First Person: How Will the Payroll Tax Holiday Affect Your Paycheck?

As the Senate begins to debate a tax package compromise put forth by the Obama administration, many taxpayers wonder what it will really do for them. A proposed payroll tax holiday is at the center of the proposal. This plan will give relief to almost all taxpayers with earned income in 2011. But what does the proposal really do to your paycheck?

As an accountant, I keep abreast of proposed tax changes so that I can advise my clients what to expect on their bottom line in the upcoming year. The proposed payroll tax holiday can be difficult to understand, especially when it must be viewed in conjunction with other tax relief measures that may or may not be expiring at the end of the current year.

The first thing to keep in mind is that the proposed payroll tax holiday takes over from 2009 and 2010's "Making Work Pay" benefit, which will expire at the end of December 1010. Under Making Work Pay, taxpayers with earned income received a credit of 6.2% of their earned income up to a maximum income level of $6,451 for individuals and $12,903 for couples filing jointly. This benefit was created to allow taxpayers to not have to pay Social Security tax on some of their income. The benefit was capped at $400 for individuals and $800 for joint filers.

The proposed payroll tax holiday gives only a partial Social Security tax abatement but does not cap it (except for the cap already on Social Security withholdings). It is estimated that it will result in a savings of one third of payroll taxes (or 2% of earned income). For those who make more than approximately $20,000, the payroll tax holiday will provide more of a benefit than the old Making Work Pay credit. Those making less than $20,000 will pay more in Social Security taxes than they did last year.

The largest difference between the two relief strategies is who gets the benefit. Under Making Work Pay, most employed taxpayers got the $400, making it a progressive tax strategy, meaning that the benefit decreases as a percentage of income for higher income levels. The new proposed payroll tax holiday is a proportional credit, meaning that everyone gets the same percentage benefit at all income levels up to $106,800. Many senators are likely to argue, however, that the new tax holiday does less to stimulate the economy for those with higher incomes. As incomes rise, a smaller percentage of that income is spent on consumer items and more is saved.

The payroll tax holiday is still in the discussion stages and has not been passed in the House yet. If other income tax cuts are not extended past December 31, your overall taxes could rise compared to last year. As the intention of the tax cuts is to stimulate the economy and get people spending again, it is unlikely that these tax cuts will be allowed to expire.

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