Free to Work: Real Tax Reforms to Liberate America’s Working Class
Wall Street had a very good year in 2017; stock exchange indices set new highs and Congress delivered the Tax Cuts and Jobs Act of 2017 (TCJA) — a present that had been on their wish list for years. Workers got another promise of trickle-down benefits that was not taken seriously. What is happening here? Some called it political suicide — predicting a “bloodbath” in the November mid-term elections. But if that was in the works already, the tax cut was more likely a desperate act by politicians with nothing to lose. Either way, we should be far less concerned about which party controls the White House, the Senate, and the House of Representatives, and focus our attention on the growing exploitation of the working class by the ruling class.
As I argued in an essay, “Work and Ethics,” U.S. voters have allowed exploitation of workers by “job creators” who have taken control of the federal work/welfare/tax system. Fifty years ago, power in the labor market was more balanced; employers and workers shared the benefits of productivity growth. Since then, wages have not kept up and yet the ruling class responds to the evidence with policies such as the recent corporate tax cut. In 2014, a House Budget Committee Report admitted Congress’ failure: “Today, the poverty rate is stuck at 15 percent — the highest in a generation. And the trends are not encouraging. Federal programs are not only failing to address the problem. They are also in some significant respects making it worse.”
Voters who are fed up with this sort of representation need to insist on change but may not know where to begin. This paper will suggest policy options that mitigate the damage by improving the returns and bargaining power of labor, making us all free to work — or not. Most Americans have no choice but to work for others in pursuit of life, liberty, and happiness. We should put freedom first by enacting policies that provide citizens the widest possible choice regarding our own labor.
Shame is not working
Shaming people into work is not working, and neither is shaming elected officials in Washington into changing those policies. Welfare-to-work policies have not reduced poverty, but politicians continue to push them because they believe work is a duty for citizens and a resource we have elected them to manage. They suggest that those who are not working are lazy, that if employers cannot fill positions, it is because no one is qualified, and that workers’ lack of qualifications is a problem for public institutions. The national unemployment rate excludes people who have lost hope and quit looking for work; some interpret lower numbers as suggesting jobs are plentiful. And to make matters worse, all jobs are counted the same, regardless of hours worked or wages paid. Unfortunately, labor statistics have become measures of gifts from the “job creators” to the people. National welfare is measured by production, not prosperity of the producers.
An enlightened public policy would replace the class-based, sanctimonious notion that work is noble with an honest recognition that work is primarily a means to consumption. It’s evil to pretend we are helping someone by giving them a job when that is the only way they can survive. Proposals to guarantee jobs are wasteful and do nothing to address the injustice of such an attitude. No wonder we have a system that is carefully designed to make all able-bodied persons “earn” their keep and hypocritically avoids subjecting those with means (plenty of unearned income) to the same indignities. Instead of shaming people who don’t work, we should help those who do, and focus on alleviating poverty.
The payroll tax entitlement trap
The payroll tax is a suffocating burden on the working poor and small businesses that a real citizens’ legislature would recognize as a worthy target for reform. But somehow, Social Security is still considered the third rail of politics long after benefits have been delayed for all, taxed for some, and became widely regarded as a pipe dream for young workers. The regressive nature of the tax is its worst feature, but there are other reasons why we need to fund benefit payments from general revenues, starting now.[1] The corporate income tax reform campaign relied heavily on arguments that marginal tax rates in the U.S. are not competitive. In the rush to provide relief to corporations, there was no offsetting consideration of implicit marginal tax rates on the supply of labor — the poverty trap.[2] Thanks to the lockbox myth (treating payroll taxes as savings), analysis of federal taxes on individuals is overwhelmingly focused on the income tax, which is considered fair to low and middle income taxpayers because they pay a small percentage of the total. But what really matters is the total tax picture, in which the payroll tax dominates for all lower income workers.[3]
That picture is difficult to assemble under the current structure. Our social safety net is in trouble, and we need to have all cards face up on the table in order to have honest and productive conversations about policy options. As indicated above, the effect of payroll taxes on the overall distribution of federal taxes is not widely recognized. In addition, the special funding of Social Security and Medicare makes it easy to ignore these programs’ additions to the federal deficit — which are projected to grow rapidly over the next 30 years.[4] Off-budget trust fund accounting and separate funding streams do not affect obligations that are already being paid to some extent from general revenue. For Social Security, this practice facilitates determination of benefits based on taxes collected from specific individuals — a policy I will argue in the next section should be revisited. This convenience is increasing the risk that we may not be able to understand what is happening or make adjustments until we find ourselves in a fiscal crisis. Merging Social Insurance and Retirement accounts into the rest of the federal budget will make our choices more transparent and provide flexibility needed to adjust benefits and taxes.
Another pernicious feature of the current system is the faux savings aspect whereby benefits are “earned” through contributions. As I explained in a journal article proposing Social Security Basic Income, fiscally responsible changes are resisted by several generations of workers who were promised benefits based on taxes paid over a lifetime of work. Each retiree’s benefits are paid by taxes collected from several working people. And every dollar collected is an entitlement to future benefits, which will require several more people to pay out of their wages, etc. The demographic/fiscal problem with this arrangement is well known. Not so widely recognized is that the entitlement is created by contributions; the only way to stop this cycle is to stop making promises by eliminating the tax.
What happens to the safety net? Obviously, we must satisfy existing obligations. However, grandfathering “earned” benefits will not satisfy everyone. In fact, the admission that we cannot increase annuities will provoke strong opposition by anyone heavily invested in the status quo. Many low-income workers who are 10–20 years from retirement have already paid a lot into Social Security, have no other savings or retirement plan, will spend any increase in take-home pay, and may find themselves in poverty when they are too old to work and the benefit earned decades earlier isn’t enough to pay rent. We need to replace it with something.[5]
Of course, not all old people are poor and not all poor people are old. Should the new safety net cover everyone below the poverty line, regardless of age or employment status? How much are we willing to spend? How will it be distributed? Who will pay for it? These questions will stoke fear and anger that more people will starve; others will be afraid of skyrocketing taxes. It’s time we had the difficult conversation about goals and effectiveness of federal social welfare policy. We need to engage citizens in prioritizing federal spending (e.g., domestic vs. defense), defining the federal role (vs. state and local governments and the private sector), and considering everyone’s needs (not just retirees). These are important questions, but as indicated earlier, they will be easier to address when we have increased the amount of information and the flexibility to use it by simplifying the tax structure. The rest of this paper describes my proposal to replace payroll taxes (Federal Insurance Contributions Act or FICA, which includes Old Age, Survivor, and Disability Insurance or OASDI and Hospital Insurance or HI) with federal income taxes.
Goals of Free to Work (FTW) reforms
America’s social welfare policy has become a complex array of taxes and benefits that can be very difficult to analyze. For this purpose, it will help to have a few guidelines for distinguishing good from bad. First, any given provision should lift more people above the poverty line. Second, it should incentivize work. Third, it should reward savings. Finally, and perhaps most importantly, it should treat everyone equally. Listed below are additional, related objectives that guide specific policies described in the following pages:
a. Raise take home pay of poor workers.
b. Relieve the middle class of a tax burden that prohibits real savings they own and control.
c. Let small business owners keep or reinvest earnings.
d. Remove incentives to incur debt.
e. Correct imbalance in treatment of earned vs. unearned income.
f. Cut tax expenditures, which are highly regressive.
Individually and collectively, these are true reforms that will help slow and perhaps reverse the trend of growing income inequality.
Income tax cuts, especially the TCJA, do nothing for those who do not pay income taxes, which includes not just the poor but most of the lower middle class. Raising the minimum wage is an alternative that has been getting plenty of attention. However, it has many limitations, foremost among them being that it reduces employment of low-wage workers. Eliminating the payroll tax would be a far more effective way of helping the poor, for several reasons. First of all, every worker benefits; take-home pay goes up by 7.65 percent for part-time, full-time, hourly, salaried, etc. This is a big boost in an era when most workers who get annual raises may only get a 1–2 percent increase. Employers may not pass along savings on their end but will find it easier to hire new workers without the additional burden.
Forced savings is paternalistic; it deprives workers of the right to act on their own preferences regarding consumption and investment. Social Security participants don’t have any choice in the amounts paid in or taken out or on the schedule for either phase — and their “contributions” do not build wealth, so there is no asset they control and may pass along to survivors. The system crushes entrepreneurs; cash flow is dear to any small business, and having to fork over 15 percent of every dollar to the tax man could prevent many of the self-employed from being able to pay bills or make investments needed to survive and grow. For those living on the edge, taxing every dollar they earn makes them more dependent on income support in the future because they find it more difficult to save.
Americans might save more if our tax code did not so clearly favor debt. Credit is essential, but low interest rates discourage savings. Stock markets benefit from cheap leverage and less competition from bonds with low yields. Those with access to capital prosper while the working class settles for virtually zero interest on their savings accounts. Special tax treatment of capital gains adds insult to injury by favoring people who have money to invest over those struggling to make ends meet. Businessmen complain about people being unwilling to work at the wages they offer. Many have taken their business abroad where labor is cheaper. Monetary policy is the main culprit here but tax policy does not help. At the very least, we can remove preferential tax treatment of unearned income.
Why is our largest income support program based on attainment of an arbitrary retirement age? And how can we justify taxing the poor to pay benefits to the rich? Social Security needs more than means testing; it needs a complete overhaul that changes the basis of payments from age to need. A lot can happen over a lifetime. A federal income support “safety net” should not withhold benefits people need today because we think they will need it years from now. Benefits should be available to any adult citizen who can demonstrate need based on income alone.[6] The system should avoid social engineering requirements that add to the cost of administration and serve primarily to exclude people. It would replace all existing federal income support programs and it would not be adjusted for locality, marital status, dependents, or any other statistical criteria. Other institutions (e.g., state and local governments or charities) may adapt their programs to eliminate redundancies or to fill gaps in cash assistance or social services according to the needs, preferences, and means of their constituents.
How much help are we able and willing to provide? Stinginess won’t really help. Excess generosity invites moral hazard and bankruptcy. A reasonable place to start is $1000/month, for two reasons: It is roughly where experts have established the poverty level and it is also near the average benefit level for the Social Security program we are replacing. Numbers will be crunched and the political process will yield a compromise of some sort. But hopefully, we will not repeat the mistake of spending now and taxing or inflating later. Whatever is decided regarding eligibility rules and benefits, it should be obligated and paid for on budget, i.e., one fiscal year at a time. This rule provides flexibility to make adjustments as needed to the fiscal and political environments. It will work if the benefit remains universal, i.e., everyone remains in the same boat and factions are not allowed to throw others overboard or sink the ship, so to speak. When the nation prospers and we can afford it, benefits will rise with the poverty level. When the economy is in recession, tax revenues fall, and average incomes are lower, benefits must be cut.
Paying for benefits no longer funded by the payroll tax will require someone’s taxes to go up. Tax Expenditures (TE) are an obvious target because generally, 1) they do not satisfy any of the FTW criteria, especially equal treatment, 2) they add up to nearly enough to offset the loss of revenue, and 3) the TCJA has made itemized deductions less valuable to lower income taxpayers.[7] It will not work to take on every special interest by arguing the merits of each item individually. A better approach is to repeal them all at once. However, there are several that affect a very large number of taxpayers and may be worth keeping because they contribute to FTW goals.
Exemption from income taxation of employer-paid health insurance premiums is the largest TE and it affects more taxpayers than any other. Employers treat premiums like wages, which are fully deductible as a business expense, yet these premiums are not taxable to the insured individuals. Because this policy disproportionately benefits higher income individuals, FTW would eliminate the expenditure, therefore making employer-paid premiums taxable. Due to the high standard deduction, lower income individuals may not see any increase in federal income tax liability and if they do, it will be offset by payroll tax savings. To equalize treatment of individuals with and without employer health plans, under FTW all health insurance premiums and out-of-pocket medical expenses would qualify as adjustments to gross income.[8] The rationale for retaining special treatment of medical expenses is that health care is essential — and it is high on the list of household expenses, especially for the poor. Just as it is good policy to encourage savings, we should provide incentives for preventive health care.
A fair trade
FTW proposals to change the federal tax code are designed to shift the balance of power from capital to labor and thereby reverse increasing inequality of incomes in the U.S. The direction is clear but it is important to dig deeper and quantify the impact on revenues and expenditures. Let’s start with the payroll tax revenue that would need to be replaced — roughly $1.2 trillion per year.[9] A neutral shift from the payroll tax to federal income taxes would maintain the equal burden distribution between individuals and employers. However, corporations only pay 1/8 of Federal Income Taxes (FIT)[10] and corporations’ share of TE was also 1/8 even before the TCJA, so reforms must focus on taxes paid by individuals. As indicated earlier, TE is large enough (estimated to exceed $1.3 trillion in 2016). However, the goals of FTW are better served by retaining a few items that affect a large number of taxpayers: the child tax credit ($24 billion), pension contributions and earnings ($196 billion), social security benefits ($36 billion), and individuals’ health care expenditures ($28 billion).[11] Together, these items total an estimated $284 billion, which means FTW reforms fall short of replacing FICA taxes by about $200 billion per year.
However, none of these figures account for behavioral changes due to TCJA or FTW. According to the Joint Committee on Taxation, TCJA will reduce federal revenue by about $200 billion in each of the next three years. Presumably, increased standard deductions under TCJA will reduce TE and therefore the revenue offsetting elimination of payroll taxes, but it is difficult to quantify. Likewise, FTW will certainly (and intentionally) increase deductions for retirement and health plan contributions, thereby further reducing FIT revenue.[12] Not everyone will do so; some will pay debts and others will spend it all. On the other hand, employers will not spend all of their payroll tax savings on deductible expenses — meaning their taxable income will go up. However, it is highly unlikely that increased business taxes will offset reductions in individual taxes. TE eliminations that redistribute about $1 trillion from special interests to (all) employers, workers, and small businesses may boost consumption and thereby have a net positive effect on tax revenue. But this is speculation; excluding macroeconomic effects, FTW will probably reduce tax revenue by $3–400 billion annually.
Ideally, we would collect a few years of data before increasing federal income taxes to make FTW reform revenue neutral. However, there are at least three reasons FTW should include adjustments to tax brackets and marginal tax rates: 1) It follows the TCJA and its bloating of an annual deficit near $1 trillion; 2) Some tax expenditures proposed for elimination may be retained; and 3) With no apparent appetite for reduced spending, Congress needs to take a close look at revenues to balance the budget. Serious consideration of FTW will require application of a sophisticated tax model that would improve upon my crude estimates and help address such complications.
Who pays and who benefits? Employers’ net income will increase; they save about $600 billion per year in payroll taxes and give up about $150 billion in tax breaks. Individuals will pay more, overall, because their share of TE eliminated under FTW is almost $900 billion — about 50 percent more than employees’ share of payroll taxes. This will disproportionately affect those with higher incomes. The consolation is that they may be able to use payroll tax savings to increase retirement plan contributions — which is advisable, given the likelihood that net Social Security benefits will be much lower than currently projected. Let’s look at a couple of examples.[13]
Payroll taxes for the Smiths, a married couple with one child and combined wages of $60,000 (slightly above the median household income) would be $4590. Under TCJA, they would most likely take the standard deduction of $24,000 and the child tax credit of $2000 would reduce their estimated 2018 FIT of $3939 to $1939. Their federal tax total for 2018 is $4590 + $1939 = $6529. Under FTW they would keep the payroll tax amount. They could spend it but since Social Security benefits are frozen, they put it all into IRAs, reducing their AGI to $55,410, taxable income to $31,410, and their FIT bill to $3388. They have the same disposable income ($53,471) but with FTW their net worth would be $4590 higher and they have an asset they control.
Ms. Jones is a single, self-employed woman making $120,000 net profit annually, with itemized deductions of $20,000 for mortgage interest, $5000 for charitable deductions, and the maximum $10,000 for state and local income and property taxes. Her payroll tax liability (15.3%) is $18,360 and FIT is $14,690, for a total of $33,050. Under FTW, the self-employment tax disappears, but so do the deductions from taxable income. Now taking the standard deduction of $12,000, her tax bill (FIT only) is $20,210. She has another $12,840 to reinvest in her business, spend, or save. If she is over 50, it’s a really good idea to save, and she could set aside up to $15,500 in a Simple IRA. This would reduce her FIT liability to $16,490. In summary, under the status quo she has $86,950 net income; under FTW, if she makes the maximum deductible IRA contribution, she has $88,010 net income plus $15,500 more in assets!
Impact at the individual and family level
Naturally, taxpayers’ experiences will vary and those especially dependent on existing tax expenditures would have difficult adjustments to make under FTW. But for ordinary tax situations, effective tax rates are much lower for workers — especially those who are self-employed — at all income levels. Social Security dependents are virtually unaffected. People with plenty of unearned income will pay slightly more in taxes.
Holding gross income constant, I calculated the impact of FTW on net incomes of single and married filers with five levels and four types of income ($10k, 20k, 40k, 80k, and 160k for single filers and twice the amounts for married filers; Wages, Schedule C (self-employment), OASDI (Social Security), and Unearned income. See Tables 1 and 2 below). To demonstrate the effect of changes in treatment of health insurance and itemized deductions, I applied average premium payments (roughly the same at all income levels) and itemized deductions (estimates from IRS data for each level). Then I calculated taxable income, FIT, and net incomes under the Status Quo (SQ) and FTW scenarios, which included deduction of FICA taxes from the SQ gross income amount. Finally, I compared the two results in dollar amounts and in terms of tax rates (total federal taxes as a percentage of AGI). Income levels were selected to represent individuals and families ranging from just below the poverty level to high income. To demonstrate variances due to income type, there are four examples at each level, each with just one type (except for the high incomes where Social Security (OASDI) would reach a maximum and the rest is assumed Unearned).
The most obvious result is that in all but a few cases, the net impact (FTW net income minus SQ net income in Tables 1 and 2) is positive. Only those with large amounts of unearned income pay more taxes under FTW, and even then, the impact is under 2 percent. Thus, FTW does not entail a massive shift of the tax burden from one class of taxpayers to another. The other clear pattern is that at all income levels, those with earned income will enjoy significant increases in net income — especially the self-employed. This is no surprise. However, the most interesting result is that, as indicated in Figures 1 and 2 below, FTW dramatically shrinks the gap in tax rates between small businesses, wage earners, and those with unearned income. For single wage earners, average tax rates drop by 4–6 percentage points. Schedule C individuals’ rates drop by 12–15 percentage points. Single filers with unearned income only would pay 1–2 percentage points more in federal taxes. For married taxpayers filing jointly, wage incomes would be taxed at average rates 3–7 percentage points lower under FTW. Schedule C rates drop by 13–16 percentage points. FTW effects on unearned income tax rates are almost nil under assumptions for the scenarios described in Table 2.
Conclusion
Analysis of Treasury data demonstrates that it is feasible to relieve America’s workers of the tremendous burden imposed by FICA taxes on their wages and self-employment earnings. The biggest tradeoffs are: 1) We need to determine what will eventually replace Social Security benefits, 2) Lower income workers will have to make retirement plans, and 3) Individuals and businesses that have relied upon special tax benefits will lose them. Each of these issues is controversial, and there are many more — meaning this proposal is no magic bullet. We still have to give up the fantasy that our social insurance system will become solvent and wages will rise without any painful confrontations, choices, and uncertainties. The good news is that we have more room to maneuver than we may have thought.
Table 1. Single Filer
Table 2. Married Filing Jointly
[1] See for example “The Best Way to Reform Social Security” and “Why Not Cut the Payroll Tax?”
[2] In addition to the risk of losing benefits that are fragmented and complex, poor people find the payroll tax a barrier to entering the workforce.
[3] In the Tax Policy Center model, marginal tax rates for the lowest quintile tax units (percent of all filers) are almost entirely due to the payroll tax.
[4] See the Congressional Budget Office report, p. 13.
[5] I propose a broader safety net, but if we stick with retirees only, an option worth considering is to gradually transition to flat benefits as described on p. 14 in this report.
[6] I support a negative income tax version of the Universal Basic Income (UBI). The Social Security Administration (SSA) is the obvious candidate for determining eligibility and making payments. To mitigate improper payments and inefficiency, they would administer a system that maintains a marginal tax rate that encourages work. Net benefit payments would expire at a multiple of 4–5 times the poverty level income.
[7] For example, the impact of the popular home mortgage interest deduction will be much lower due to the $750K limit and doubling of the standard deduction.
[8] Under current law, individuals’ share of health insurance premiums for employer plans and self-employed individuals’ premiums are not subject to FICA; they are treated as adjustments to gross income (not itemized). Participants in high-deductible plans can use Health Savings Accounts (HSAs) to exclude additional amounts from taxation. Other premiums and medical expenses are not deductible unless they exceed 10 percent of AGI.
[9] The FY 2019 President’s Budget (Table 2.1) estimates Social Insurance and Retirement receipts for 2018 at $1.169 trillion.
[10] The same table (2.1 in the FY 2019 President’s Budget) shows, for 2018, estimated individual income tax receipts of $1.660 trillion and corporate income tax receipts of $218 billion.
[11] FY 2018 estimates from the Treasury Tax Analysis October 16, 2017 pp. 31–3. The pension figure includes defined benefit and defined contribution employer plans, IRAs, savers’ credits, and self-employed plans (#144–8). The health care figure includes self-employed premiums, HSAs, and deductible medical expenses (#127–9). Six items account for almost half of the total deductions and credits for individuals: #59 mortgage interest $69 billion, #60 state & local property tax $36 billion, #71 capital gains $116 billion, #121 charitable contributions $50 billion, #126 employer contributions for medical insurance $228 billion, and #167 state and local income taxes $75 billion.
[12] Despite being dated, this study of the effects of eliminating tax expenditures is quite relevant.
[13] These calculations use the same assumptions, sources, and Excel formulas that produced results discussed in the next section and presented in Tables 1 and 2.
