Much of the $240 billion payroll tax holiday will be spent on lattes, but discipline can turn yours into real money. Image: CC i need coffee/coffee hero/Flickr

The payroll tax holiday gives everyone earning a paycheck a 2 percent raise in 2011. The government enacted the payroll tax holiday as an economic stimulus and hopes you will spend it. But there are better ways to use the payroll tax holiday to stimulate your own economy in the next two years.

Happy payroll tax holiday!

To figure out how to use your payroll tax holiday, calculate how much the tax break will add to your disposable income. Until Jan. 1, you’ve been paying 6.2 percent of your wages to Social Security. For the next two years you will only pay 4.2 percent. Two percent doesn’t seem like much, but it adds up to $120 billion a year the government won’t be spending on weapons, Fannie and Freddie or ethanol subsidies. The Obama administration is counting on you to spend your fair share instead, on everyday essentials like lattes, smartphone apps and cigarettes.

How much is your payroll tax holiday worth?

The payroll tax holiday is designed so that a little extra money trickles in every pay period. The money shows up in such indiscernible amounts that most people won’t notice as it’s spent. But over the course of a year, the nickels and dimes add up to dollars. For example, two percent of $40,000 a year is $800. The best way to corral that bonus is electronically. The simple strategy is to divert 2 percent of your paycheck to an additional savings account set aside for the payroll tax holiday. Then use it to reward yourself for your discipline by paying cash for something you always wanted.

Maximizing your payroll tax holiday

Paying down debt is the absolute best way to use your payroll tax holiday. Your credit cards probably carry 15-to-20 percent interest. Saving money on credit card interest adds more to the value of your 2 percent raise long after the payroll tax holiday is history. If you make an automatic electronic payment, increase the monthly amount by 2 percent of your paycheck. You take home the same amount you did before, and your debt is reduced faster. If you have a 401K, boost your contribution by 2 percent. In two years you’ll have $1,600 extra. If your employer matches, $3,200. In 20 years at 6 percent a year you get $10,593. Now that’s a tax break.

Sources

New York Times

Consumerism Commentary

The payroll tax holiday in the Bush tax cut deal would boost everyone's paycheck by 2 percent until 2012. Image CC orphanjones/Flickr

The Bush tax cut deal includes a payroll tax holiday that gives most working Americans a 2 percent raise. Lawmakers view the payroll tax holiday as an economic stimulus on the assumption that people will spend that extra money. But some economists say that consumers will probably save more of that money than the politicians hope.

Payroll tax holiday: economic stimulus?

The payroll tax holiday proposal rolls back the employees’ share of the payroll tax from 6.2 percent to 4.2 percent on income up to $106,000. When the tax deal was announced, firms like Deutche Bank revised their economic growth predictions for 2011 from 3.3 percent to 4.1 percent. Here’s the math behind that reasoning:

Wages and salaries in the U.S. in 2010 total $6.44 trillion. That figure grew nearly 5 percent in the second and third quarter. If that rate continues, wages and salaries will total about $6.75 trillion a year from now. Deutche Bank estimates about 85 percent of total wages and salaries are dinged by the payroll tax. A 2 percent reduction in that tax puts $115 billion back in workers’ wallets. Based on the current personal savings rate of 5.8 percent, $108 billion — 0.7 percent of estimated 2011 GDP — would be spent. Therefore, 3.3 + 0.7 = 4.1 percent.

The reality of the Permanent Income Hypothesis

Some believe Deutche Bank is overly optimistic. John Carney at CNBC writes that the payroll tax holiday won’t increase spending nearly that much because informed consumers will realize their 2 percent raise is only temporary. Economists call this the Permanent Income Hypothesis. People spend based on expectations of future income, not current take-home pay. Before the financial crisis and its aftermath, most people spent more than they earned and didn’t save a dime. Then the bottom fell out. Now people spend less and save more because expectations for the future are diminished.

How to use your payroll tax holiday

What do do with that payroll tax holiday raise? If you don’t run out and spend it, SmartMoney suggests putting that 2 percent raise into a 401(k), a traditional IRA or a Roth IRA. That will make those after-tax dollars worth more than when the payroll tax holiday ends in 2012. Health care costs are expected to go up next year, so saving now to cover those increases is an option. Another suggestion is to spend it — on new appliances that can save hundreds of dollars on energy in the coming years.

Sources

SmartMoney

CNBC

Business Insider

Keynesian economics lie at the center of the political debate over government spending, deficit reduction and economic recovery. Image: CC Ivy Dawned/Flickr

Keynesian economics advocates using government spending in hard times to stimulate consumption and economic growth. A wave of austerity measures sweeping through Britain signals that Keynesian economics are being abandoned in the birthplace of John Maynard Keynes. American conservatives are using the example of Britain and the struggling U.S. economy to declare Keynesian economics dead.

Keynesian economics 101

Keynesian economics is based on the cycle of money. Spending by one person creates earnings for another in a healthy economy. During the Great Depression people stopped spending, the cycle of money stopped, and the economy tanked. Keynes argued that the government must spend to revive the cycle of money. He was ridiculed by proponents of laissez-faire capitalism, the most popular economic theory of the time. Keynes’ ideas were taken to heart by the Roosevelt administration, which spent to build roads, dams and other public works projects. Then World War II came along with massive government defense spending and the U.S. economy boomed for 50 years.

Europe rejects Keynesian economics

The global financial crisis exposed massive government deficits in Europe as the continent’s economy crashed. U.S. Treasury Secretary Timothy Geithner recommended Keynesian economics to European governments. Instead, Europe is heading the other way with austerity measures. Britain is cutting $130 billion in spending that will erase 500,000 jobs and affect the military, pensioners, the middle class and the poor. Nobel Prize winner Joseph E. Stigliz told The Guardian that the British government’s plan will result in less growth, less tax revenue and higher national debt.

Keynesian economics and the midterm election

A U.S. economy that remains sluggish despite billions in government stimulus has conservatives arguing that the Obama administration should follow Britain’s example. Right wing pundits eagerly anticipating Republican gains in Congress are trumpeting the 2010 midterm election as the official declaration that Keynesian economics have failed. The White House cautions that an abrupt end to government economic stimulus will extend the downturn. Conservatives argue that the economy has stabilized, and it’s time to wean the country from deficit spending.

Sources

Wisegeek.com

New York Times

National Review