new technologies that allow us to produce the same product or service at less cost. The technological innovations of the past two decades led to lasting economic gains because they fundamentally improved productivity - they raised living standards and reduced the cost of doing business.

This is why supply-siders focus on policies that encourage the efficient production of goods and services. Increasing productivity drives down costs, freeing up more capital for investments in innovation and raising living standards. When people have more money to invest in their business, education or charitable projects, their higher standard of living is a sign that true wealth creation has occurred.

Consider the cost of energy. By lifting barriers to energy exploration, the federal government would encourage oil and gas companies to increase our energy supply. Doing so could permanently reduce the cost of doing business in America, as it would be cheaper to run a factory, heat an office building or fuel an airplane. Just as companies that increase their productivity have a competitive advantage, lowering our energy costs would make America more competitive in the global marketplace and could spur new investments in energy research and development that further drive productivity.

In terms of tax policy, if robust economic growth is the goal, rather than temporarily extending the payroll-tax holiday, it would make more sense to permanently cut capital-gains taxes to encourage investment and further lower barriers to producing goods and services. Similarly, permanently cutting marginal income-tax rates would give individuals an incentive to increase their earnings by working more. This would add to the nation’s overall output. The lower and flatter the tax rate, the greater the incentive would be to produce.

The supply-side case for growth has been mostly lost in Washington’s recent debates. But supply-side economics helps explain the nation’s overall slow growth despite the 2011 payroll-tax holiday and other measures aimed at stimulating demand, such as extended unemployment benefits and government spending on federal buildings and teacher salaries. Demand-focused policies don’t create wealth because they don’t put “new” money into people’s pockets or the economy - they simply shuffle around dollars that already exist.

Regardless of whether Mr. Obama succeeds in extending the payroll-tax holiday through 2012, the U.S. economy can’t escape reality. We must create wealth to have lasting prosperity.

Paulette Miniter covered finance and investing for Smartmoney.com and the Associated Press.