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Commentary By James C. Capretta

GOP Should Stop Avoiding Payroll Tax Reform

Economics, Economics Tax & Budget, Employment

A consensus is emerging that reforming the federal tax code must be among the very top priorities of a new agenda focused on restoring growth and opportunity in the United States. This is an achievement in itself. For years, economists debated the merits of broadening the tax base and lowering rates, but that debate is now largely over. Every credible analysis now indicates that a serious tax reform plan would vastly expand the U.S. economy and provide more jobs and higher incomes for U.S. workers. The Joint Tax Committee's analysis of the ambitious individual and corporate tax reform plan introduced by House Ways and Means Committee Chairman Dave Camp confirms the large gains to growth and opportunity that the right kind of reform plan would provide.

The basic direction for reform is therefore clear: a tax system with lower rates, a broader base, fewer distortions in economic activity, and reduced barriers to business formation, job creation, and work. 

But, although there is broad agreement on the overall direction, there are still on-going debates over some important details--including how to help the middle class.

Traditionalists have argued that the main benefit from tax reform for the middle class is more abundant job opportunities and higher incomes. There would be some reduction in tax liabilities for middle class households because of lower individual income tax rates. But the rate reduction would be, in relative terms, small because the current income tax system is already highly progressive. In 2014, married couples filing joint returns pay a 15 percent marginal tax rate on incomes all the way up to $73,800--a level that is well above the median household income in the United States. Of course, that is only the marginal rate on the next dollar earned. Lower levels of income are untaxed or taxed at a 10 percent rate. These tax rates can be reduced further in a tax reform plan, but perhaps not enough to be noticeable to the middle class. 

This is one reason why another group of tax reform advocates are pushing for a major increase in the child tax credit. This idea was recently championed by Robert Stein in Room to Grow, the policy blueprint published by the YG Network. It is also a central feature of the tax reform plan introduced by Republican Senator Mike Lee.

The policy rationale for helping middle class parents is strong. Social Security and Medicare are pay-as-you-go systems, meaning that current retirees get their benefits paid out of taxes collected from current workers. These social insurance systems are thus entirely dependent on a steady stream of new entrants into the workforce. But the middle class households who are raising the next generation of workers, and incurring large financial obligations as they do so, pay the same Social Security and Medicare payroll taxes as everyone else, including households without children. In other words, the costs of raising children are confined almost entirely to the households that are doing the childrearing, even though the benefits that come when the children reach working age are more broadly shared by everyone in society. A large body of research indicates that pay-as-you-go pension and health schemes such as Social Security and Medicare are suppressing family sizes all over the developed world and contributing to rapid population aging.

Stein's solution is to supplement the existing $1,000 per child tax credit with a new credit of $2,500 per child. The new credit could be used to offset both income and payroll tax liabilities. 

The downside of this approach is that it is financed within the income tax system. Consequently, in a revenue-neutral reform, it pushes up the necessary tax rates. For instance, the top rate under Senator Lee's plan would be 35 percent--below today's 39.6 percent rate, but far higher than the 28 percent top rate seen in the 1986 tax reform plan.

An alternative solution would be to directly correct for the anti-parent bias in the Social Security payroll tax system itself. For instance, parents might get a 2.5 percentage point reduction in the standard payroll tax rate for every dependent child in the home, as suggested by Charles Blahous and Jason Fichtner. Parents with three children would thus pay a tax that is 7.5 percentage points below the standard payroll tax rate. 

This approach to helping middle class parents would have substantial benefits over a larger child credit. It would directly lower tax rates on the earnings of parents, and thus reinforce the pro-growth effects of an individual income tax reform plan. It would be a very visible tax cut, seen directly in the paychecks of millions of workers, and thus add to its political potency.

It would also open the door to other important changes in the payroll tax system. For instance, workers who are already eligible for Social Security and Medicare benefits still owe payroll taxes on their earnings even though they generally get nothing back from these additional "contributions." The imposition of this tax on these workers is a major disincentive to continued work among those age 65 and older. A serious payroll tax reform would eliminate this tax on senior citizens to encourage longer worker lives.

Stein correctly notes that reforming the payroll tax is more complicated than boosting the child tax credit. Under Senate rules, it would be possible to enact a major increase in the child credit with a simple majority, while a payroll tax reform would almost certainly require support from a supermajority of 60 Senators to pass. Moreover, changing the payroll tax structure within Social Security to favor parents and older workers would likely require making other adjustments to help improve the program's long-term solvency. Those adjustments would put Congress squarely in the middle of an entitlement reform discussion, which is sure to be contentious and difficult.

But perhaps that is a reason to embrace payroll tax reform instead of avoiding it. For too long, Republicans have focused their tax reform energies on just the individual and corporate income tax systems, on the assumption that payroll taxes cannot be changed because of their connection to financing the major social insurance programs. But the largest tax most families face is the payroll tax, not the income tax. And if the major entitlement spending programs are not reformed to lower their long-term costs, the payroll tax burden on these families will rise in coming years, not fall, and could potentially offset any tax rate reductions that are achieved in the individual income tax system. If the GOP is serious about holding down overall tax burdens, the payroll tax cannot be ignored forever.

Sooner or later, reform of the major entitlements will also be necessary, even if payroll tax reform is not pursued. It would be far better politically to connect sensible reforms that must be pursued anyway with targeted reductions in the payroll tax burden for middle class parents. That would create a new and powerful constituency who would see the benefits from a fairer approach to paying for long-term spending commitments.

 

James C. Capretta is a senior fellow at the Ethics and Public Policy Center, a visiting fellow at the American Enterprise Institute, and a contributor to e21.

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