Ross Douthat on the Payroll Tax Cut

by Reihan Salam

Ross Douthat has an excellent new column that makes the case for making the payroll tax cut permanent. The politics of doing so are very attractive. My own view is slightly different, however. Consider Ross’s historical case against the payroll tax as we know it:

Payroll taxes are a relic of New Deal Machiavellianism: by taking a bite of every worker’s paycheck and promising postretirement returns, Franklin Roosevelt effectively disguised Social Security as a pay-as-you-go system, even though the program actually redistributes from rich to poor and young to old. That disguise has helped keep Social Security sacrosanct — hailed by Democrats because it protects the poor and backed by Republicans as a reward for steady work.

But the costs of this disguise have grown too great to bear. Whatever its past political advantages, the payroll tax now imposes an unnecessary burden on a stagnating economy. In an era of mass unemployment, mediocre wage growth and weak mobility from the bottom of the income ladder, it makes no sense to finance our retirement system with a tax that falls directly on wages and hiring and imposes particular burdens on small business and the working class. [Emphasis added]

Charles Blahous has been drawing attention to what he calls “the dark side of the payroll tax cut,” and he offers a contrasting take on its history:

Social Security, as originally envisioned and implemented by President Franklin D. Roosevelt, has historically been financed through a separate payroll tax levied on covered workers. Its finances have been tracked through a separate Trust Fund system, distinct from the general federal budget. This financing method reflects a foundational principle of the program, distinguishing it from welfare. Under a welfare program, by contrast, benefits are based on need while revenue contributions are based on one’s ability to pay. Social Security was instead designed such that all workers—rich and poor—would pay payroll taxes. Benefits in turn were to be based on the amount of an individual’s wages subject to this tax. A higher-wage worker would thus pay more in taxes but also receive more in benefits.

This arrangement represented a politically stabilizing compromise between the left and the right. The right was to be assured that Social Security costs would not, at least in the aggregate, exceed the revenues the program generated. The left received an additional political protection for benefits, arising from the popular perception that beneficiaries had paid for them.

Now that Social Security has begun to be subsidized directly with income taxes, neither of these assurances can continue. The new policy ends the longstanding requirement that Social Security expenditures be limited to the total amount of its tax collections (plus interest). And, by subsidizing payments with income taxes, it ends the idea that the Social Security benefits are fully “earned” by recipients. [Emphasis added]

The crux of the disagreement is over whether or not the politically stabilizing compromise that undergirds Social Security is at this point doing more harm than good. Given the landscape Ross describes, I am inclined to agree with his analysis. Conceptually, the idea of abolishing the distinction between the payroll tax and the federal income tax by replacing both with a new revenue source, e.g., a progressive consumption tax of some kind, very appealing. Yet the process of getting from here to there will be a difficult one, in part because many workers think of the payroll tax very differently from the income tax. Crafting a progressive consumption tax that can generate as much revenue as the payroll tax and the federal income tax combined will likely induce serious sticker shock. And unfortunately, masking the real cost of government is a crucial part of how Washington does business, as Suzanne Mettler illustrates in The Submerged State

Recently, we discussed the payroll tax in the context of a 2007 proposal from Kenneth Scheve and Matthew Slaughter to permanently elimate the payroll tax burden on workers earning less than the national median, an approach that is broadly in line with Ross’s argument. In 2005, this measure would have cost $256 billion in 2007 dollars, so one assumes that we’d be looking at a 10-year price tag in the neighborhood of $3 trillion or more. To achieve revenue neutrality, middle-income households would have to face a sharp tax increase.

My preference would be to embrace Robert Stein’s tax reform approach, which would effectively remove the vast majority of middle-income and low-income households with children from the payroll tax and the federal income tax rolls. There is, however, an important downside to this approach: measures that reduce the tax burden on families with children will make family formation more attractive at the margin, yet they might also have the perverse effect of making it more difficult for childless workers to accumulate that resources that will make them more attractive marriage partners. Consider the following passage from Reconnecting Disadvantaged Young Men:

In the 1990s, the nation developed a range of “work supports” for low-wage welfare mothers and custodial parents—including an expanded earned income tax credit (EITC) that subsidizes low wages by as much as 40 percent, and increased child care and health care subsidies. But most of these efforts have little effect on childless young men or those who are noncustodial parents. Efforts to raise or subsidize their low earnings should be part of a comprehensive plan to motivate them. And, where we can identify reciprocal obligations—which were successfully implemented in some states with welfare mothers—we should use them. [Emphasis added]

The normative case for offering more favorable tax treatment to parents is, in my view, very sound. As Stein, Philip Longman, Jonathan Last, John Mueller, and many others have argued, pay-as-you-go social insurance programs depend on favorable old-age dependency ratios, which in turn flow from the willingness of young adults to have children and to make large human capital investments in them over the course of a lifetime. But if a sharp shift in the tax burden to the childless actually delays family formation, we will find ourselves in a bind. Fortunately, the Stein plan is designed to only increase the tax burden on childless high-earners, which will tend to mitigate this effect. It is nevertheless important to keep in mind. 

The Agenda

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