The Right Tax
A Moral Economy #12. Part III: How do we get from here to there?
This continues a three part series of excerpts from Social Security Basic Income: A Safety Net for All Americans, which I published in March 2020. Part I: What would it look like? concluded with #2 and Part II: What do we have? concluded with #8. This essay includes text from Chapter 5 Slaying the Payroll Tax Dragon. Refer to #1 in the series for a brief introduction of my purpose and perspective on this subject.
What’s in it for me?
In the preceding essays, I demonstrated that we could pay for Social Security and Medicare benefits with income taxes instead of the payroll tax with a scheme I call Free to Work (FTW). This one will illustrate how that impacts people with different types and levels of income.
Many with high incomes who have become accustomed to low federal income taxes will be hit hard. Nevertheless, we should have no qualms about reversing policies that have worsened income inequality. FTW is a step toward correcting past wrongs; it shifts tax burdens to those able to bear them; leaving tax breaks in place will require raising taxes even more for people who have not enjoyed those breaks, which would be most unfair.
Generally, the poor will strongly favor my proposals while the rich will just as strongly oppose them. Those who need convincing that this is a move in the right direction are in the middle class; they, too, are most interested in how tax reforms will affect their own pocketbooks.
Under FTW, almost everyone above the Federal Poverty Guidelines — currently $14,580 for individuals and $30,000 for a family of four — will have to pay more income tax, but most low and middle income taxpayers will be significantly better off (5–10 percent more net income) because their paychecks are at least 7.65 percent larger.
There is one exception — those receiving above average Social Security payments. They are also most likely to have other sources of earned or unearned income. However, those who do not may not pay any federal income tax currently, but will find their benefits fully taxable under FTW and cost them 4–8 percent of adjusted gross income. This group, having worked hard enough and long enough to pay significant sums into the system and finding themselves completely dependent on it, may be outraged by having their benefits taxed. But their benefits are being paid by current taxes on others. I’m sympathetic toward those who did not ask for special treatment and merely played by the established rules. On the other hand, I think we owe more to those who have carried disproportionate burdens, and allowing exceptions to drive the debate could abort overdue reforms and impose tremendous opportunity costs on the undeserving middle class.
Smith and Jones
Let’s look at two examples of what FTW would mean for a middle-income family and for a single, self-employed individual with higher earnings.[1]
Payroll taxes for the Smiths, a married couple with two children and combined wages of $75,000, which is slightly above the median household income, would be $5738. Their taxable income is $49,900 and they pay $1607 in income tax (after deducting $4000 for the child tax credit). Their federal tax total is $5738 + $1607 = $7345 and their net disposable income is $63,555 after paying for health insurance ($4100). Under FTW, their total tax bill (including the FTW child allowance of $10,000) is just $90 and their disposable income is $70,810, which is $7255 or 11 percent higher. Since their earned Social Security benefits are frozen and the earnings that would have gone toward payroll taxes are available, they should consider investing some of those savings in an IRA or 401(k). Suppose they have IRAs and decide to invest $6000 ($3000 each). Their taxable income drops to $45,900; they get a tax refund of $630 and their disposable income is $65,540, which is still higher than the status quo (SQ) amount. Moreover, their net worth is $6000 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, $5,000 for charitable deductions, and the maximum $10,000 for state and local income and property taxes. She pays $7700 annually for health insurance. Her self-employment tax (OASDI + HI) liability (15.3 percent) is $17,182 and FIT is $12,755, which yields a net disposable income of $82,364.[2] Under FTW, the self-employment tax disappears, but so do itemized deductions. Now taking the standard deduction of $12,550, her taxable income is much higher, but her total tax bill is much lower ($20,449), and her disposable income is $91,852 — $9488 (12 percent) higher than under SQ. That’s money she can reinvest in her business, spend, or save. Since $120,000 is a very nice income, especially for a single person, it may be surprising that Ms. Jones’ take-home pay would be so much higher after losing over $20,000 in deductions and covering the 5 percent surtax on taxable income above $50,000. Look at the numbers. She can pay her share of the surtax and have money left over because she no longer has to pay self-employment tax.
[1] Calculations use 2021 tax brackets. Health insurance cost for individuals and families with wages at or above $40K and $80K, respectively, and higher Sched. C or unearned incomes estimated using the 2021 Kaiser Annual Survey of Employer Health Benefits. Other estimates use the Kaiser 2021 Health Insurance Marketplace Calculator. Those with very low incomes or OASDI as a sole source of income are assumed to be receiving Medicare or Medicaid.
[2] To maintain comparability with those taking the standard deduction, items like mortgage interest and state taxes are not subtracted from disposable income, whereas (per the preceding Smith example), out-of-pocket health costs are subtracted.
Closing the gap and bending the curve
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. All examples include estimated health insurance premium payments and standard or itemized deductions based on recent national averages from reliable sources. For married filers, I assumed two children and included the EITC and proposed child allowance. Then I calculated taxable income, taxes (including payroll for SQ), and net incomes under all three scenarios. Finally, I compared net incomes and average tax rates (total federal taxes as a percentage of gross income, including employer-paid health insurance premiums). Results for each income type at each level are shown in the tables below.[1]
The most interesting results are in the last two columns, which compare tax rates for individuals and families with different sources of income and tax rates for individuals and families at different levels of income. Together, these data show how FTW changes relative taxation of wage, self-employment, and unearned income and the slope or progressivity of tax rates at different levels of income, as compared to SQ.
In the first chart below, we see that tax rates are lowest for those with unearned income and highest for the self-employed.[2] For single filers, the difference is 10 percentage points at the low end ($10K), where those with unearned income pay zero taxes; at $160K, the average rates are 18 percent and 25 percent, respectively. Clearly, this is the payroll tax effect. This is a best-case scenario in terms of inequality because the unearned estimates assume ordinary income tax rates, not the lower capital gains rates.
The second chart shows tax rates for the same income types and levels under FTW. It’s a very different picture, with rates starting at zero for single filers with all types of income and rising steadily to 21–23 percent. The impact of FTW is dramatic; it almost eliminates differences at each income level and lowers all tax rates at lower levels of income, thereby creating a truly progressive federal income tax. Due to taxation of employer paid health insurance, wage earners pay the higher rates, but never more than three percentage points higher than the self-employed and unearned income groups, which pay the same rates at every level of income.
[1] High incomes where Social Security (OASDI) payments would reach a maximum assume the rest is unearned.
[2] For simplicity, OASDI results are omitted. Married filer charts are similar to those for single filers, but average tax rates are uniformly lower and fall below zero for low incomes due to the child allowance.
Biting the bullet
Analysis of Treasury data demonstrates that it is feasible to relieve America’s workers of the tremendous burden imposed by payroll taxes on their wages and self-employment earnings. The big tradeoffs in FTW are: 1) Individuals who have relied upon special tax benefits will lose them, and 2) All workers will have to save for retirement. These are controversial changes, but that’s unavoidable for significant changes to the tax code or to Social Security. The case for eliminating the payroll tax is very strong. Nevertheless, it will encounter fierce resistance fueled by momentum and tradition. Once we recognize the need for change, I see no alternative to funding existing obligations for Medicare and Social Security that does not involve slashing tax expenditures. The numbers are too big and we cannot justify raising taxes on the middle class to continue special treatment of the wealthy.
Our economy will not crumble if capital gains and mortgage interest payments are fully taxable. In fact, it may restore some semblance of reality — and justice — to markets. This is not socialism; it’s real capitalism, in which borrowers pay savers (instead of financial institutions that enjoy rents created by artificially low interest loans from a central bank). In other words, these two tradeoffs are not separate but related. Real interest rates must rise to encourage savings so that workers can obtain financial security during their working years as well as for retirement. They have been abandoned by employers who no longer find it profitable to fund pension benefits and by a government that has also made promises it can no longer keep. The mechanism and tax incentives are in place for privately funded savings accounts; unfortunately, wages are insufficient and yields are at the mercy of Wall Street, which is not a friend to Main Street, never mind workers.
Until we figure out what can be done about monetary policy, the least we can do is use fiscal policy to mitigate the damage. Shifting the tax burden back to those with incomes that can bear the burden, through simple yet radical reforms along the lines of FTW, is a blunt instrument to counter the blunt instrument of inflation that is pounding the working class even without help from regressive taxation. My proposal offers no magic bullet. We will eventually have to abandon 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.
The next essay in this series will continue Part III: How do we get from here to there? It will include text from Chapter 5 Slaying the Payroll Tax Dragon.
