Magazine | October 16, 2017, Issue

Cut the Payroll Tax

It will help middle-class households and boost growth

Republicans are assembling tax-reform plans aimed at pushing economic growth above the subpar performance of recent years. Since the deep recession associated with the financial crash that ended in mid 2009, the U.S. economy has grown, in real terms, at an average annual rate of just 2.2 percent, far below the 3.4 percent average annual rate over the period of 1983 to 2007.

Faster growth is the essential precondition for addressing the country’s many economic challenges. Without stronger growth, workers will not see the wage gains they want and expect, and the federal government will never have enough revenue to pay for the mounting entitlement obligations of an aging society.

Republican leaders in Congress are committed to pushing tax legislation onto President Trump’s desk. They aim to focus it, first and foremost, on boosting growth, but their effort could falter if the public perceives it as mainly a giveaway to the rich. Many Democrats are sure to make that argument.

And there is a real risk that the accusation could stick. To boost growth, Republicans want to cut the 35 percent corporate income-tax rate, which is well above the average corporate-tax rate in other advanced economies. The GOP also wants to move to a territorial system of corporate taxation to allow companies to bring overseas profits back to the U.S. without paying punitive taxes. Further, many Republicans would like to see across-the-board tax-rate cuts for all individuals paying income taxes.

Tax-reform plans with these provisions will inevitably confer large benefits on upper-income households because high earners pay the most income tax and also own the most corporate stock.

Republicans can partially blunt the inevitable attacks on their emerging plans by embracing a tax cut that would mainly benefit the middle class — namely, a cut in the payroll tax. Cutting payroll taxes presents the rare opportunity to target pro-growth tax relief on households with modest incomes.

Some in the GOP are wary of cutting payroll taxes because the revenue from them helps pay for Social Security and Medicare Hospital Insurance (HI) benefits and both programs are projected to run short of funds. The current tax rate for Social Security is 12.4 percent of wages, split evenly between workers and their employers, up to a maximum income of $127,200 in 2017. Social Security has an unfunded liability of $12.5 trillion over the next 75 years. Workers and employers also pay a combined 2.9 percent tax for Medicare, and there is no limit on the amount of wages subject to the tax. High earners — individuals who earn above $200,000 and couples who earn above $250,000 — pay an additional Medicare tax of 0.9 percent. The Medicare HI trust fund has an unfunded liability of $3.3 trillion over the next 75 years.

The payroll tax is a much heavier burden for the middle class than income taxes. According to the Tax Policy Center, 62 percent of all taxpaying households paid more in payroll taxes than income taxes in 2016; and 67 percent of households with annual incomes below $100,000 paid more in payroll taxes. The average effective payroll-tax rate for households in the middle quintile of the income distribution was 8 percent in 2016, well above the average effective rate of 3.5 percent for income taxes for the same households.

In 2011 and 2012, President Obama supported and Congress enacted a reduction of two percentage points in the employee portion of the Social Security payroll tax, reducing revenue by about $100 billion in 2011 and slightly more in 2012. The law transferred an identical amount from the general fund of the Treasury to the Social Security trust funds to prevent the latter’s depletion.

Congress could enact another cut in the payroll-tax rate of 1.5 to 2 percentage points (perhaps splitting the reduction between the Social Security and Medicare portions of the tax) without depleting either Social Security or Medicare trust funds and without relying on another transfer from the Treasury.

Tax reform should be about cutting tax rates and broadening the tax base by closing loopholes and limiting tax breaks. To help pay for a cut in the payroll-tax rate, the government could narrow several existing tax breaks that now reduce the amount of payroll-tax revenue collected.

For starters, the current exclusion of employer-paid health-insurance premiums from taxation will reduce payroll taxes by $1.8 trillion over the period of 2017 to 2026. Capping the amount that is tax-free so that the least expensive 75 percent of employer-provided plans fall below the cap would increase payroll-tax revenue by about $72 billion over ten years. In addition, company payments for disability insurance and other income-replacement programs are now also excluded from the taxable compensation of workers. Limiting that tax break could provide at least another $100 billion in payroll-tax revenue over ten years. In a large tax-reform package, there are likely to be additional opportunities to increase payroll-tax collections by broadening the tax base.

Congress could limit the benefits of a payroll-tax cut to households with incomes below a certain threshold, such as $75,000 per year. These households would see their total payroll-tax rate drop from 7.65 percent of their wages (the employee share for Social Security and Medicare) to perhaps 5.65 or 6.15 percent. Workers with wages above that threshold would see the benefits of the tax cut phased out as their incomes increased. The tax cut could also be time-limited in the initial legislation to fit within available offsetting revenue increases and then extended as more offsets were identified.

A cut in the payroll-tax rate would be good for workers. A two-percentage-point reduction in total tax would increase the after-tax income of a household with $50,000 in earned income by $1,000 annually.

Cutting payroll taxes would also boost economic growth. The payroll tax is, after all, a tax on work. Cutting it would encourage more people to join the labor force; it would also motivate those who are already working to increase the number of hours they work. This would be the “supply-side” effect of a payroll-tax cut. Cut the tax, and the supply of labor will increase.

Some skeptics argue that a cut in the tax rate could, at least in theory, reduce the supply of labor by boosting the income of workers who could then substitute more time off for time at work. But there is substantial evidence from many countries that increases in payroll taxes generally have the opposite effect: High tax rates reduce work effort by reducing the economic value of time spent working relative to that of time spent not working.

Some economists also argue that because Social Security and Medicare benefits are partly based on what an individual earns while working, the economic value of a payroll-tax cut is lessened because workers equate paying the tax with making contributions toward their retirement. But the benefits owed to a worker under Social Security are based on the worker’s earnings each quarter, not the amount of taxes paid on those wages. Consequently, a cut in the payroll-tax rate would in no way lessen future Social Security benefits. Further, the opaqueness and complexity of the formula for Social Security benefits makes it nearly impossible for most workers to make a sensible connection between what they earn and what they will get in retirement. (There often is very little connection.) Medicare benefits are in no way tied to the amount of taxes paid or even to overall earnings. Instead, workers must meet a minimum threshold of wages over a ten-year period to become eligible for coverage at age 65.

If anything, a cut in the payroll-tax rate is likely to increase benefits owed under Social Security by encouraging an increase in the supply of labor, which increases earnings and hence the amount owed to workers under Social Security’s benefit formula.

The federal income tax is already progressive; during successive rounds of tax changes, the income-tax burden on low- and moderate-wage households has been steadily reduced. But, in relative terms, these workers still pay hefty payroll taxes.

Cutting that tax is the best way to deliver real tax relief to the families that need it most, in a manner that will also provide a much-needed boost to economic growth.

– Mr. Capretta is a resident fellow at the American Enterprise Institute, where he holds the Milton Friedman Chair.

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