Time to Cut the Payroll Tax

Since the 9/11 terrorist attacks, many policymakers have advocated a payroll tax cut to reduce labor costs and boost consumption. Surprisingly, many conservatives who normally support tax cuts of any sort become wobbly when it comes to payroll taxes. Some, including supply-side guru Bruce Bartlett, have openly criticized the wisdom of enacting payroll tax cuts if they are not accompanied by comprehensive Social Security reform.

Their argument is straightforward: Payroll tax cuts are a trap that would prevent the partial privatization of Social Security by returning the funds necessary for the transition to a system of Personal Retirement Accounts – estimated at roughly $1 trillion – to taxpayers. Cutting payroll taxes now, these critics argue, would mean even higher taxes later as the pay-as-you-go system goes from surplus to deficit.

Payroll taxes are unique in that they are specifically earmarked for future benefits, as opposed to taxes that go into general revenue. Payroll taxes are paid with the expectation that the tax will be recouped in the form of old age or disability benefits. But because both Social Security and Medicare are intergenerational income transfer systems where today’s workers pay benefits for today’s retirees, there is really no linkage between a worker’s payroll tax dollars and the actual benefits he or she will receive.

Indeed, as the Supreme Court ruled in Flemming v. Nestor, workers have no right to collect payments made into Social Security; once collected, payroll tax dollars become the property of the government. Talk of Social Security as some sort of “social covenant” is just that: In reality, lawmakers set Social Security taxes and benefits with little regard for past contributions or expectations for the future. Social Security and Medicare are quintessential government redistribution schemes that enrich one constituency at the expense of others.

Social Security’s benefits and taxable income ceiling are based on an annual Cost-of-Living Adjustment (COLA) that indexes taxes and benefits to the Consumer Price Index (CPI). This year, for example, taxes on the average worker will rise by $558, while the average monthly benefit for all retired workers will rise from $852 to $874. Such reliable annual benefit increases – irrespective of the economy’s ability to sustain them – has placed Social Security in quite a bind. Current projections by Social Security’s actuaries suggest that if the program is not reformed, payroll taxes will need to increase by at least 6 percent in the next 20 years simply to maintain current benefit levels.

A payroll tax cut may exacerbate Social Security’s current $3.2 trillion un-funded liability, but the entire system is in such dire financial straits that a payroll tax cut at this stage would be akin to cutting half an hour off the Titanic’s voyage. In other words, it is not the drastic measure that some payroll tax defenders would have you believe.

But a payroll tax cut will not only do little to harm an already doomed system, if done right, it could provide an immediate economic benefit. The payroll tax is particularly damaging in a time of growing unemployment because it increases the cost of labor. The 7.65 percent payroll tax paid by employees, listed as FICA on pay stubs, is only 50 percent of the total payroll tax burden. The other 50 percent is paid directly by employers, who must send 8 cents of every dollar in wages (up to $80,400 per employee) to the government.

Worse, the withholding and remittance regulations are so cumbersome that employers must incur significant costs simply to comply with federal rules. Compliance difficulties are so great that in a recent letter to House Ways and Means Chairman Bill Thomas (R-Calif.), the National Payroll Reporting Consortium (NPRC) advised Congress against any payroll tax cut that is retroactive, targeted for select payroll taxpayers, or takes effect before January 1, 2002, because the administrative costs of such changes would outweigh their benefits. Clearly the payroll tax should be simplified as its rate is cut.

Unfortunately, most proposals for payroll tax relief tend to focus on temporarily reducing the employee contribution, where the economic benefits would not be as great. It would give money directly to lower income workers – those who are most likely to spend it – thereby increasing current consumption. But, it could be argued, that such demand-driven “pump-priming” could be just as likely to cause inflationary pressures in the wake of the 9/11 terrorist attacks as it would be to promote growth.

One thing is for certain: Cutting workers’ payroll taxes, even temporarily, would be far better than more government spending. Even a temporary cut would be better than a rebate check for people who don’t pay taxes,which is essentially a spending program dressed up as a tax cut. Moreover, allowing workers to see how much the government takes out of each paycheck in payroll taxes – even if it is just half of the total payroll taxes withheld – makes for great politics. When the payroll tax returns to confiscate the extra hundreds of dollars workers enjoyed in its absence, the political pressure for future tax cuts will intensify.

And after all, the best argument for the partial privatization of Social Security is to allow workers to keep and invest their own money instead of trusting their security to the whims of elected officials. Private control of their own finances gives workers what Social Security does not – private ownership and a guarantee that what they earn and save for retirement is theirs and theirs alone.

If comprehensive Social Security reform is not on the immediate political horizon, simply returning the government funds to workers in the form of a payroll tax cut is the best available option. Concern for the immediate finances of a dying wealth transfer system should not override a worthwhile attempt to reduce the nation’s overall federal tax burden, which currently accounts for over 20.6 percent of U.S. Gross Domestic Product, a peacetime record.