President Trump has proposed a payroll tax to deal with the economic shock of the Corona recession. In normal circumstances, a cut in income tax should help to boost economic growth. Workers will see an increase in disposable income and spend more. This creates additional demand in the economy, so firms are more likely to employ new workers. This would help mitigate the effects of a downturn.
Also, if firms have lower tax contributions, they can afford to keep on workers rather than make them redundant. This may be a small benefit of the payroll tax cuts. The business may be more able to keep workers employed if there are lower tax contributions.
However:
1. Tax cuts will not help the most distressed individuals. People who are made unemployed and the workers who see a big fall in income. The need is not so much to try and boost aggregate demand, but provide a social safety net for those with no income. Income tax cuts are no benefit when you don’t have any income.
2. The paradox of thrift. Another important feature is that lower-income tax is very unlikely to cause – either higher consumer spending or higher business investment. The paradox of thrift states in a recession, individuals make the rational choice to save more, but if individuals save more, it causes a fall in total demand.
This is because households will not have the confidence to spend the extra income. Given the uncertainty, people may fear future income. The rational response for individuals would be to save the extra income and not spend. The incentive to save is heightened by the fact households will not be shopping like usual. Rather than go to restaurants, they will be eating in. Therefore income tax cuts will not help struggling business because consumers are either unwilling or unable to go out and spend the extra money.
Similarly, with business, lower tax contributions are not going to encourage business to invest. The outlook is too bleak.
Conclusion
A payroll/income tax cut can be enacted fairly quickly which is important.
The tax cut may have a small benefit. Workers have seen a drastic drop in income, will benefit from a smaller tax rate, it will at least limit the drop in their income.
If business can cut back on their tax contribution, it may mean the difference between keeping or laying off workers. But, there is no guarantee this would happen.
Still, it would be better to use the money on
- Direct income support to business on condition of keeping workers
- Loans to business to get through the crisis.
- Direct income support to unemployed (universal basic income) and those working as self-employed and who are experiencing a drop in income
Related
- The effects of lower income tax. (in normal circumstances)