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How a Payroll Tax Hike Could Actually Help You

Rick Newman

New Year's Day seems likely to usher in one unwelcome change for most American workers in 2013: An automatic tax hike.

A temporary reduction in the payroll tax, first enacted in 2009, is set to expire at the end of this year, and Congress seems unlikely to renew it. The cut reduced the amount withheld from the typical paycheck to help finance Social Security from 6.2 percent to 4.2 percent. That boosted the take-home pay of the average worker by about $85 per month, or $1,000 per year. But the reduction costs the federal government about $120 billion for every year it's in effect, and with Washington already spending way more than it takes in, neither Democrats nor Republicans are pushing to extend the lower deduction.

[READ: The Mysteries in Mitt Romney's Tax Return]

Losing the extra income might seem like a raw deal for consumers, but it's one of several painful measures that might forestall even greater pain in the future. Congress and the next president face a tricky task in the coming months, since they need to show genuine resolve to start paying down the $16 trillion national debt without torpedoing a weak economy. Allowing the payroll tax cut to lapse might be just enough austerity to show they're serious, without triggering the kind of punishing economic consequences that would hurt nearly everybody.

The end of the payroll tax cut is just one part of a huge set of tax hikes and spending cuts that are due to go into effect at the end of 2012. This is known as the "fiscal cliff" because if all those changes happen at once, the economy will probably enter a free-fall.

[READ: See How to Prepare for the 'Fiscal Cliff']

The expiration of the "temporary" tax cuts enacted in 2001 and 2003 would raise taxes by nearly $300 billion, altogether. Planned spending cuts would take another $110 billion per year out of the economy. Together, those measures would lop nearly 5 percent off of GDP, according to Moody's Analytics--which means they'd instantly cause another nasty recession and raise unemployment by at least a full percentage point.

Congress can put off or even cancel all of those austerity measures. But that would cause a different type of pain. When Congress failed to reach a deal to reduce the national debt in the summer of 2011, Standard & Poor's cut the U.S. credit rating for the first time ever, citing political gridlock as the source of its growing pessimism about Washington's ability to manage its debt. Moody's, another rating agency, has indicated that it, too, will cut the U.S. credit rating if there's no meaningful action on the debt within the next few months.

[READ: See What Will Happen to Your Taxes in 2013.]

At some point, an impaired credit rating will unnerve the markets and force Uncle Sam to pay more to borrow. It might seem easy to blow that off today, since the Treasury is paying interest rates of less than 2 percent to borrow money for 10 years. But that can't last, and there are many things that could quickly push U.S. borrowing costs up, such as higher inflation, a sell-off of U.S. debt by China or some other major holder, or a simple turn in market sentiment against U.S. Treasuries.

Rising borrowing costs would rapidly make the entire debt problem worse, while diverting money from other types of government spending such as defense, Medicare, highway funding or medical research. It would also force Washington to raise taxes in order to rapidly reduce the amount it borrows to finance the government. The United States isn't going the way of Greece, but it could certainly experience a milder strain of the financial anguish that has wrecked the Greek economy.

Allowing the payroll tax to lapse would be a tangible sign that Congress won't shovel borrowed money to taxpayers indefinitely. It might not forestall another ratings downgrade on its own. But it could serve as the down payment on a broader, phased-in commitment to pare spending, judiciously raise taxes, and reverse the outsized growth of the national debt.

It's worth keeping in mind that while America's debt problem is worrisome, it's not unsolvable. Rating agencies and the world's most influential investors have consistently said that Washington's problem isn't a lack of solutions, it's a lack of political will. So if Congress finally showed a little backbone, taxpayers might feel a pinch--but it would be more like an inoculation than the convulsion that could come later, if Congress does nothing.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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