Eliminate the payroll tax ceiling

7 Feb

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An excellent piece in the NY Times today drives home the way in which policy at the federal level can significantly impact the lives of individuals and families. The piece describes how the expiration of the payroll tax cut at the end of 2012 has forced middle-income Americans to cut back on certain pleasures – such as date night – and, in some cases, to stop paying their bills on-time. The article also underscores that the payroll tax, as currently structured, is one of the most regressive forms of U.S. tax policy, and that reforming it could significantly – and progressively – improve the sustainability of one of our most cherished entitlement programs, Social Security.

The tax break, which lowered Social Security-related payroll taxes from 6.2 to 4.2 percent, took effect in 2011. It formed one component of a broader White House-led effort to boost consumer spending and economic growth. When the economy continued to slump, Congress, at President Obama’s urging, renewed the cut thru 2012.

But, as the NYT piece explains, with the GOP-led House and Administration locked-in a battle over how to avert the quickly approaching fiscal cliff (a combination of tax hikes and spending cuts set to take place at the beginning of 2013), neither side made a serious effort to extend the cut. The reduction in disposable income triggered by the expiry of the tax break has left many households that already lived paycheck to paycheck struggling even more to make ends meet.

Still, since the levy is used to finance future Social Security obligations, a good argument can be made that the restoration of the previous, higher rate represents a necessary, if painful, reversion. What is far less defendable, though, is the fact that the Social Security tax only applies to income up to $113,700. That is, if you make $500,000 per year, then $386,300, or 77%, of your income is not taxed for Social Security contributions.

Interestingly, some of the same people who sound the loudest warning cries on the alleged impending bankruptcy of our Social Security Trust Fund (SSTF) are the same individuals pushing most aggressively against any increase in taxes. Actually, this is more than interesting. It’s blatantly hypocritical, as Patrick argued in a recent post.

Allowing the Social Security tax to apply to income at all levels would generate billions of dollars in new revenue, helping to safeguard our SSTF for future generations. What it would probably not do is significantly affect the spending behavior of high-income earners. And, even if it did, that might not be such a bad thing. 

This is where the Times piece is at its best. While taking readers inside the difficult choices middle-income earners are having to make now that they’re earning $20, $30, or $60 less each month, the article quotes Richard Thaler, a professor at the University of Chicago’s Booth School of Business, as saying, “I wouldn’t expect [the recent Social Security tax hike] to have much of an effect on BMW consumption.” But, it may stop Eddie Phillips, who lives in Harlem and makes $22,000 a year, from making next month’s life insurance payment on-time.

Federal policies, especially fiscal policy, have an intimate impact on the everyday decisions of middle-class Americans. Slightly smaller paychecks don’t mean much for high-income earners. But, for those living from week to week, a small reduction in disposable income can mean the difference between buying healthy groceries in the next town over, or saving gas money to buy cheaper, yet less nutritious food at the corner closer to home.

In light of this, it behooves policymakers to do everything they can to make sure that the tax code does not arbitrarily burden middle-class Americans, let alone the most vulnerable. In the case of the payroll tax, there is no sound reason – based either in practice or in theory – why we should cap the levy at $114k. To the extent that removing the cap reduces the wealthiest Americans’ demand for things like sports cars, yachts, and private planes, one can easily counter that the benefit of increased revenues to the sustainability of the SSTF far outweighs the consequences for the economy of reduced spending on high-end goods.

Plus, it’s just fair. Why should wealthier Americans face less of a burden in their tax payments than their lower-earning counterparts, particularly when it comes to footing the bill for Social Security? Moreover, by raising or eliminating the ceiling on the payroll tax, we could perhaps lower the marginal rate for middle- and lower-income earners. Doing so would still generate significant new revenue, increase the take-home pay of non-rich Americans, and help ensure that Mr. Phillips can both put money towards his life insurance to protect his family in case of an accident and look forward to a steady income when he reaches old age.

The politics of fiscal policy are brutal. They should be. These are big decisions, and they impact literally every American. But some things just make sense. Eliminating the payroll tax ceiling is one of them.

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