Tax Analysts Blog

Think Twice Before You Kill FICA Taxes

Posted on Feb 24, 2016

What if someone waved a magic wand and suddenly increased your take-home pay? No, you wouldn’t need to put in longer hours. You’d simply be allowed to retain a larger slice of the paycheck you already earn. Who wouldn’t enjoy that?

Such is the temptation being offered by two Republican presidential candidates, Sens. Ted Cruz and Rand Paul. (Paul has discontinued his campaign, but we’re including his tax plan in this analysis.)

While their tax proposals differ, they share one common attribute. They would both eliminate the 15.3 percent payroll tax that working Americans pay on their salary and wages. These are sometimes referred to as FICA taxes, a reference to the Federal Insurance Contributions Act. Strictly speaking, half of payroll contributions are paid by employers – but the true burden of that tax is shifted to employees in the form of reduced wages.

FICA taxes fund two of the government’s biggest entitlement programs: Social Security and Medicare Part A. In the absence of a dedicated revenue source, Cruz and Paul would finance these programs through general government receipts. The revenue lost from repeal of payroll taxes would be made up through a new fiscal creation – a subtraction method value added tax -- which would also replace the corporate income tax.

Neither Cruz nor Paul dares to use the term “VAT.” Instead, they refer to the measure as either a “business activity tax” (Paul) or a “business flat tax” (Cruz). That’s because VAT has a negative connotation among much of the Republican faithful. Their opposition is rooted more in political considerations (i.e., aversion to big government) than in economics. If anything, the current election cycle illustrates how enthralled some conservatives are with the merits of a consumption-based tax code, although they struggle with the messaging.

But does it make sense to replace payroll taxes with a VAT?

No, says Alan Viard, economist and resident scholar at the American Enterprise Institute. Viard addressed this issue in his Tax Notes column, On the Margin. You can read his insightful analysis here. Viard makes two convincing arguments on why repealing payroll taxes is a terrible idea. He also does a nice job of describing the key attributes of a broad-based consumption tax. We recently discussed these topics on my weekly webcast series, Tax Notes Live. You can listen to our interview here.

Viard first points out that if Social Security were funded by general revenues, it would become more difficult to control the program’s long-term growth. The presence of a dedicated funding source functions as an indirect limit on how much the program can spend. Dollars out are dictated by dollars in. There’s a natural inelasticity to how much politicians can raise payroll taxes. (Democrats object that FICA taxes are regressive, and Republicans object to tax hikes generally.) That establishes a de facto ceiling on overall benefits. The constraint would vanish if the funding linkage were eliminated.

Viard’s second reason for not repealing payroll taxes is political common sense. It would be a catastrophic mistake to commingle Social Security funding with our annual budget fiasco. That would be a nightmare. You don’t want members of Congress continually tinkering with the Social Security benefits formula for the same reason you don’t want vampires working at the blood bank.

As always, Viard’s ability to reduce complex economic concepts to concise policy observations is refreshing. The most important thing I learned from our conversation is that if we must alter Social Security, it’s better to proceed through comprehensive entitlement reform, not stand-alone tax reform. Also, it behooves us all to call a VAT a VAT. It others don’t, Tax Analysts will.

 

Read Comments (1)

eugene patrick devanyApr 24, 2016

The article is rather one sided when it comes to VAT replacement of payroll
taxes. It points to Alan Viard’s political rather than economic concerns of
Congress too easily raising more revenue than the author is comfortable with
or, heaven forbid, increasing Social Security benefits. Health care reform is
not mentioned as a concern but we know it is there percolating just below the
surface.

Putting aside the political paranoia about what Congress might do, we all know
that expanding the tax base produces the lowest rates. Even Estate taxes enable
other taxes to be lower during life (and this explains why we have gone so easy
on the rich). I estimate that a 2% wealth tax, 4% VAT and 8% income tax
(individual and corporate) could approximate today’s revenue. Only businesses
would pay the VAT and foreign sales not subject to VAT would only pay 8% on
income. Without payroll taxes U.S. workers are more attractive and increased
take home pay can boost consumer spending.

Of course the 2% wealth tax can be problematic, but what if it were optional.
Imagine the dynamic incentives of a choose-your-own income tax rate ranging
from 8% to 28% with each rate paired with a decreasing net wealth tax ranging
from 2% down to zero. Middle class success could be encouraged by permitting
each taxpayer to save up to $500,000 exempt of wealth taxes for long term
family needs. If Estate and Gift taxes were offset by wealth taxes paid, all
individuals would want to pay some wealth taxes to both lower income tax rates
and to reduce Estate taxes. Tax avoidance can be turned upside down and middle
class stimulus turned right side up.

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