Democrats jump on tax-cut bandwagon

Posted: Feb 12, 2001 12:00 AM
With polls showing wide support for a big tax cut this year, Democrats who have long opposed any reduction in taxes whatsoever are scrambling to come up with a tax plan of their own. Many are turning toward the idea of cutting the payroll tax for Social Security in lieu of the income tax rate reduction proposed by George W. Bush. Republicans should strenuously resist any cut in the payroll tax rate that is unrelated to long-term Social Security reform. The Democratic Leadership Council recently outlined the case for a payroll tax cut. Three-quarters of workers, the DLC correctly notes, pay more in Social Security taxes than federal income taxes. That is because the lowest income tax rate of 15 percent is less than the 15.3 percent combined payroll tax rate on both employers and employees. Thus, by definition, every worker in the 15 percent federal tax bracket is paying more to Social Security, assuming that the worker in effect also pays the employer's share of the tax through lower wages. The DLC goes on to say, "Since work is taxed at a flat rate, and earnings above $80,400 are exempted entirely from the Social Security portion of the payroll tax, this tax imposes an onerous burden on low-to-middle income families." The problem arises from the fact that the Social Security tax is not like other taxes because there is a specific benefit attached to it. With the income tax, for example, we get nothing in particular in return. Most people probably don't think they get anything whatsoever. But Social Security is more akin to one's payroll deduction for medical insurance or a 401(k) contribution. Most workers get back everything they pay into Social Security, with those at the bottom getting back a great deal more. This is an important point always conveniently overlooked by liberal groups, such as the DLC, that complain about the regressivity of the payroll tax. They seldom mention that Social Security benefits are highly progressive, giving significantly higher benefits to those with low lifetime wage earnings. Looking at Social Security taxes and benefits together, those with low incomes come out well ahead on balance. Because the Social Security tax is, to a large extent, a contribution rather than a tax, economists have long noted that the disincentive effects of the payroll tax on labor are much less than the equivalent income tax. Indeed, theoretically, the payroll tax has no burden at all. As Henry Aaron of the Brookings Institution put it, "To the extent that the tax is simply prepayment for later benefits, payroll taxes and entitlements offset one another and there is no burden to allocate." Indeed, insofar as those with low incomes get back far more than they pay into Social Security, they have an incentive to work even though they pay more payroll taxes as a share of their income than those with upper incomes. That is because they are in effect getting a huge return on their Social Security contributions, thus encouraging them to work. Those with upper incomes, by contrast, get such a minuscule return on their Social Security contributions that they pay a de facto tax much higher than the taxes that are withheld. This de facto tax takes the form of the return they lose on their Social Security contributions that they would get if they had invested those funds in stocks or bonds. Therefore, the truth about the Social Security tax is that it is not regressive and has almost no disincentive effects on low-wage workers. Thus the DLC's argument that a cut in the payroll tax is needed to help those with low incomes simply is not correct. I think that the DLC knows this and has an ulterior motive -- that is to ultimately put Social Security on a pure pay-as-you go basis, with tax rates rising automatically to pay future benefits. The prospect of a cut in Social Security tax rates now is simply a hook to get the unwary to sign on to future tax increases without realizing it. It is like those low "introductory" interest rates that banks offer on credits cards, which rise sharply after a few months. Data from the most recent Social Security Trustees report shows how pay-go would work. Right now, there are more revenues coming into the trust fund from payroll taxes than are needed to pay current benefits. We could, therefore, cut the payroll tax rate by about 2 percentage points and still have enough current revenue to pay current benefits. However, in about 15 years it would be necessary to start raising payroll taxes above their current level in order to pay promised benefits at that time. Eventually, the Social Security tax rate would have to rise by 6 percent above today's level, to almost 20 percent by 2075. Of course, the Social Security tax rate should be cut. But it must be done in the context of true Social Security reform, which eventually establishes a funded system based primarily on private accounts. Achieving such a reform will be politically difficult, however, and the prospect of much lower payroll tax rates than necessary to maintain the current system is the principal payoff. If the tax rate is cut now, without privatization, reformers will have lost their best argument for privatization. Thus we see that the liberal plan to cut payroll taxes instead of income tax rates is really a stalking horse for moving toward a pure pay-go system, with huge future tax rate increases in return for a temporary cut, and a way to derail privatization. It is clever, but wrong. Conservatives should not allow themselves to be suckered into supporting a payroll tax cut without Social Security privatization.