Conservatives are having a healthy debate about a new tax-reform program, but most of the debate is focused only on reducing income taxes. James Capretta of the American Enterprise Institute says we should also consider cutting the payroll tax. I might agree. I’ll summarize his argument below.
Currently, the tax-reform plan getting the most attention is one advanced by Republican Senators Mike Lee and Marco Rubio. The Lee-Rubio plan would reduce the tax code to only two income-tax rates and would broaden the tax base by eliminating and limiting many current exclusions and deductions. It would also cut taxes substantially for middle-class families with children by adding another $2,500 per child to the existing $1,000 per-child tax credit.
The Senators are also proposing a vast simplification of business taxation, with an emphasis on lowering the top corporate rate from 35% and on more rational treatment of business investments and overseas operations. The Lee-Rubio tax-reform framework has been embraced by several conservative groups but is opposed by others who say that the plan insufficiently promotes economic growth.
Most Americans want a vastly simpler tax code, with lower rates and a broader base of taxpayers. The trick is to put together a plan that embraces these goals and has real political appeal. After 15 years of stagnant incomes for middle-income families, a tax plan that we could credibly call a large middle-class tax cut has perhaps the best chance of catching fire politically.
There’s also a strong case for helping families who are raising children, as Lee and Rubio would do in their plan. The expanded child credit in the Lee-Rubio framework is aimed at correcting the imbalance embedded in current tax and entitlement arrangements, and it would thereby invest in the families that are raising the next generation of American workers.
Yet the Lee-Rubio approach is also not the only way to provide credible tax relief to middle-class families. A more direct route would be to cut the payroll tax itself.
The payroll tax imposes, by a wide margin, the largest federal tax burden on middle-class families. As Social Security and Medicare spending commitments rose over the last half of the 20th century, the payroll contribution climbed dramatically. As recently as 1972, the combined employer-employee payroll tax rate was 7.5%. Today, it is 15.3%.
Some conservatives shy away from taking on the payroll tax because they view it as a lesser evil than the income tax. They argue that because the payroll tax is not progressive (except for the Medicare component, above $250,000 in yearly income), it approximates a “flat” tax on consumption, not savings. This is a terribly flawed understanding of the tax. The payroll tax is a tax on work, not consumption.
Conservatives generally oppose raising the minimum wage and other mandates that raise the cost of labor and thus limit opportunities for lower-wage workers. Given that the payroll tax raises the cost of labor far more than any of these other federal mandates, conservatives should embrace reducing it.
An across-the-board payroll tax cut would be a powerful pro-work, pro-growth policy. The primary obstacle to changing the payroll tax is, of course, the connection to the Social Security and Medicare programs. The payroll tax is used to finance both programs, and so, absent other changes, a broad-based payroll tax cut would be viewed as draining the trust funds of resources needed to pay benefits.
President Obama got around this problem in 2011 and 2012 by replacing the revenue lost from a 2.0 percentage point payroll tax cut with general revenue payments to the Social Security Trust Fund. Even though the payroll tax reduction was not extended beyond 2012, the precedent for a cut in payroll taxes has been set, and Republicans could return to the same formula in the future if they wanted to.
One approach would be to reduce the payroll tax owed by parents with dependent children. This would take the pressure off of increasing the child tax credit (lee-Rubio plan) and thus also free up resources within the income-tax-reform plan for other priorities. The lost revenue from this tax cut could be replaced in the Trust Fund with general revenue on a temporary basis.
The federal budget over the past five decades has been radically transformed. Three-fifths of all spending now goes to automatic benefit and transfer programs – entitlements. As the spending side of the budget has shifted, so have federal taxes. For most Americans, the payroll tax is now far more consequential than the income tax. This is one reason it is difficult to cut taxes for the middle-class when making changes only to income taxes.
With broad-based tax reform emerging as a national issue heading into next year’s presidential election, we should at least broaden the discussion to include reducing or eliminating the payroll tax.
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