Further Thoughts on a Tax Cut for the Young

by Reihan Salam

My latest column for The Daily advocates a tax cut for the young:

Matthew Weinzierl, an economist at Harvard Business School, recently made an intriguing theoretical case that age-dependent taxation could raise the efficiency of the tax system. The mechanics of such a reform are easy to imagine. The governments of Australia and Singapore already give a tax break to older workers, recognizing that they need a stronger incentive to remain in the work force. Giving a substantial tax break to the young would hardly represent a huge conceptual leap. Rather than give young workers a lump-sum credit, we’d make the rate schedule for under-30 workers significantly lower. For example, the basic rate would be 5 percent instead of 10 percent. This would recognize that the marginal tax rate makes a bigger difference in decision-making when you’re young and carefree than it does when you’re middle-aged and have to make mortgage payments.

It should be clear that a tax break for the young wouldn’t magically solve the youth unemployment problem. There is, however, good reason to believe that it would yield significant economic dividends for everyone by giving young workers more disposable income that they can use to make investments in their future and, even more importantly, to encourage family formation. Bigger families will make it easier to finance the retirement of the baby boomers, while also fueling consumer demand for the long term. Tax cuts for the young would be such a boon that I think middle-aged workers should be willing to accept higher taxes to pay for them.

Unfortunately, it’s far from obvious that most middle-aged voters will feel the same way. A tax break for the young would be an extremely tough sell in Congress. All the same, it is a cause worth fighting for.

Apart from Weinzierl, the idea was prompted by Edward Glaeser’s anxieties about family formation, which he recently discussed in Bloomberg View:

 

From 2006 to 2010, the number of Americans older than 15 who had never married rose by 5.7 million, dwarfing the 1.7 million rise in the number of married adults. The number who were divorced or separated also went up, by 1.5 million.

More specifically, among Americans ages 25 to 29, the number of those married fell by 524,000, and the number of those who never married rose by 1.7 million. (Marriage likewise declined substantially during the early years of the Great Depression.) The decline in young marriages is also making us more like Europe, where young adults have long been more likely to marry later and — until they do — to live at home.

In the short run, the marriage drop means fewer households being formed — only 378,000 from 2008 to 2010; this, in turn, keeps the housing market down. If new households were still forming at the 2005 rate of 1.3 million per year, our excess housing inventory would probably go away, and the construction industry would likely be back to normal in no time.

The marriage drop matters for another reason:

 

Low marriage rates typically lead to low fertility rates, which ultimately mean declining populations. Population growth is needed to finance social programs, such as Medicare and Social Security. If America’s low marriage rates lead to lower birth rates, we may have even more trouble supporting our social programs, unless immigration continues to pick up the slack.

There are ways to boost employment and household formation. We could cut the payroll tax, which hits lower-income jobs hardest. We could provide a renter’s credit, equivalent to the mortgage interest deduction, to make it easier for young adults to afford to move out of their parents’ homes. If we were feeling really radical, we could even lower the home-mortgage interest deduction for parents with adult children living at home.

Glaeser’s observation on fertility and the sustainability of retirement security programs brings to mind this classic op-ed by Phil Longman:

 

There are many reasons birthrates are falling, but Social Security itself is likely a major cause because of the raw deal it creates for parents and the enormous subsidies it provides to non-parents. By raising and educating their children, parents provide the system with essential human capital. The cost of this contribution, in both direct expenses and forgone wages, is often measured in the millions.

Yet parents get no compensation from Social Security, nor from the wider economy, for the investments they make in their children. Instead, Social Security pays the same benefits, and often more, to people who avoid the burdens of parenthood. So long as Social Security effectively penalizes people for having the very children the system requires, it contributes to a downward spiral of falling birthrates leading to higher and higher tax rates.

Here’s a possible solution. Instead of slashing benefits across the board and borrowing trillions to create a risky system of personal accounts, use the same money to offer substantial tax relief, and extra benefits, to married parents who successfully raise their children. For example, have one child, and the payroll tax you pay (and that your employer nominally pays) drops by one-third. A second child would be worth a two-thirds reduction in payroll taxes. Have three or more children and you wouldn’t have any payroll taxes again until your youngest child turned 18.

James Capretta has also been drawing attention to the role of fertility in determining Social Security’s finances:

 

The relationship between social insurance and fertility points toward an internal contradiction in the social insurance model. To finance programs providing for the retired elderly, society needs a growing working-age population, but the presence of the state-based pension benefit—particularly if it is large—reduces the incentive of younger workers to have children. Thus, U.S. Social Security, like government pension plans the world over, is built on a fundamental and poorly understood contradiction: it reduces the economic incentive within a family to invest in children even as it remains ever-dependent on a new generation of productive workers to keep the program afloat.

This insight, it turns out, is not a recent revelation. In a paper presented at the Family Research Council, historian Allan Carlson pointed out that as early as 1940 Gunnar Myrdal, the Swedish economist, had observed in a Harvard lecture that social insurance pensions contained a contradiction.6 For all of human history, adult children were the safety net for the elderly, taking care of aging parents, often in the same homes. With social insurance, the government takes resources from workers to finance direct government assistance in old age, effectively absorbing what was once an entirely family responsibility. While social insurance depends on a productive workforce to pay taxes, families have less of an economic incentive to have children because now they are counting on—and paying for—government-based old-age support.

Sluggish family formation was one of the central concerns of Grand New Party, and it was interesting to see one of my favorite scholars write about this subject in such a forthrightly prescriptive manner. 

Having spent a fair bit of time with the literature on pro-natalist policies, my sense is that there is a danger that generous subsidies for parents can raise the overall tax burden in a way that can actually delay family formation, thus defeating the purpose of the initial intervention. That is why I was drawn to an age-dependent approach: it can influence the decision to leave the nest before children enter the picture. 

As for the mechanism, the column suggests a lower marginal tax schedule — say we shave all of the marginal tax rates by 5 points. This will be a boon for young workers with the highest earning potential, but it will also give all workers, who tend to have lower incomes than middle-aged workers, a stronger work incentive and a boost in disposable income.

My ideal approach, however, would involve reforming Social Security and the Social Security payroll tax along the lines Edward Prescott proposed several years ago. Basically, the system would become a defined contribution system. Between 18 and 35, contributions would steadily increase, thus facilitating consumption smoothing. Among other things, a prefunded system of this kind — which, of course, raises the question of transition costs — would address Myrdal’s contradiction, and it might give family formation and fertility a significant boost.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.