Integrating the tax burdens of the federal income and payroll taxes on labor income: 1. INTRODUCTION

By Geier, Deborah A.
Publication: Virginia Tax Review
Date: Saturday, June 22 2002

자료: Integrating the tax burdens of the federal income and payroll taxes on labor income

"The [Social Security] tax is the neglected stepchild of tax policy analysis." (1)

 

I. INTRODUCTION

When politicians, or even the average guy on the street, debate whether the allocation of the federal tax burden is "fair" and "efficient," they typically do so by talking only about the federal income tax burden. For example, columnist Jerry Heaster, correctly reporting that the top one percent of income earners in 1999 paid about thirty-six percent of "all federal personal income taxes," writes, "How much tax do high income Americans need to pay before the class warriors will be satisfied?" (2)

But the fact of the matter is that about as much federal revenue is collected from the payroll taxes (Social Security and Medicare) as from the personal income tax, (3) and the payroll taxes are extremely regressive, significantly diluting the percentage of the total federal tax burden paid by the wealthy. For example, in a year 2000 study, the staff of the Joint Committee on Taxation estimated that, under the law at that time, those earning more than $200,000 would pay 42.7% of the total federal personal income tax collected, while the top 1% would pay 33.6%. (4) If, however, all federal taxes are measured, including the regressive Social Security and Medicare taxes, the shares plummet to 27.5% for those earning more than $200,000 and 18.6% for the top 1%. (5) These reductions will become even more dramatic after the full phase-in of the 2001 tax cuts for the super wealthy. (6)

While the tax debate centers on the federal income tax burden, provocative empirical studies published by economists Andrew Mitrusi and James Poterba in 2000 show that nearly two-thirds of American households now pay more in federal payroll taxes than income taxes, (7) chiefly because of significant increases in the payroll tax burden over the last twenty years. This results in much higher effective tax rates, as well as a higher total tax burden, for the lower and middle classes than is probably widely appreciated. Further, it results in a higher portion of the federal tax burden being borne by labor income (as opposed to capital income, which is concentrated in the wealthier households) than is probably widely appreciated. In other words, there is a huge elephant in the room that few politicians talk about and even fewer citizens recognize.

This article explores the historical reasons why we have three separate taxes on labor income at the federal level--the income tax, the Social Security tax, and the Medicare tax--and considers how and why the government might integrate the tax burdens on labor income in some way today. (8) For ease of discussion, this article will refer to the "double tax" on labor income, which 'consists of the income tax on labor income and the two payroll taxes on labor income lumped together. (9)

The case for integration rests more on equitable grounds than on grounds of economic efficiency. In one sense, the efficiency argument is a function of the extent of the disincentive effect that a double tax on labor income has on work effort. Because of the $84,900 wage ceiling that caps the Social Security tax base, (10) and the low rate for the Medicare tax that continues to apply above that ceiling, there is likely no disincentive effect at the margin for wage earners or self-employed individuals earning more than $84,900. Indeed, the income effect (11) might predominate for workers earning slightly below the wage ceiling, who might work longer and harder to exceed the margin and begin taking home more after-tax income for dollars earned above the ceiling.

The case is certainly more complicated for those earning significantly less than the wage ceiling, but there might not be as large a disincentive effect as might be imagined for several reasons. The obvious reason is that, to the extent the worker has control over hours worked, we do not know whether the income effect predominates over the substitution effect or vice-versa. Moreover, lower- and middle-class taxpayers might have far less control than the upper-class taxpayers over the extent of work effort. For example, the worker might not have the freedom to choose to work only thirty-five hours per week instead of forty hours if the employer rigidly defines the worker's job to require forty hours. In short, it might not be possible to disentangle the myriad incentives that affect work effort and isolate the incentive effects of the payroll taxes in particular.

Another factor might be the worker's perception, whether accurate or not, regarding the "rate of return" that she receives in retirement on her "insurance contribution." The disincentive effect on work effort should be weakened if the worker believes that the return is reasonable. While low-wage workers have historically obtained a high "return" on their "insurance contributions," (12) Kotlikoff and Sachs argue that low-wage workers tend not to appreciate this, because some low-wage workers, such as domestic workers, have striven to avoid imposition of the tax (and the subsequent enjoyment of the return) through a failure to report self-employment income. (13) This tendency, however, might be due simply to a pattern of high "discount rates" among low-wage workers. That is to say, low-wage workers might require an unreasonably high rate of return before they are willing to defer consumption to the future. (14)

In any event, to the extent that payroll taxes do discourage work at the margins for low- and middle-class taxpayers and thus raise efficiency concerns, or encourage the underreporting of wages, integrating the payroll and income tax burdens could help to ameliorate these effects.

The more persuasive argument for integrating the payroll tax burden on labor income with the income tax burden on labor income is simple equity. The combined tax burden on labor income from the payroll and income taxes on the poor and middle classes has increased dramatically in the last two decades, and the increase in tax burden is clearly due to substantial increases in the Social Security and Medicare tax rates as well as the Social Security wage base during that time. (15) In other words, there has been a dramatic increase at the federal level on the taxation of labor income, particularly for the middle class. Moreover, this period also witnessed a decreasing reliance on the corporate tax, one of the biggest sources of capital taxation. (16) Michael Graetz argued:

If the basic principle of tax justice requiring taxes to be distributed in accordance with ability to pay is to be satisfied, a significant portion of the tax burden must be borne either by wealth (or wealth transfers) or income from capital. Taxes on labor income alone--even if, unlike [Social Security] taxes, they were progressively structured--do not produce taxation based upon ability to pay, for those with the greatest ability to pay often have channeled their monies into capital. (17)

One can defensibly argue that this state of affairs is simply unjust, particularly at a time when the tax burdens of the super wealthy are being significantly reduced through repeal of the estate tax (18) and reduction in the top income tax (19)--all in a period of unprecedented wealth concentration in this country. In considering whether the distribution of the tax burden is "fair" by examining the extent to which it is "progressive," the right inquiry might not be whether the percentage of tax collected across income strata is progressive but rather how taxes affect the distribution of after-tax discretionary income and wealth. (20) If this is right, information on income and wealth concentration is crucial to the inquiry, and "wealth in America is more highly concentrated today than at any time since 1929...." (21) The wealthiest 1% of households has more than doubled its ownership of private assets in this country since 1976. Whereas the top 1% owned about 19% of our country's assets in 1976, it now owns nearly 40%. (22)

Examining Federal Reserve data, Edward N. Wolff found that between 1983 and 1998--a period that coincides with substantial increases in the payroll tax burdens on the labor income of the poor and middle classes--the trend in wealth concentration accelerated. As reported by Tom Redburn:

The number of households with a net worth of more than $1 million nearly doubled, to 4.78 million from 2.41 million. At the same time, the ranks of the truly rich exploded even more, with those worth more than $10 million nearly quadrupling, to 239,000 from about 67,000.

That's great. A rich society like the United States should have plenty of rich people--and the more the merrier. But what is disturbing is what happened to just about everybody else.

"The richest 1 percent accumulated 53 percent of the total gain in marketable wealth over the 1983-1998 period," Mr. Wolff wrote. "The next 19 percent received another 39 percent, so that the top quintile accounted for 91 percent of the total growth in wealth, while the bottom 80 percent accounted for a mere 9 percent."

"The results indicate rather dramatically," he added, "that the fruits from economic growth in the last few decades were enjoyed by a surprisingly small part of the population--the top 20 percent, and particularly the richest 1 percent." (23)

Though most agree that extreme wealth concentration can lead to plutocracy and can damage democratic values, there can never be universal agreement on the proper criterion for arriving at what constitutes the "most" equitable distribution of the tax burden across the members of the population. Nor will there ever be universal agreement regarding the proper balance between equity, however defined, and economic efficiency and growth, or even the "best" tax policy approach to support growth.

For example, a tax system premised on the classic utilitarian theory of minimal aggregate sacrifice would result in taxing only Bill Gates until his income was brought down to the next highest income earner, taxing those two until their incomes were brought level with the third, etc., until the requisite amount of revenue was raised. Yet, such an approach to "equity" concerns--involving exclusive taxation of the rich at confiscatory rates--completely ignores other criteria of fairness, such as just dessert, and also completely ignores the effects of such a tax system on economic efficiency and investment. (24) At the other extreme, an equal sacrifice or head tax might free up huge amounts of capital for investment by slashing taxes on the wealthy but completely ignores the intuitive notion of the decreasing marginal utility of money (sticking with classic utilitarian theory for the sake of comparison).

There is also no simple agreement within the realm of economics itself regarding how best to promote growth, as exemplified by the disagreement between supply-side and demand-side economists regarding the role of savings in economic growth. As summarized by John F. Witte:

According to Keyne's analysis of the depression, excess savings do not necessarily lead to growth; rather, they stifle consumption, which is the engine that stimulates economic activity. The policy argument that follows from this analysis is that one should reduce taxes, but reduce them for the poor and middle class, who consume the most. Supply-side theorists stress the need for investment and an increase in savings to fuel corporate expansion. The corresponding policy recommendation is again to cut taxes, but in this case the taxes of upper-income groups that have a higher propensity to save and greater capital to invest. (25)

In short, those who believe that the tax burden ought to favor capital substantially may not see any need to explore how the income tax and payroll tax burden on labor income might be integrated. But for those troubled by the increasing percentage of the tax burden borne by labor income (as opposed to capital income) and by the increasing magnitude of wealth and income concentration, this article shall press on with its exploration.

The most straightforward way to integrate would be to repeal the payroll taxes (the Social Security tax and Medicare tax) and raise the revenue formerly raised via those taxes through the income tax. After all, "Social Security is just a part of a larger tax-transfer system that matters solely insofar as it affects people." (26) A combined system could make these allocative and distributional choices much more transparent, even if the decisions are to keep the relative allocations and distributions the same. Having several, separate taxes at the federal level on labor income masks the combined effective tax rate and tax burden imposed on labor income.

Nevertheless, there are sound reasons for maintaining the payroll taxes as separate taxes. Just as when they were adopted, the separate taxes might be perceived by the average taxpayer as the equivalent of "insurance premiums," with the benefits received in retirement as merely the receipt of insurance benefits previously purchased. While, as later described, this is an absolutely inaccurate description of the Social Security and Medicare systems, the common perception can lead to political support for the old-age and survivor's benefit and Medicare benefits, which are generally redistributive in a way that many consider good as a matter of public policy. (27) In other words, some might argue that there are sound public policy reasons to nurture what amounts to an inaccurate view of the Social Security system in order to protect it--a "benign propaganda" of sorts. The insurance analogy that leads to widespread political support could be lost if the separate payroll taxes were repealed and the programs funded with general revenue from the individual and corporate income taxes. (28)

Short of repealing the payroll taxes entirely, full or partial integration might consist of an income tax deduction for the employee portion of the Social Security and Medicare taxes. Alternatively, payroll taxes could be made creditable against income tax liability, with a gross-up in the compensation inclusion if the employer-paid portion were also made creditable by the employee. Since I assume, however, that revenue constraints would not likely allow crediting even the entire employee portion of such taxes, I also assume that any plausible proposal would be limited to either deducting or crediting a portion of the employee portion. That issue is what this article addresses.

It makes little sense to allow a deduction (or a credit) for a tax within the same tax. That is to say, it makes little sense for the federal income tax to be deducted for purposes of computing how much federal income tax is owed. As Senator Henry F. Hollis said when a deduction for federal taxes was repealed in 1917, "It is a pure matter of expediency. If you so arrange the income tax this year that you allow those who pay it to take back a third of it next year, you have simply got to put on a bigger tax ...." (29) It would make the tax system more complicated with no fundamental shift in the tax burden.

But the matter is not so clear-cut when considering whether a flat wage tax of approximately fifteen percent on wages up to, but not exceeding, approximately $85,000 with no deductions or credits (30) ought to be deductible or creditable under an income tax on both wages and capital with no ceiling and progressive rates up to approximately thirty-five percent. Absent massive changes in the structure of the income tax itself, either a deduction or a refundable credit for a portion of the payroll tax should make the tax burden more progressive and less oppressive on the labor income of lower- and middle-income taxpayers. If the argument for integration of the payroll and income tax burdens is to rest on equity grounds, however, the spending side must also be considered. That is to say, welfare might not actually be increased for low- and middle-wage workers if they suffer disproportionately any spending cuts that may accompany the integration.

For this reason, this article might be more than a year too late. Substantial budget surpluses were forecasted prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Act). (31) Once our elected representatives decided to decrease tax collections significantly to decrease this surplus, they had to decide which form the tax reductions should take. Integrating the payroll and income taxes in a manner considered in this article would have resulted in the allocation of much more of the tax cut to the lower and middle classes than occurred with the decision to repeal the estate tax and decrease the marginal income tax rates on the highest income earners without a concomitant reduction in social spending. Absent a rollback of those tax decreases, which seems unlikely, the revenue lost with any integration proposal would have to be matched with spending cuts today, since no budget surpluses are foreseeable in the near future. (32) If the spending cuts of $X that were needed to p ay for the lost revenue of $X that integration would produce were aimed disproportionately at the poor and middle classes, then no net change in utility for those classes would result. Indeed, they might be worse off if they were deprived of necessary services that they could not obtain in the marketplace for a price equal to (or less than) their tax savings.

For that reason, this article explores one other possibility that does not involve explicitly integrating the tax burdens of the income and payroll taxes on labor income but might nevertheless address the equity concerns inherent in the high combined tax rates on such income for the lower and middle classes. That remedy is to repeal the wage ceiling on the imposition of the Social Security tax, which would allow drastically slashing the relatively high marginal rates that we now have under that tax, while maintaining such a ceiling in the payment formula (33) in order to protect the redistributive function. The rate reduction could be calibrated to be revenue neutral and thus would not require spending cuts. Eliminating the wage ceiling on the Social Security tax, while maintaining a ceiling under the payment formula, might be perceived as unfair if the tax is thought to be the equivalent of a private pension contribution. The arguments developed in this article, however, which build on seminal work done by P atricia Dilley, show why such a perception of the Social Security system is fundamentally misguided. Viewed as a general tax that supports the infrastructure of a capitalist economy by maintaining consumption spending by the retired, etc., there is no reason why the tax should not be structured in a progressive fashion, as is the income tax itself. With a flat-rate tax, the only way to make it progressive (and to lower the single, flat marginal rate) is to expand the wage base upward.

Part II briefly sets out the double tax on labor income that arises under the income, Social Security, and Medicare taxes and even more briefly describes the current income tax treatments of the latter two taxes as well as the benefits received under the Social Security and Medicare programs. Part III provides information on the history of relative income tax and payroll tax burdens in order to place the issue in historical perspective. Part IV explores the history of the separate payroll tax itself. Part V confronts arguments that the combined Social Security and Medicare payroll tax is not a double tax (in addition to the income tax) at all because it purchases individual future benefits that, on average, exceed the tax payments made. The issue of whether we ought to link the payroll tax paid to future benefits received on an individual basis is a critical aspect of analyzing how they ought to be treated under an income tax. I reject that linkage. Even though I reject that linkage, Part VI nevertheless explores how payroll taxes as well as cash benefits and medical care received under Social Security and Medicare might be treated under the income tax if we accept that linkage as a legitimate one. Part VII discusses these issues from the more persuasive view that severs the tax from possible futu re benefits. At bottom, it argues that a portion of the employee payroll taxes, both Social Security and Medicare, ought to be creditable, dollar for dollar, against any income tax liability, with a refundability feature capped by reference to a reasonable "personal exemption" amount. Cash Social Security payments received, if any, ought then to be fully includable in gross income under the income tax when received, though the value of medical care received under the Medicare program ought to remain excludable. (34)