The Worst Tax


July-August 1997
Washington Monthly


Browse in Diseconomy

Few subjects inspire more tub-thumping in Congress than the virtues of honest toil. We must eliminate welfare because people must work. We can’t curb our gluttonous use of energy because — they say — it would jeopardize jobs and work. NAFTA and GATT and even capital gains tax breaks aren’t boons for the very rich; no, their main purpose is to help people who work.

Yet when it comes to taxes, what’s the thing Congress singles out to tax the most? That’s right — work. Today work bears over 75 percent of the federal tax load; and the worst part of the work-tax system is the payroll tax, which is deducted from a worker’s paycheck to provide the funds for Social Security. Unlike the income tax, which applies to all income, the payroll tax falls primarily on the wages and salaries of the working and middle class. It takes a big slice off the top of the entry-level paycheck, with no exemptions or deductions. Earnings above $65,000 a year are exempt, as is income from the stock market, real estate speculation, antiques — everything that isn’t work.

Though they don’t say so, when politicians bewail the federal tax burden on working folks, they are really talking about the payroll tax. It accounts for more than half the federal taxes the average American pays. The payroll tax is also a heavy burden on small businesses, the ones that create all those new jobs. Employers pay one half of workers’ payroll taxes, thus the burden of this tax falls especially hard on small businesses, which tend to be labor intensive

With all the hand-wringing in Washington over oppressive tax burdens, you’d think the payroll tax would be at the top of the list. It’s not. In fact, Republicans want to turn the entire tax system into an extension of the payroll tax. Their “flat-tax” plans are really work tax plans. When you exempt non-work income at the personal level (such as dividends and interest and profits from the sale of stocks, bonds, real estate, etc.), as proponents like Richard Armey, the House Majority Leader, and Steve Forbes want to do, a work tax is what’s left. Reporters obediently call the proposal what spin-savvy ideologues call it, instead of what it really is. But that doesn’t change the reality. Under cover of a flat rate structure, Republicans want to turn the federal income tax into a tax on the toil they rhapsodize on other days.

It would be easy to conclude, in fact, that most of official Washington doesn’t even know the payroll tax exists. With an occasional exception, they never mention it; and when they do, they usually cut and run. Jack Kemp floated an idea for modest payroll tax relief through his tax reform commission last year. But by the time he was running for vice president, that was in a dumpster. Instead, Kemp and Dole were talking up a supposed 15 percent tax cut which was actually much less; include payroll taxes in the calculation — as most workers do — and the actual cut would have been more like 6 percent. (No wonder they didn’t want to bring up the payroll tax.)

Why the studied avoidance? A few Democrats have spoken out, such as Nebraska Sen. Bob Kerrey, who did an op-ed piece on payroll tax relief in The Washington Post on April 15. But there’s been no groundswell in the ranks. On the whole, Democrats are spooked by the Social Security connection; try to fix the way we fund the system, they fear, and opponents will accuse them of undermining it.

Republicans share that fear, of course. Republicans also like a tax that makes working people angry at government and at the same time lets high-income contributors off the hook. Majority Leader Armey even wanted to eliminate withholding, so we would all have to write checks to the IRS every month.

That may be sly politics, if your goal is to make people angry at Washington. But in other respects, the work-tax system, and the payroll tax in particular, is an insane penalty on work and on the employers who provide it. It says to the small business person: Give someone a job and you’ll pay more taxes for your trouble.

The tax reform the country needs would not shift even more of the tax burden onto an individual’s labor, as the work taxers — excuse me, “flat” taxers — want to do. That would make the worst part of the system the whole system. To the contrary, we should seek to lighten the payroll tax load on workers and employers, and to restore the balance between taxes on work and taxes on other things. Keep your pants on, Robert Bartley — that doesn’t mean “soak the rich,” though they certainly could pay a little more. It does mean shifting part of the tax to that which burdens the economy instead of that which moves it forward.

The best way to ensure the future of Social Security, after all, is to gear its revenue source to where the economy is going instead of where it’s already been.

How We Created the Monster

There were reasons FDR started the Social Security system with a payroll tax back in the 1930s. The tax made sense at a time when the income tax was essentially a tax on wealth, and when the payroll tax itself was very low.

Up until World War II, the income tax was the part of the tax system that well-off people paid. It balanced the excises and tariffs, which fell most heavily on everyone else. The tax began as a way to finance America’s entrance into the first World War. Rep. Dan V. Stephens of Nebraska was speaking for many in Congress when he said the new revenues should come from the “surplus wealth of the nation that has already been collected into private hands in abnormal proportions.”

When the war ended, the U.S. tax system came about as close to progressive ideals as it ever would. Some 80 percent of personal and corporate income tax revenues came from the top 1 percent or so. Eighty-five percent of households paid no federal income tax at all (though they paid a considerable amount in excises and tariffs), and there was a widespread feeling that this was right. Henry Ford took out full-page newspaper ads proclaiming it “wise and just” to compel the very wealthy to “bear a fair share of the load which has hitherto rested all too heavily on the backs of the poor.”

The basic pattern continued through the Coolidge-Hoover years of the ’20s. To be sure, the Republicans softened the blow at the top. Yet through the 1920s, only about a third of the federal tax burden fell on working people, mainly in the form of excises. Over 60 percent of federal revenues came from individual and corporate income taxes, over 75 percent of which came from the richest 1 percent of the populace. Even Treasury Secretary Andrew Mellon, that patron saint of supply siders, acknowledged that, “The fairness of taxing more lightly income from wages, salaries, than from investment is beyond question,”

This was the tax system that the New Dealers inherited when they took over in 1932. Under pressure from populists like Huey Long, FDR tried hard to ensure that the very richest paid a fair share. He gained enactment of a wealth tax, revived the estate and gift taxes, and imposed a special tax on undistributed profits to stop the use of corporations as personal tax shelters. He raised income tax rates at the top.

In that context, Roosevelt decided to finance the Social Security system with a payroll tax. It was an add-on to an income tax system that was already aimed at the top. It also created the impression that working people would be paying their own way. In reality, Social Security wasn’t entirely a “contributory” system, of course. The first wave of beneficiaries would get back more than they paid in, as would retirees with low incomes. Employers would contribute to the system too, along with workers. Most importantly, each generation of workers would support the previous one; and the early planners realized the time was coming when payroll tax contributions, at a level they deemed reasonable, would not support this load. (One Treasury analyst saw this happening by the early 1980s, and the level of tax he considered the breaking point was around 10 percent. More on that shortly.)

Some of FDR’s key advisors didn’t like the payroll tax approach. These included Rexford Tugwell, the Brain Truster, and Frances Perkins, the Secretary of Labor. One problem was the obvious injustice: With a payroll tax, those who made money from investments would not contribute their share. Others saw the writing on the demographic wall. In her memoirs, Ms. Perkins recalls the warning of then-Senator Hugo Black of Alabama, that the payroll tax was doomed for breakdown. “The burden on small employers and the poorest paid workers would be too great to allow of the gradual expansion of the coverage and benefits,” Black had said, “unless the tax resources of the whole United States were involved from the beginning.”

But FDR was adamant. He knew that Congress was not likely to pass a Social Security bill that looked too much like welfare. Conversely, future administrations wouldn’t dare tamper with a system that people felt they had paid for out of their own paychecks, like retirement insurance. “With those taxes in there,” FDR said, “no damn politician can ever scrap my social security program”

The big task was to get the system going; accounting problems could be dealt with later. The well-to-do were paying most of the income tax, so a small deduction from the weekly paycheck to support a system of retirement security didn’t seem too much to ask.

Then came WWII, which threw off all the calculations. To finance the war, Congress turned the income tax into a mass tax. It cut the exemption level for low-income Americans in half; by 1948 close to 10 times as many Americans were paying federal income taxes as a decade earlier. These taxes were being withheld, along with payroll taxes. Soon the progressive rate structure, which was supposed to take away the sting, tended to become the sting, as inflation pushed working people into tax brackets originally intended for the upper-middle classes.

At the same time, the payroll tax itself was starting to explode. When the Social Security tax was first enacted in 1937 it was only 2 percent of wages and salaries. By 1960 the rate had tripled to 6 percent, which approached the upper range of what Treasury staff had thought workers could bear without needing extra compensation. By the time Ronald Reagan took office, it had more than doubled again, to 12.3 percent. (In 1917, that was the effective tax rate for Americans making today’s equivalent of $500,000 a year.)

The payroll tax rate now stands at 15.3 percent, split between employers and employees. That is more than the effective income tax rate paid by all but the richest 5 percent of taxpayers in the land. A family of four today making $40,000 will pay almost twice as much in payroll taxes as income taxes. Imagine that kind of burden falling primarily upon the people who attend the $1,000-a-plate political fundraising dinners in Washington. Indignant demands for change would fill Congress the next morning. They do — but to cut the tax rate for capital gains.

The tax that burdens the people the most, concerns the politicians the least. Few issues show the political economy of Washington so starkly. Suggest a tiny increase in the income tax, and Republicans get polemical St. Vitas Dance. Perdition will be upon us; we will suffer many plagues. Yet payroll taxes have glided upward with barely a whimper of opposition.

At the beginning of the decade, Senator Daniel Patrick Moynihan tried to call the bluff of the Bush Administration by proposing a payroll tax cut. The Social Security Trust Fund was racking up a big surplus, and Bush was using it to mask the size of the deficit and justify a capital gains cut. This would be a blatant income transfer scheme from working people to the very rich; why not cut Social Security taxes instead? Moynihan provoked much foot-shuffling and embarrassment, but his proposal never moved. Since then, with the exceptions noted above, few have ventured even to mention the subject.

A payroll tax cut wouldn’t be a threat to Social Security. It could help save Social Security by reconnecting it to a revenue stream that could actually sustain it.

Taming the Beast

There are a number of ways to support a payroll tax cut. The simplest would be to raise the individual income tax. This would spread the burden more fairly, and tax income from sources other than work. There would be built-in relief for low-wage workers, because these pay little if any tax. The effect would be a supply-side cut — a work-side cut for the working and middle classes, to balance off the Reagan version that was skewed heavily to the top.

Another possibility is a broad-based consumption tax. Senator Ernest Hollings of South Carolina once proposed a 5 percent Value Added Tax, or VAT, like the ones used commonly in Europe. The tax would have raised just over $50 billion, almost exactly the amount that Moynihan’s payroll tax cut would have cost.

Another possibility is to demand a fair price for the public assets the nation has been giving away: mining rights on public lands, the broadcast spectrum, private patents derived from research the taxpayers have paid for. The broadcast spectrum alone could have raised some $70 billion. These assets are a common trust; and we could use them to supplement the Social Security fund.

We could take that concept one step further. For decades, supply-siders have been telling us that when you tax something you get less of it. Perhaps it’s time to take them at their word. Instead of taxing work, why not use taxes to promote more of it?

Something along this line was what the framers of the original income tax actually intended. They drew inspiration from a journalist and self-taught economist named Henry George, whose 1879 classic, Progress and Poverty, sold several million copies worldwide. George focused on the distinction between natural assets such as land, and real capital — that is, between unearned gain and productive gain. Rising land values don’t result mainly from the efforts of the owner, George observed, but rather from the enterprise of the “whole community” — streets, police, and improvements to surrounding properties.

The issue was economic as well as moral. Unearned land gains, paid ultimately by workers and entrepreneurs operate as a kind of tax — a private sector tax. They siphon off funds that could otherwise go to build the business or pay the workers. If there must be taxes they should fall first upon these unearned gains: “Well may the community…let the laborer have the full return of his labor, and the capitalist the full return of his capital,” George said.

George was not a popular figure among the industrial barons of the era. A number of them funded economics departments to put the vexatious “land question” to rest. Yet his themes have persisted in the national debate. There were echoes in FDR’s insistence on a connection between contribution and reward. Today, when Democrats try to restrict capital gains tax breaks to job-producing new investment they are harkening back to that same concern.

The issue even strikes a residual chord among supply-siders, the more honest ones at least. George Gilder sounds it in his best-selling Wealth and Poverty, the title of which is a nod to George’s Progress and Poverty. Jack Kemp has made the connection to taxes, local ones at least. In his book The American Renaissance, Kemp argues that local property taxes should “fall more heavily on land, rather than, as at present, penalizing property improvements.” The thought is pure George. Tax building values less and the underlying land values more, and you reduce the insane penalty — in the form of higher assessments — for people who improve their property.

But people like Kemp ought to see that the reasoning applies more broadly. If the property tax should fall more heavily on land than on the fruits of productive endeavor, for example, so too should the rest of the tax system. If the property tax shouldn’t “penalize” property improvements, then neither should a payroll tax penalize the labor that creates those improvements — to the extent we can avoid it.

Start with capital gains. Any new tax breaks for these should be limited to job-creating new investment such as venture capital; there’s no reason to increase the deficit to reward gains that create no new jobs or wealth.

Step two is to eliminate special tax breaks for land and natural resources. These serve no economic function; the land will still be there, with tax break or without. For intrepid political souls this could include the array of subsidies for home ownership for the well-to-do, from mortgage interest deductions to the exemption of capital gains at death. Some two-thirds of the benefit of the mortgage interest deduction goes to the richest 10 percent, which means most federal housing subsidies go to those who need them least.

Most importantly, we should stop giving away the air and water as a dump for toxic waste. You don’t have to think like an economist, and believe there’s a “correct price” for poisoning the nest, to agree that people should accept the consequences of their actions, and that the price system is one way to accomplish this. Polluters should pay, just as they would pay for dumping trash at a landfill. Levied as a tax on, say, energy use, such fees would help cut pollution in the most efficient way — by giving companies a big cost reason to do so. It would nudge our economy in the direction the world is moving, toward leaner and cleaner modes of production.

Steps like these could reduce a substantial portion of the payroll tax, which would be a major boost to both employers and the working poor. (Of course, rebates or other protection for the poor should be built in.) We’d have a tax system that encourages intelligence and human endeavor rather than an accretion of stuff; we’d also begin to restore the connection between action and consequence, contribution and reward, which is the moral basis of a market economy. As Winston Churchill put it early in the century, urging a tax on unearned gains from land, “Where, no service, but rather disservice, is proved, then whenever possible, the state should make a sensible difference in the taxes it is bound to impose.”