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No, Payroll Tax Cuts Won’t Create Immediate Stimulus. That’s Exactly Why We Need It.

The centerpiece of the jobs plan unveiled by President Obama Thursday night—the extension and expansion of payroll tax cuts to employees totaling $175 billion—has turned out to be among its most controversial aspects. Indeed, policymakers and commentators from across the political spectrum have argued that its stimulative effects could be negligible. A continued payroll tax break, they say, would increase our deficit and put the solvency of Social Security in jeopardy, without lowering unemployment or leading to any significant immediate increase in consumption.

These criticisms miss the mark. A cut in payroll taxes is rightly at the center of the government’s jobs proposal, precisely because the type of stimulus it will create is not immediate.

It’s true that many workers are likely to initially save at least part of the extra money in their paycheck that will appear as a result of a payroll tax cut. That will ultimately help solve the problem that has been the greatest drag on national growth: The enormous debt that burdens middle class households.

Consumption is by far the largest share of the American economy, comprising 70 percent of GDP. Indeed, it’s possible to track the story of our current recession in our consumption rates: It has increased by a well-below average rate of two percent in inflation-adjusted terms over the past year.

It’s important to realize that the real reason consumption has been increasing at only a modest rate is that many families are working hard to lower their debt loads rather than continue to spend like they used to. And with good reason. The middle class is still trying to rebuild trillions of housing and stock market wealth lost during the financial and housing crises in 2007 and 2008. Middle class wealth diminished precipitously because of the drop in house values and stock portfolios, but families still owed the mortgages they borrowed against those houses to finance their spending during the good times.

As long as those debts are at an unmanageable level, it won’t be possible to increase consumption in sustainable fashion. At the current rate, however, it will be many years before private debt levels shrink sufficiently. Families owed about 90 percent of their after-tax income on average in the 1990s, the last business cycle before the mortgage boom. At the current rate of deleveraging it would take more than five years to just get back to that level—never mind the lower debt levels of the 1970s and 1980s.

In the next several years, however, faster deleveraging won’t be possible unless incomes grow more quickly. (Faster income growth helps deleveraging since leverage is the ratio of debt to income: As long as income is increasing, in other words, leverage falls, even if total debt stays the same.) Total after-tax income has indeed grown since the recession officially ended in June 2009, but at a very low 4.8 percent.  More typical income growth of ten percent for a period of seven quarters would have brought down families’ leverage below 109 percent; normal income growth, in other words, would have already naturally lowered leverage by about the same amount that it would take current American families, with their strenuous saving, to accomplish in a year’s time.

Raising income growth, then, is the necessary condition to getting families out from under their crushing debt burden and to getting the rest of the economy back on track: It’s only private deleveraging that can speed up the return of healthy growth and steady job creation. The alternative is that household debt will continue to put a drag on consumer spending increases and job growth, regardless of what other stimulus measures we devise.

Federal policy can make a difference, however. The government has tools at its disposal to lower the ratio of debt to after-tax income, thus alleviating the pressures on the middle class. That said, not all forms of government-sponsored deleveraging are created equal. The government is right to focus on middle class tax cuts as a large part of the jobs package. The debt burden is largest among moderate-income and middle-income families, and it’s difficult to design spending measures to target moderate and middle incomes. Maintaining and expanding the payroll tax holiday that expires at the end of the year seems, in many ways, the best way to foster faster deleveraging.

Indeed, the great thing about the payroll tax cut is that it allows us to have our cake and eat it, too. With the effective increase in their incomes, consumers will be able both to save more and spend at a faster rate: Faster income growth will allow families to reduce their debt burden (the ratio of debt to after-tax income) and thus facilitate spending and saving at the same time.

Moreover, the extension of the payroll tax cut will give momentum to a process that is already underway. Families have already made progress on easing their debt burden. The ratio of debt to after-tax income stood at a record high of a little over 130 percent in September 2007, just before the economy tanked. It had fallen to about 114 percent in March 2011. Banks that had tightened their purse strings to the middle class are beginning to ease up. The country’s unprecedented wave of home foreclosures has allowed a lot of extant debt to be written off. Low interest rates have made it easier for families to shoulder their debts. (And President Obama has already proposed policies to help families refinance faster to take advantage of these historically low interest rates, though the benefits from that move, although a welcome step to further deleverage households, are limited given that interest rates are already at rock bottom.) The only way to further speed private deleveraging, in other words, is by increasing the income growth of America’s middle class.

President Obama’s proposed payroll tax holiday does just that. Indeed, it does more. By easing the debt burden that families feel, President Obama’s tax cuts would not only not only foster immediate consumption, but sustainable and long-lasting economic growth.

Christian E. Weller is an Associate Professor at the Department of Public Policy and Public Affairs, University of Massachusetts, Boston, and Senior Fellow, Center for American Progress, Washington, DC