Watch Out for the Making Work Pay Credit (2009 Economic Stimulus)

Smithee has been keeping me up-to-date with a major part of the 2009 economic stimulus, the $400 for individuals or $800 for couples tax credit. Here are some things to keep in mind about this stimulus going into effect today, called the “Making Work Pay” credit in the law that established it.

This variation of the economic stimulus is taking the form of a small bonus in each pay check from April through December. The increase will occur thanks to an automatic change in tax withholding put into effect by your employer.

A small increase in each pay check is “better” than receiving a lump sum payment. I suppose this depends on the definition of “better.” First of all, the lump sum payments to taxpayers in 2001 and 2008 did little to stimulate the economy directly. Surveys suggested that recipients used the lump sum as “found money” or an increase in wealth and directed the funds towards savings accounts and debt repayment. In normal circumstances, adding a lump sum to savings on a large scale should boost the economy, though not as much as spending. The theory is the banks will take the deposits and turn the money around by lending money to businesses. But thanks to the “credit crunch,” that didn’t happen in 2008.

Also, when lump sums do encourage spending, it’s usually for large purchases. If you buy an electronic device, clothing, a car, or most other large purchases, you aren’t necessarily boosting the local economy. When stimulus is presented in small bits over time rather than one lump payment, is is perceived as an increase of income rather than wealth and it encourages a gradual incorporation of the extra money into daily spending. Tax payers are more likely to spend the extra stimulus, even if it is only about $10 to $20 a week. Perhaps this increase will mean one more dinner at a restaurant, contributing to the health of local businesses.

While the form of the credit is good, I expect more problems a year from now when it’s time to file 2009 income taxes based on the fiasco that was the 2008 economic stimulus credit.

The Making Work Pay credit is a new tax credit that will be claimed on 2009 and 2010 income tax forms. In 2008, millions of tax payers received an economic stimulus payment, essentially new money to be spent or saved. But when the time approached for filing 2008 income taxes, the Recovery Rebate Credit appeared on 2008 income tax forms. Much confusion ensued. The 2008 economic stimulus payment was simply an advance of this new Recovery Rebate Credit. So those who already received the economic stimulus payment could not claim the Recovery Rebate Credit. If they could, they would have been receiving the same credit twice.

The confusion that this created is bound to return in the form of the Making Work Pay credit. The extra tax withholding starting today is an advance of the Making Work Pay credit, which will likely appear as another line item on the 2009 income tax forms, just like the Recovery Rebate Credit.

Many people will have the correct amount of tax withheld. Your employer makes a number of assumptions. First, your employer knows about only the income they provide you. If you earn $60,000 from your day job, your employer will adjust your withholding because based on the information they have you qualify for the tax credit. If you earn an additional $40,000 outside of your primary job from your investments or from a second job, your total income disqualifies you from receiving the Making Work Pay credit. If you don’t instruct your employer to adjust your withholding, you will have to repay the credit to the government when it comes time to file your tax return.

Second, if you are married, filing jointly, and your spouse works, both employers may reducing withholding enough for the entire couple. In this situation, similar to the above, you could end up owing the government money for receiving too much in your pay checks.

Some employers began offering the reduced withholding early. The new withholding formulas are based on calculations assuming the adjustment occurs on April 1. Some employers have opted to adjust the withholding early. As a result, the employer will be offering employees a larger credit than they are entitled to. Any under-withholding as a result will be sought by the IRS when tax payers file 2009 income taxes. If an employer applies the new withholding formula late, then the employee may be entitled to an additional credit when he or she files the return.

Economic stimulus payments, to be effective rather than to be seen as “bread and circuses” or politicians buying votes from the public, should be incorporated into income as much as possible, but shouldn’t be buried in the tax code, creating confusion and frustration among taxpayers.