The Case for a Payroll Tax Cut

The Case for a Payroll Tax Cut
(AP Photo/Eric Gay, File)
X
Story Stream
recent articles

Senate Republicans are reluctant to include a temporary payroll tax cut in the next coronavirus response bill even though the Trump administration is championing it. The arguments against this idea are unpersuasive. A payroll tax cut would work better than other options to help the middle-class and encourage a return to work.

Moderate income households pay much more in payroll taxes than income taxes. Under current law, employers and employees both pay 7.65 percent of wages in Social Security and Medicare taxes. The Social Security tax (6.2 percent each for firms and workers) applies to wages earned below an annual upper limit ($137,700 in 2020). The Medicare portion of the tax (1.45 percent for both employers and employees) applies to all wages, without limit. For families with incomes in the second lowest quintile, the average payroll tax rate is 9.4 percent while the average income tax rate is -1.2 percent.

The burden of the payroll tax falls almost entirely on workers. Firms pay the employer share of the tax but pass on as much of the cost as possible to their employees in the form of reduced wages.

To the extent that the supply of labor is sensitive to the compensation offered by firms, a payroll tax cut could increase overall employment, although perhaps modestly. In the current environment, with millions of workers abruptly pushed out of jobs because of strict social distancing policies, a reduction in the payroll tax may entice some of the unemployed to re-engage in the labor market.

The main benefit of a payroll tax cut would be an increase in take-home pay. For a worker at the median wage, a reduction in the payroll tax rate of 4 percentage points would be worth $2100 over the course of a full year, or about $175 per month. In combination with a tax rebate, a payroll tax cut would provide significant financial support to households, and thereby support economic recovery.

Opponents argue that a payroll tax cut would undermine budget discipline in Social Security and Medicare by compromising the principle of self-financing. Social Security’s trust funds are credited with payroll tax collections, which then pay for program benefits. Medicare’s Hospital Insurance (HI) trust fund is likewise financed entirely by payroll tax receipts.

Cutting payroll taxes will require holding the trust funds harmless for the revenue loss by substituting general revenue for lost payroll tax payments. Otherwise, both programs’ trust funds would face insolvency in short order. Current projections — which do not reflect the effects of the pandemic or the contraction it precipitated — show Social Security running out of reserves in 2035, and Medicare HI in 2026

Concerns about the effect of a payroll tax cut on trust fund integrity are overblown. The Medicare program is awash in subsidies. Over the period 2020 to 2029, the general fund will send $5.3 trillion to Medicare’s other trust fund, for Supplementary Medicare Insurance (SMI). In the late 1990’s, Congress shifted some home health expenses from HI to SMI to make the HI trust fund appear more solvent. The transfer did not lower Medicare’s overall burden on the budget. With HI running out of reserves soon, there are already proposals being floated to shift costs to SMI again.

Medicare needs serious reform, to lower its burden on taxpayers over the long-term. The problem is not HI insolvency but total program spending. An excessive focus on the HI trust fund will only distract from the changes needed to sustain the program for future beneficiaries.

Similarly, modernization of Social Security has been complicated by the myths surrounding the program’s trust funds. Many Americans believe their benefits are tied directly to what they paid in payroll taxes while working. In reality, benefit payments are calculated based on workers’ earnings, not their tax payments. Moreover, other factors also affect monthly benefits. The formula provides a higher rate of return to lower earnings than to higher earnings, and married couples get spousal benefits. The program also pays survivors of deceased beneficiaries and disabled workers.

A year-long payroll tax cut, with general revenue holding the trust fund harmless, is unlikely to lead to a full-scale unraveling of the trust fund financing construct. However, if it opened the door to further payroll tax reforms, that would be a welcome development.

For instance, today the payroll tax is applied uniformly to all wages, without regard to circumstances. Beneficiaries age 65 and older who are drawing benefits must continue to pay the tax on any additional earnings even when there is no possibility that the added wages will improve their monthly benefit payments. The implicit tax on work for those age 65 and older is high and discourages labor force participation among the elderly, even as lifespans increase. The payroll tax should be eliminated or reduced for older workers to encourage the extension of careers.

Some critics of a payroll tax cut say it is less progressive than other options for supporting households. That is only true if the tax rate reduction is uniform across all earnings. The cut could be more pronounced at low levels of earnings and then pulled back as earnings rise. The tax cut could also be phased out entirely for households with wages above a certain level (such as $100,000).

Republicans in Congress are reluctant to embrace a payroll tax cut not because the idea is without merit but because they fear a broader debate about the future of Social Security and Medicare. A temporary payroll tax cut is unlikely to precipitate such a conversation, but if it did, it would be another reason to embrace it.

James C. Capretta is a Contributor at RealClearPolicy and holds the Milton Friedman chair at the American Enterprise Institute.



Comment
Show comments Hide Comments