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Last year around this time we were in the midst of a debate in Washington D.C. about whether or not our legislators would be extending the Bush era tax rates. The Bush tax cuts lowered rates for everyone who pay taxes. The concern for a lot of politicians was that if they didn’t extend the rates and taxes went up – that it would reflect badly on them and their re-election chances.

On December 17th of 2010 the President signed into law a tax package that extended the current rates for everyone, meaning that in theory most part people would not be seeing a huge increase in their taxes. The only problem was that there were existing tax credits expiring like the Making Work Pay tax credit. The effect of that credit expiring was an instant increase in taxes of $400 per worker and $800 per working couple. Also, since the credit was refundable, even those who didn’t make enough to owe income tax were able to claim it.

The politicians knew they had a problem brewing – so they came up with a replacement for the Making Work Pay credit, the temporary payroll tax holiday for 2011.

What Is The Payroll Tax Holiday

So how did the payroll tax holiday work in 2011?

Usually when you get your paycheck from your employer they will withhold taxes, including on FICA portion of your paycheck – which funds Social Security and Medicare. Last year Congress and the President cut the employee contribution for the Social Security portion from 6.2% to 4.2% – for the 2011 tax year only. So that means if you’re paying taxes you ended up getting more in your paycheck every payday.

For the average taxpayer that 2% cut in Social Security taxes meant a savings of about $1000 in taxes. The maximum savings seen by higher income individuals was around $2136 since the tax is capped at $106,800 in income.

So now that the payroll tax holiday will be expiring, the President and Congress are looking to act in order to extend the payroll tax holiday. Nobody wants to be seen as the ones who created a tax increase for average taxpayers – even if the payroll tax holiday wasn’t meant to be permanent.

2012 Payroll Tax Holiday In The Works?

So now we have the President and Congress trying to come to some sort of a solution in order to extend the payroll tax holiday into 2012.

Senate Democrats on Monday unveiled a scaled-back version of a bill to extend the payroll tax holiday, but one that still pays for the cuts by taxing millionaires at a higher rate that Republicans have opposed. At the White House, President Obama urged congressional Republicans to join Democrats in approving the extension, arguing that it is urgently needed to prevent what would amount to a tax hike on middle-class families next year. The latest version of the Democrats’ bill was offered Monday by Sen. Robert P. Casey Jr. (D-Pa.), setting up a vote expected later this week. It comes as the two parties race to find a compromise to extend the one-year tax break for workers, which expires Dec. 31. Without a deal, taxes will rise on the average family by about $1,000 next year.

The Democrats have put forth a plan that would extend the cut, but in the process would increase taxes on millionaires, and rely on savings in the budget that some say are questionable. For many Republicans that has been a non-starter.

“Senate Democrats say they have a credible ‘compromise’ proposal, which presumably does not include job-killing tax hikes or phony war savings. We look forward to reviewing it,” said Michael Steel, a spokesman for House Speaker John A. Boehner (R-Ohio). House Republicans are trying to come up with their own alternative, hoping to overcome objections from many rank-and-file Republicans who have resisted supporting the payroll tax holiday as ineffective at spurring hiring. Boehner has floated the idea of attaching to the payroll extension other conservative proposals, such as a bill that would mandate a speedy decision from the State Department on a proposed energy pipeline from Canada to the Gulf Coast. “We are continuing to work with our members on legislation to extend the current payroll tax holiday, protect Social Security, reform unemployment insurance and cut government spending,” Steel said.

So the Republicans are open to extending the payroll tax holiday. The question is, just how will it get passed? What compromises will each side make in order to get the other side to vote for it?

Should We Just Allow The Payroll Tax Holiday To Expire?

To me, one of the real questions is whether or not we should be extending the payroll tax holiday at all. Some experts have said that Social Security already has problems with remaining solvent in the future, and having payroll tax holidays like this only exacerbates the problem by borrowing against the future to have some gain now.

In the name of making Americans feel less bad about their situation now, lawmakers are proposing something that sounds good, but will actually make our financial future worse… the government has often taken the cash from Social Security and left IOUs, and the program is confronting looming demographic challenges. But Social Security also resembles a bank: It doesn’t have all the money it owes, but it has always paid out in the past. Besides, it has a civic benefit. Paying money in, and then getting it back later, has taught Americans good things about savings and trust in government. That virtuous cycle could continue. Social Security requires only a few reforms to stay solvent: raising the age at which pensions start, slowing the growth in benefit levels, and — crucially — ensuring that everyone pays the full amount due, every year. But those payments haven’t been happening lately. In the name of economic emergency, lawmakers reduced Social Security payments in 2011. …Each time lawmakers negotiate a cynical fiscal deal full of pretend holidays, they make the next deal — square or round — harder to seal. The best way to get public support for future reforms is to surprise everyone by honoring at least one of the old deals

Politicians are saying that the Social Security fund would not be affected by this tax cut, with losses in projected revenue to be made up by the Treasury and the general fund – but even so – we’re just doing fancy accounting here. In an age where deficits are skyrocketing, some say that money could be used elsewhere to offset increased spending. Other say we need to focus on re-writing the tax code altogether, cutting spending and reducing taxes to spur growth.

I’m not sure what the answer is, but I hardly think that this payroll tax holiday will be the death of the republic. In the end, our skyrocketing debt and deficits will be much more to blame I think.

What are your thoughts on a possible extension of the payroll tax holiday? Do you think they should extend it- or allow it to expire? Does it matter much in the long run?

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