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Posts Tagged ‘Payroll Tax’

My views on the value-added tax are very simple and straightforward.

If we completely eliminated all income-based taxes, I would be willing to accept a VAT (or even a national sales tax) as a revenue source for government.

But unless that happens, I’m unalterably opposed because it’s far too risky to give politicians two major sources of tax revenue. Just look at what happened in Europe (and Japan). Before the VAT, the burden of government spending wasn’t that much higher in Europe than it was in the United States. Once VATs were adopted, however, that enabled a vast expansion of the welfare state.

This is why I’m worried about the Rand Paul and Ted Cruz tax plans. On paper, both plans are very good, dramatically lowering income tax rates, significantly curtailing double taxation, and also abolishing the corporate income tax. But I don’t like that they both propose a VAT to help make up the difference. It’s not that I think they have bad intentions, but I worry about what happens in the future when a bad President takes office and has the ability to increase both the income tax and the value-added tax. When the dust settles, we’re France or Greece!

By contrast, if we do some type of tax reform that doesn’t include a VAT, the worst thing that could happen when that bad president takes office is that we degenerate back to the awful tax code we have today. Which would be unfortunate, but not nearly as bad as today’s income tax with a VAT on top.

Bad since I’ve already addressed this issue, let’s focus on a part of the Paul and Cruz tax plans that has received very little attention.

Both of them propose to get rid of the payroll tax, which is the part of your paycheck that goes to “FICA” and is used to help fund Social Security and Medicare.

Alan Viard of the American Enterprise Institute has a column in U.S. News & World Report that explores the implications of this repeal.

Would you like to see the FICA item on your pay stub go away and be able to keep the 7.65 percent that the payroll tax takes out of your paycheck? If so, Republican presidential candidates Rand Paul and Ted Cruz have a deal for you – each of them has proposed getting rid of the tax. The senators’ plans would also eliminate the other 7.65 percent that the government collects from your employer, which you ultimately pay in the form of lower wages.

That sounds good, right? After all, who wouldn’t like to keep 15.3 percent of their income that is now being siphoned off for entitlement programs.

But here’s the catch. As Alan explains, other revenue sources would be needed to finance those programs, particularly Social Security.

The payroll tax finances two large benefit programs – 6.2 percent goes to Social Security and 1.45 percent goes to Medicare Part A. If the payroll tax went away, we would have to find another way to pay for those benefits. Paul and Cruz would turn to a value added tax, known as a VAT. …using it to pay for Social Security would have repercussions for the program that the candidates haven’t thought through. …once the payroll tax was gone, Social Security would no longer be a self-financed program with its own funding source. Instead, it would draw on the same general revenues as other government programs.

Viard thinks there are two problems with using VAT revenue to finance Social Security.

First, it means that there’s no longer a limit on how much money can be spent on the program.

…having a separate funding source for Social Security has been good budgetary policy. It’s kept the program out of annual budget fights while controlling its long-run growth – Social Security spending is limited to what current and past payroll taxes can support.

Second, replacing the payroll tax with a VAT eliminated the existing rationale for how benefits are determined.

And that will open a potential can of worms.

…what would happen to the benefit formula if the payroll tax disappeared and Social Security was financed by general revenue from the VAT? Paul and Cruz haven’t said. …One option would be to switch to a completely different formula, maybe a flat monthly benefit for all retirees. …that would be a big step, cutting benefits for high-wage workers and posing tricky transition issues.

I imagine there are probably ways to address these issues, though they might wind up generating varying degrees of controversy.

But I’m more concerned with an issue that isn’t addressed in Viard’s article.

I worry that eliminating the payroll tax would make it far harder to modernize Social Security by creating a system of personal retirement accounts.

With the current system, it would be relatively easy to give workers an option to shift their payroll taxes into a retirement account.

If the payroll tax is replaced by a VAT, by contrast, that option no longer exists and I fear reform would be more difficult.

By the way, this is also the reason why I was less than enthused about a tax reform plan proposed by the Heritage Foundation that would have merged the payroll tax into the income tax.

Yes, I realize that genuine Social Security reform may be a long shot, but I don’t want to make that uphill climb even more difficult.

The bottom line is that I don’t want changes to payroll taxes as part of tax reform, particularly when it would only be happening to offset the adverse distributional impact of the VAT, which is a tax that shouldn’t be adopted in the first place!

Instead, let’s do the right kind of tax reform and leave the payroll tax unscathed so we’ll have the ability to do the right kind of Social Security reform.

P.S. Some of you may be wondering why Senators Paul and Cruz included payroll tax repeal in their plans when that leads to some tricky issues. The answer is simple. As I briefly noted above, it’s a distribution issue. The VAT unquestionably would impose a burden on low-income households. That would not be nice (and it also would be politically toxic), so they needed some offsetting tax cut. And since low-income households generally don’t pay any income tax because of deductions, exemptions, and credits, repealing the payroll tax was the only way to address this concern about fairness for the less fortunate.

P.P.S. Since we have a “pay-as-you-go” Social Security system, with benefits for current retirees being financed by current workers, some people inevitably ask how those benefits will be financed if younger workers get to shift their payroll taxes into personal retirement accounts. That’s what’s known as the “transition” issue, and it’s a multi-trillion-dollar challenge. But the good news (relatively speaking) is that coming up with trillions of dollars over several decades as part of a switch to personal accounts will be less of a challenge than coming up with $40 trillion (in today’s dollars) to bail out a Social Security system that is actuarially bankrupt.

P.P.P.S. It goes without saying (but I’ll say it anyhow) that class-warfare taxation is Obama’s (and Hillary’s) ostensible solution to Social Security’s shortfall.

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It’s time for a lesson in tax economics.

Though hopefully today’s topic won’t be as dry and boring as my missives on more technical issues like depreciation and worldwide taxation.

That’s because we’re going to talk about the taxation of workers, which is something closer to home for most of us.

And our lesson comes from Belgium, where the government wants a “new social contract” based on lower “direct” taxes on workers in exchange for higher “indirect” taxes on consumers.

Here are some excerpts from a Bloomberg column by Jean-Michel Paul.

Belgium’s one-year-old government announced measures, radical by that country’s standards, to move the burden of taxation to consumption from labor.  The measures are being hailed as the start of a new social contract in the heart of Europe.

But before discussing this new contract, let’s look at how Belgium’s system evolved. Monsieur Paul explains that his nation has a bloated welfare state, which has resulted in heavy taxes on workers (vigorous tax competition precludes onerous taxes on capital).

…In order to sustain large government expenses of more than 50 percent GDP on top of servicing its debt, Belgium became the OECD’s second most-taxed economy. …Belgium made a choice: It decided to heavily tax labor, which it figured, wrongly, was stuck. At the same time, it decided to provide attractive tax treatment to highly mobile capital. The gambit meant that Belgium attracted a large number of wealthy families from higher tax countries, particularly France and the Netherlands, eager to take advantage of the low rates of tax on capital. However, Belgian workers got hammered. In 2014 Belgian workers were the most taxed labor in the developed world, taking home only 46 percent of employers’ labor costs.

Here’s a chart from the article, showing that Belgian workers are the most mistreated in the developed world.

Keep in mind, by the way, that average rates only measure the overall burden of taxation.

Marginal tax rates, which are what matters most for incentives, are even higher.

According to Wikipedia, the personal income tax has a top rate of 50 percent, and that punitive rate hits a lot of ordinary workers (it’s imposed on income “in excess of €37750”). But there’s also a 13 percent payroll tax on workers and a concomitant payroll tax of more than 30 percent on employers (which, needless to say, is borne by workers).

So an ambitious Belgian worker who wants to earn more money will be confronted by the ugly reality that the government will get the lion’s share of any additional income. Geesh, no wonder Belgium gets a high score (which is not a good outcome) in the World Bank’s “tax effort report card.”

Not surprisingly, high tax rates on labor have led to some predictably bad consequences.

The entrepreneurial class is voting with its feet and regular workers are being taxed into the unemployment line.

This unusual policy mix has increasingly created problems. …Educated professionals and entrepreneurs, those most in demand in other countries, have voted with their feet in borderless Europe. As a result, productivity growth has been limited and Belgium’s economy remained low-growth. Its business start-up rate is the second lowest of the EU. …Whole segments of the country’s industrial tissue, such as the automobile sector, have gradually closed down… This has led to what the European Commission described as “a chronic underutilisation of labour” (read: unemployment) especially among the least qualified and the young. Youth unemployment stands at over 22 percent. …In its 2015 country report the Commission noted that this “reflects Belgium’s high social security charges on labour, which add to the large tax wedge”

Given these horrid numbers, it’s understandable that some policy makers in Belgium want to make changes.

But as Americans have learned (very painfully), “change” doesn’t necessarily mean better policy.

So let’s see what Belgian policy makers have in mind.

The new policy…is to reduce taxes on labor and increase indirect taxes to compensate. Social Security taxes on companies are being reduced to 25 percent from 33 percent over the next two years, bringing an increase in the net after-tax income of 100 euros ($113) per month for low and middle-wage earners. This is mainly financed by an increase in value added tax on electricity consumption. …Belgium is the first to implement what some call a “social VAT” (a tax on consumption to finance social security). …it rewards work and may well change the entitlement mind-set that has hampered innovation and job growth for decades. …a significant step in the right direction, correcting some of the worst distortions of Belgium’s social model.

In other words, politicians in Belgium want to rearrange the deck chairs on the Titanic.

Workers will be allowed to earn more of their income when they earn it, but the government will grab more of their income when they spend it.

Now for the economics lesson.

People work because they want to earn money. And they want to earn money so they can spend it. In other words, as Adam Smith observed way back in 1776, “Consumption is the sole end and purpose of all production.”

Now ask yourself whether the change in Belgian tax policy will boost employment when there’s no change in the tax wedge between pre-tax income (the income you generate) and post-tax consumption (the income you get to spend)?

The answer presumably is no.

This doesn’t mean that the proposed reform is completely useless. It appears that the VAT increase is achieved by ending a preferential tax rate on electricity consumption. And since I don’t like distorting tax preferences, I’m guessing the net effect of the overall package is slightly positive.

In other words, the lower payroll tax rate is unambiguously good and the increase in the VAT burden is only partially bad (I would be more critical if the proposal included an increase in the VAT rate rather than the elimination of a preference).

That being said, now let’s address Belgium’s real problem. Simply stated, it’s impossible to have a good tax system when government spending consumes more than 50 percent of economic output.

In no uncertain terms, an excessive burden of government spending is the problem that needs to be solved.

P.S. Interestingly, Belgium’s tax shift is somewhat similar to Rand Paul’s tax plan. In addition to all the other changes envisioned by the Kentucky Senator, he would get rid of the payroll tax and replace it with a value-added tax.

P.P.S. In addition to much smaller government, I suspect Belgium also needs to split into two different countries.

P.P.P.S. To get an idea of Belgium’s challenge, the politicians in Brussels actually criticize Germany for being too capitalistic.

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Washington is filled with debate and discussion about the economic burden of the federal income tax, which collected $1.13 trillion in FY2012 ($1.37 trillion if you include the corporate income tax).

Yet politicians rarely consider the economic impact of payroll taxes, even though these levies totaled $.85 trillion during the same fiscal year.

Yes, we had a gimmicky payroll tax holiday for the past few years. And it’s true that Obama has signaled that he wants to increase the payroll tax burden at some point to prop up the Social Security system.

But there’s rarely, if ever, a discussion of wholesale reform.

That’s actually a good thing. Compared to the income tax, the payroll tax does far less damage. And it’s not just because it collects less money. On a per-dollar-raised basis, the payroll tax is considerably less destructive than the income tax.

Why? Because it’s actually a form of flat tax.

  • It has only one tax rate. There’s a 12.4 percent tax for Social Security and a 2.9 percent tax for Medicare, which means a flat tax of 15.3 percent.
  • There’s almost no double taxation. The payroll tax applies to wage and salary income, as well as personal earnings from business activities (sometimes known as “Schedule C” income). But dividends, interest, and capital gains are generally spared – other than the 3.8 percent Obamacare surtax.
  • There are no loopholes or deductions for politically connected interest groups.

And because of these three features, the tax is remarkably simple and doesn’t even require a tax form unless taxpayers have Schedule C income.

None of this, by the way, means the payroll tax is a good or desirable levy.

  • It takes for too much money from the American people and is far and away the biggest tax paid by the majority of American workers.
  • Those revenues are used for two programs – Social Security and Medicare – that are actuarially bankrupt and contributing to the nation’s long-run fiscal collapse.
  • The 15.3 percent tax undermines work incentives by driving a wedge between pre-tax income and post-tax consumption.
  • And the tax is very non-transparent, particularly since many taxpayers don’t even realize that the “F.I.C.A.” tax on their pay stub only reflects 50 percent of their payroll tax burden. In a hidden form of pre-withholding, employers pay an equal amount to the government on behalf of their workers – funds that otherwise would be part of worker compensation.

In other words, the payroll tax is a bad imposition. That being said, it still does considerably less damage, on a per-dollar-collected basis, than the income tax.

With that in mind, I’m puzzled that some folks want to keep the income tax and get rid of the payroll tax.

My friends at the Heritage Foundation, for instance, have a tax reform proposal that would fold the payroll tax into the income tax. Since they’re also proposing to turn the income tax into a form of flat tax, with one rate and no double taxation, the overall proposal clearly is a big improvement over today’s tax system. But all of the improvement is because of reforms to the income tax.

The Washington Examiner has an even stranger position. The paper recently editorialized in favor of abolishing the Social Security portion of the payroll tax and expanding the income tax.

The payroll tax — 12.4 percent, split between workers and their employers to help finance Social Security — is one of the worst taxes on the books for several reasons. A basic economic principle is that when the government taxes something, the nation gets less of it. Because the payroll tax makes it more expensive and administratively burdensome for businesses to hire workers, it’s a drag on employment. Also, even the employer’s share of the tax is effectively passed on to workers in the form of lower salaries and benefits.

There’s nothing overtly wrong with the above passage. The tax does all those bad things. But the income tax does all those things as well, but in an even more destructive fashion.

The editorial addresses a couple of potential objections, starting with the notion that the payroll tax is a revenue dedicated to social Security.

There are two main objections to scrapping the payroll tax. The first is the theoretical idea that payroll taxes are a dedicated revenue stream for Social Security. In practice, it just isn’t true. All government expenditures ultimately come from the same place. Payroll taxes help subsidize other government functions, and the government will use other tax revenue and borrowing to pay for Social Security when revenues are short.

They’re right that all taxes basically get dumped into the same pile of money and that the relationship between payroll taxes and Social Security benefits is imprecise.

But since my argument has nothing to do with this issue, I don’t think it matters.

Here’s the part of the editorial that doesn’t make sense.

The other objection is the massive revenue hit to the federal government. In 2010 (the last year before the recent payroll tax holiday), social insurance taxes raised $865 billion in revenue, according to the Congressional Budget Office. But there are a number of ways to recoup that revenue. As stated above, eliminating the payroll tax would make it easier to get rid of a lot of credits, loopholes and deductions. Also, if lower-income Americans aren’t paying payroll taxes, they can pay a bit more in income taxes. This would also deal with a conservative complaint that the income tax system needs to be reformed so everybody has at least some skin in the game.

This passage has a policy mistake and a political mistake.

The policy mistake is that the proposed swap almost surely would make the overall tax code more hostile to growth. The Examiner is proposing to get rid of an $865 billion tax that does a modest amount of damage per dollar collected, and somehow make up for that foregone revenue by collecting an additional $865 billion from the income tax system – which we know does a very large amount of damage per dollar collected.

To be sure, it’s possible to collect that extra money by eliminating distortions such as the state and local tax deduction or the healthcare exclusion. Compared to raising marginal tax rates, those are much-preferred ways of generating more revenue. But even in a best-case scenario – with politicians miraculously trying to collect an extra $865 billion without making the income tax system even worse, it’s hard to envision a better fiscal regime if we swap the payroll tax for a bigger income tax.

The political mistake is the assumption that more people will have “skin in the game” if the income tax is expanded. That’s almost surely not true. The poor don’t pay income tax, but the payroll tax grabs 15.3 percent of every penny earned by low-income households. And since very few taxpayers pay attention to which tax is shrinking their paychecks, it doesn’t really matter whether the “skin” is a payroll tax or an income tax.

Since the Examiner isn’t proposing a specific plan, there’s no way of making a definitive statement, but it’s 99 percent likely that eliminating the Social Security payroll tax would result in low-income households paying even less money to Washington. I think everybody should send less to Washington, but I don’t think shifting a greater share of the tax burden onto the middle class and the rich is the right way of achieving that goal.

I have one final objection, and this applies to both the Heritage Foundation plan and the Examiner proposal.

Notwithstanding everything I just wrote, I actually agree with them that we should eliminate the Social Security payroll tax. But we should get rid of the tax as part of a transition to a system of personal retirement accounts.

This is a reform that has been successfully implemented in about 30 nations and it also should happen in the United States. But an integral feature of this reform is that workers would be allowed to shift their payroll taxes into personal accounts. Needless to say, that’s not possible if the payroll tax has disappeared.

This video explains why genuine Social Security reform is so desirable.

And let’s not forget that the Medicare portion of the payroll tax could and should be part of a broader agenda of entitlement reform. But that’s also less likely if the payroll tax is folded into the income tax.

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I’m disappointed, but not surprised, to read in the Washington Post that President Obama has decided against any changes to restrain Social Security spending. He’ll still probably subject us to pious and insincere rhetoric about fighting red ink in tonight’s State-of-the-Union address, but it is very revealing that the President is rejecting even the recommendations of his hand-picked Commission.

More than two months after his deficit commission first laid out a plan for reining in the national debt, President Obama has yet to embrace any of its controversial provisions – and he is unlikely to break that silence Tuesday night. …the president’s decision not to lay out his own vision for reducing the national debt has infuriated balanced-budget advocates, who fear that a bipartisan consensus for action fostered last month by Obama’s commission could wither without presidential leadership. …Liberals…applauded the decision, arguing that Social Security cuts are neither necessary to reduce current deficits nor a wise move politically.

I won’t be surprised, though, if Obama proposes in his budget to increase the Social Security payroll tax burden. That’s an idea he endorsed during the 2008 campaign.

The right approach, by the way, is not just cutting benefits, but rather letting younger workers shift their payroll taxes into personal retirement accounts, as explained in this video that was released earlier this month.

But the President’s reluctance to touch Social Security is only part of the story. The White House actually intends to push for more government spending. Only they won’t phrase it that way. The President will claim the new spending is an “investment.” But Senator Durbin of Illinois committed a gaffe and admitted this is just a repeat of the failed stimulus.

“It’s part of a stimulus. but we’re sensitive to the deficit,” Durbin said on “Fox News Sunday” when asked by host Chris Wallace about the president’s expected plans to call for more spending for infrastructure, education, research in his State of the Union address Tuesday night to a joint session of Congress.

I’m not sure why people are talking about a new, centrist-oriented Obama. Recycling big-government proposals is hardly a sign of fiscal restraint. And ducking-and-running on entitlements hardly seems to indicate a new era of fiscal responsibility.

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A “bipartisan” task force recently unveiled a budget plan that includes lots of tax increases, but also has a one-year payroll tax holiday supposedly designed to boost the economy. In a debate with a former Bush Administration appointee on CNBC, I explain why this is a dumb way to try to boost growth. My Lima-beans-in-a-steakhouse analogy hopefully gets the point across, though the line about supermodels will get more attention.

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