Strings Attached: Why the Payroll Tax Deferment Could Hurt Savers

Strings Attached: Why the Payroll Tax Deferment Could Hurt Savers

Friday, September 25, 2020
The President signed a memorandum in August 2020 allowing employers to defer federal payroll taxes for employees earning up to $4,000 biweekly. While this could help create near-term financial slack for families in the coming months, this deferment could potentially hurt savers — at least from a behavioral economics perspective — in several ways.

Here’s why: First, while it allows workers to have more money today, they will have a balloon tax bill next year that could be hard to pay. Secondly, it unwinds many of the financial behavioral benefits in the current method of automatic payroll tax withholding. Two of the most important features of current automatic payroll tax are automatic withholding and small regular payments.

That said, the near term benefits of extra cash are real — and should individuals or employers enact this deferment — we offer some tips for navigating below.

Automatic Withholding Helps People Get Over the Hurdles of ‘Paying Taxes’

Psychologically, people have an aversion to paying taxes. Just mention the word ‘tax’ and purse-strings tighten, research has shown. So it makes good sense that a more pain-free way to pay taxes is simply have them automatically withheld. In fact, U.S. employers have been automatically withholding payroll taxes and income taxes since the 1930s and 1940s.

Apart from tax aversion, making the withdrawal automatic significantly reduces the frictions or barriers to making the tax payments; barriers can be large or small actions that stand in our way of accomplishing a task including: having to remember to pay, calculating the amount of tax, taking the time to write out a check, or looking for postage to put on envelope to mail in the payment.

By eliminating the potential barriers, automatic withdrawals make it much easier to pay the taxes. Again, research has demonstrated that automatically withholding payroll taxes (and other income taxes) from paychecks improves tax compliance compared to systems without tax withholding.

…It Also Helps People Budget Wisely

Another benefit to automatic withholding is that it is clear for the earner how much of their paycheck is available to spend; no math is required on the employee’s part to ensure that money is budgeted and saved for later to cover payroll taxes.

By contrast, this payroll tax deferral adds a cognitive burden on households to figure out how to make sure that they will have the money to pay the payroll taxes after the deferral period. We often divide up our money into mental accounts, with some basic ideas of how much of our income should go into each account.

If households treat the increased money in their paychecks as a windfall, they may be more likely to spend it on things they wouldn’t normally. Money that is seen as a windfall is often spent on items that are more discretionary, out-of-the ordinary, rather than typical expenses. While people under financial stress may need the money now, they have difficulty retaining some portion of the increase to cover their tax bill after deferment.

Small Payments All Year Are Easier Than Lump Sums

The frequency of withholding the payroll taxes are also key to their success. We find it much easier to save small amounts frequently than large amounts infrequently. By breaking the total tax bill into smaller pieces, it feels more achievable. Consider whether it would be easier to pay $250 each week from a $4,000 income or to have to cover $1,500 for a single quarter. Most people would find the first case easier to do, as the amount is spread out over time, and it allows people to more easily plan their spending which is more consistent in the first case.

We have a bias toward the present, and most people find it very difficult to take unpleasant actions, e.g., saving or making a payment, today to meet future goals or needs. One of the drivers of this difficulty is temporal discounting, which means that we don’t get as much enjoyment from future rewards as from those same rewards offered today. That means even though people could go through the effort of saving money for the tax payment after deferral, they will find it very difficult to do so.

Ok, You’re Deferring Anyway. Here Are Some Tips:

For individuals who will have deferred payroll taxes, how can they mitigate the above factors?

Partition it. When households deposit their paycheck, they should put the portion of their paycheck that would normally cover payroll taxes into their savings account or another separate account that they won’t be tempted to touch. If they do need to use some of the deferred payroll payments now, then they should set aside at least a portion, so that they will have less money that they will need to scrape together when the deferred period ends, and the taxes are due.

Make it automatic. If their paycheck is directly deposited into their checking account, households should set up automatic transfers of the payroll tax amount into their savings account.

How can employers help?

Ask your employees if this deferment would help them. Understanding whether deferring payroll taxes will actually help currently struggling employees is the first step in choosing to put the burden of repayment on them, as well.

Clearly communicate the repayment. Be sure your employees understand the differences between this deferment and other stimulus money they may associate with prior forms of assistance; this money comes with strings attached.

Offer partial deferment. Households in financial straits may need some of these funds right now, but maybe they don’t need all of their payroll tax defer. If possible, encourage households to only defer what they need to make ends meet.

Collect deferred payments gradually. When the deferral period ends, do not pull a lump sum repayment of the payroll taxes. If possible, spread the repayment over the months from January to April to reduce the shock of a large drop in income.

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