This might be effective depending how it's structured.  There are several ways to accomplish this, each with different growth prospects:

1. Rebate of payroll taxes.  It's important to note that this is more than fully, fully, and/or partially accomplished for poor and near-poor households via the Earned Income Credit and the Additional Child Tax Credit.  If your goal is to relieve poor and near-poor households with children of their FICA responsibilities, mission accomplished.  Anything further would yield precisely nothing in new economic growth.

2. Exempt the first (say) $10,000 in wages and self-employment profits from FICA/SECA.  This would effectively serve to lower the marginal tax rate on wages and SE profits on the low end.  The lowest rate would decline from 25% to 10%, and part of the next highest rate would decline from 30% to 15%.  The upside here is that the marginal cost of working full-time vs. part-time would decline.  This would create some marginal uptick in labor force growth, hours worked, etc.

3. Lower the FICA/SECA rate generally.  This option would have the same effect on the low end as (2).  On the upper end, it would serve to smooth out the integrated marginal tax rates on labor.  Under current law, the integrated labor/self-employment tax rates are approximately:

25%
30%
40%
31%
36%
38%

As you can see, the highest marginal rate is the third one, not the sixth.  This is because the OASDI portion of the FICA tax stops at about $105,000 of wages/SE profits.  Lowering that tax rate would lower all of the bottom three integrated rates.  While it would take a 9 percentage point reduction to fully smooth things out, any rate reduction would be an improvement.

The SE tax rate of 15% is a high barrier to starting a small business.  It's also an impediment to working longer hours and being more productive.  Tax something less, and get more of it.  In this case, you would get more small business startups and middle class earnings on the margins.

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I’m pleased that attention is now shifting to the content of a stimulus package, especially a tax piece to complement the President-Elect’s spending initiatives. See the case I made for a tax component to an economic recovery package in a recent commentary in the Washington Times.  The suggestions by some for a payroll tax holiday or a gasoline tax should just begin the debate.

Renowned economist Allen Sinai just completed new research for the American Council for Capital Formation using the Sinai-Boston Econometric Model. Sinai concludes that a temporary one-year reinstatement of the dividends received deduction for repatriated foreign subsidiary earnings would have several simulative results—including a significant increase in real GDP, significantly higher corporate cash flow, increased capital expenditures like R&D, improved business financial conditions, and more jobs at both nonfinancial corporations and at financial institutions. In addition, the U.S. Treasury would receive funds it would not otherwise get, thus helping to reduce the federal deficit.
 
See links to the ACCF summary and full report.

If policymakers wish to stimulate consumer spending through temporary tax reductions, a cut in the FICA payroll tax offers a couple of advantages.  First and probably most important, it is comparatively straightforward and would be inexpensive to administer.  It can be implemented with little delay.  The IRS does not need to process a year’s worth of income tax returns in order to determine who is eligible and the size of the rebate.  Second, a FICA tax cut would reduce the marginal tax on labor earnings faced by workers or employers (or both).  This may slightly improve labor market incentives and speed job market recovery.  Finally, depending on the way the FICA tax cut is designed, it can be targeted on workers in the middle and at the bottom of the earnings distribution.  These are the workers who are most likely to respond to a temporary tax cut with a spending increase.

Set aside the question of whether taxpayers would consume most of the tax cut in the short run.  The possibility that taxpayers will save rather than consume a tax cut is an objection that can be raised against nearly all temporary tax cut plans, except plans based on a temporary cut in the sales tax.  The main practical objection to a cut in the FICA tax is that it would deprive Social Security and Medicare of needed revenues.  Both programs already face severe long-term funding problems.  A cut in the FICA tax would worsen those problems unless Congress replaced the lost revenues with a transfer of funds from the U.S. Treasury.  If this transfer of funds takes place, I think the advantages of a temporary FICA tax cut make it a potentially attractive method for delivering temporary tax cuts.

Voters and policymakers should bear in mind, however, that the FICA payroll tax provides a relatively crude instrument for delivering finely targeted tax relief.  If, for example, Congress cuts workers’ Social Security contributions by 2%, workers earning $20,000 a year would enjoy a tax cut of $400, and workers at the taxable maximum ($106,800 in 2009) would receive $2,136.   A large portion of the tax relief would go to high income workers, and these workers are likely to save rather than spend most of their tax relief.  To reduce this problem Congress could place a limit on the tax cut, perhaps by capping tax relief at $1,000 per worker.  Even with this kind of restriction, a substantial part of the overall tax cut would be received by families with high taxable incomes.  It is obviously much easier to target tax relief to low and middle income families if tax cuts are calculated using information on the IRS 1040 form.  Carefully calibrated tax relief is easier to deliver through an income tax cut than through temporary reductions in either the payroll tax or the sales tax. 

If policymakers prefer speedy and administratively simple tax relief, a FICA tax cut has much to recommend it.  However, if they want to target tax relief on taxpayers who are most likely to spend it in the short run, a temporary cut in income taxes is the way to go.

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The most urgent economic riority is boosting demand, to moderate what is already a severe recession. Martin Feldstein argues that very little of the tax rebate earlier this year was spent, precisely because it was explicitly temporary, so that households rationally used the money to raise their saving rate (more precisely, in most cases: to pay off some of their troublesome debts). Yes, eliminating the payroll tax on lower-income workers would indeed be a better-targeted way of achieving the objective, especially it were made permanent rather than a "holiday" (not that anything is permanent in tax policy). Beyond from the desired stimulus to demand, it would also accomplish a few other objectives: it would provided a sorely needed reduction in the MARGINAL tax rate on lower-income workers, and thus establish the work incentives that "supply siders" are always talking about (even though such talk somehow during the last 8 years only resulted in lower taxes for the rich rather than for the lower-income Americans who in fact face the most severe disincentives to work). Of course cutting payroll taxes on low income workers would also deliver on the progressive tax cuts that Barack Obama successfully campaigned on.

Finally, there is a seldom discussed benefit for the rich (that upper 5% of Americans who earn more than roughly $250,000 a year and are due for the expiry of their Bush tax cuts even if Obama were to take no action to raise their taxes). I believe that most of this class of Americans employ one or more housecleaners, nannies, gardeners, etc., for whom they are legally obligated to pay social security tax. The paperwork is onerous for a small household, sufficiently so to discourage employment of such services and/or compliance with the law. Removing the payroll tax could remove this obligation from the upper income elite (who of course have political power beyond their numbers).

Although short-term stimulus is urgent, long-run fiscal responsibiltiy is also important. Unfortunately, the outgoing president was going to leave the country with a fiscal path of gaping deficits even before the recession hit. Restoring fiscal rectitude will be a nearly impossible task, but it is important to pay attention to the long-run fiscal implications even while giving short run stimulus. I agree completely with Greg Mankiw, Michael Kinsley, and many others that we ought to offset revenue losses from desired tax cuts with increased future revenues from taxes on energy, in particular those forms of energy high externality costs in terms of pollution and congestion (gasoline), greenhouse gases (add especially coal), and national security (add especially oil). The legislation should be passed now (or after the next big terrorist event or national security failure), with provisions to phase the actual tax increasesin a few years into the future (especially if world energy prices drop further in the future, or else when the US recovery is well-established).

Reform of social security and Medicare are of course the biggest components of any effort to avoid fiscal insolvency in the longer run.

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Let's start with the observation that proponents of payroll tax holidays have already taken an important step in the right direction.   Most discussions of fiscal stimulus emphasize increased federal spending.  Increased spending would be utterly ineffective as stimulus because the federal government must first borrow the funds, so private spending declines by whatever amount public spending might increase.     In contrast, well-designed tax relief would be effective, not because of the resulting deficits, but because of the resulting beneficial changes to economic incentives.

Unfortunately, and despite the encouraging instincts it reflects, a payroll tax holidy would also be of little effect.   Cutting the payroll tax rate is better than more spending because it reduces the tax disincentive to work.   A far better solution would be to cut individual and corporate income tax rates by 5 percentage points, for example.  This would improve the incentive to work, but it would also improve the incentives for investment, entrepreneurial activity, and risk taking.  

But what really limits the payroll tax holiday as a stimulus policy is that it is a "holiday", meaning that it is short-term.   To stimulate the economy noticeably, workers and investors need to expect that a reduction in marginal tax rates would be in effect for many years.  The change to future tax rates, put into the law today, is what really changes economic behavior today.  In dollar terms, an income tax rate reduction proposal that reduces receipts by $500 billion over 5 years would have a far greater effect on the economy today than a $500 billion payroll tax holiday in 2009. 

We should be encouraged by any "tax holiday" proposal as demonstrating good instincts on the basic policy.  But we need to channel those instincts into good policy to match.  Reducing income tax rates aligns instincts and policy to produce good results.

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