Conservatives are having a healthy debate about the design of an effective and appealing tax-reform program. Republican senators Mike Lee and Marco Rubio have proposed a sweeping plan that is the focal point of the discussion.
The Lee-Rubio plan would establish two income-tax rates and would broaden the tax base by eliminating and limiting many current exclusions and deductions. It would also cut taxes substantially for middle-class families with children by adding another $2,500 per child to the existing $1,000 per-child tax credit. The Lee-Rubio credits could offset a family’s income and payroll-tax liabilities and thus help many families that pay more in payroll taxes than they do in income taxes.
The senators are also proposing a vast simplification of business taxation, with an emphasis on lowering the top corporate rate from 35 percent and on more rational treatment of business investments and overseas operations.
The Lee-Rubio tax-reform framework has been embraced by the “reform conservatism” movement — a loosely organized effort aimed at providing an updated conservative governing agenda that is relevant to today’s challenges and that can appeal to America’s struggling middle class.
Some others aren’t as enthused with the Lee-Rubio effort. Larry Kudlow and Kimberly Strassel of the Wall Street Journal editorial page, among others, have criticized the senators’ plan as insufficiently focused on promoting economic growth. They believe the top marginal tax rate could be lower if the senators did not expand the child credit, which they view as an expensive giveaway with very little economic value.
The top income-tax rate under Lee-Rubio would be 35 percent. That compares with the 28 percent rate that was achieved in the last years of the Reagan administration. (The effective marginal rate was actually higher than that — probably closer to 33 percent — for many upper-income households during those years because the 1986 tax-reform law also phased out personal exemptions and some deductions for taxpayers with the highest incomes.)
We should see the debate over the particulars of a tax plan as a productive discussion among like-minded reformers. Both groups — those who like Lee-Rubio and those who are more skeptical — want a vastly simpler tax code, with lower rates, a broader base, and fewer distortions. The trick is to put together a plan that embraces these goals and has real political appeal. After 15 years of stagnant incomes for the middle class, it will not be easy to sell a tax-reform plan with large benefits for those who can save and invest but very little for families who live paycheck to paycheck. A tax plan that we could credibly call a large middle-class tax cut has a far better chance of catching fire politically and thus also of getting enacted.
There’s also a strong substantive case for helping families who are raising children, as Lee and Rubio would in their plan. Our old-age entitlement programs — Social Security and Medicare — are pay-as-you-go schemes, which means current workers are financing the benefits of current retirees. It also means that the benefits of future retirees will be paid by future workers — today’s children. Consequently, families with children effectively pay twice for their entitlement benefits: through their own payroll taxes on their wages and through the expenses they incur while raising the children who will pay for the benefits of retirees in the future.
The expanded child credit in the Lee-Rubio framework is aimed at correcting the imbalance embedded in current tax and entitlement arrangements, and it would thereby invest in the families that are raising the next generation of American workers.
But the Lee-Rubio approach is also not the only way to provide credible tax relief to middle-class families. A more direct route would be to cut the payroll tax itself.
The payroll tax imposes, by a wide margin, the largest federal tax burden on middle-class families. As Social Security and Medicare spending commitments rose over the last half of the last century, the payroll contribution climbed dramatically. As recently as 1972, the combined employer-employee payroll tax rate was 7.5 percent. Today, it is 15.3 percent. According to the Tax Policy Center, in 2013, households in the middle quintile of the income distribution paid an effective income-tax rate of 4.3 percent. The effective payroll tax rate was 10 percent.
Some conservatives shy away from taking on the payroll tax because they view it as a lesser evil than the income tax. They argue that because the tax is not progressive (except for the Medicare component, above $250,000 in yearly income), it approximates a “flat” tax on consumption, not savings.
This is a terribly flawed understanding of the tax. The payroll tax is a tax on work, not consumption. Of course, middle-class families generally spend what they earn, and so when they pay taxes, they spend less. But these families can’t avoid the payroll tax by consuming less. Conservatives oppose raising the minimum wage and other mandates that raise the cost of labor and thus limit opportunities for lower-wage workers. They should approach the payroll tax in the same frame of mind because the payroll tax raises the cost of labor far more than any of these other federal mandates. An across-the-board payroll-tax cut would be a powerful pro-work, pro-growth policy.
The primary obstacle to changing the payroll tax is of course the connection to the Social Security and Medicare programs. The tax is used to finance both programs, and so, absent other changes, a broad-based tax cut would be viewed as draining the trust funds of resources needed to pay benefits.
President Obama got around this problem in 2011 and 2012 by replacing the revenue lost from a 2.0 percentage point payroll-tax cut with general revenue payments to the Social Security trust fund. Republicans in Congress missed a golden opportunity to reshuffle the tax debate and come to the aid of the middle class when they failed to support extending the tax cut beyond the end of 2012. But the precedent for a cut in payroll taxes has been set, and Republicans could return to the same formula in the future if they wanted to.
Some Republicans oppose using general revenue to replace lost payroll taxes — they say it would undermine the usefulness of the trust fund. They worry that Congress would expand the tap on the general fund to paper over financing problems in Social Security and Medicare, and thus the use of general revenue to cover lost payroll taxes would prevent any real reforms from ever gaining traction.
But Medicare is already heavily financed with general revenue, and a general-fund transfer to Social Security need not be permanent. Indeed, making it temporary could precipitate a much-needed debate over reform. In any event, it is hard to see how lowering the payroll tax, and thus the amounts dedicated directly to financing entitlement spending, would be more of a hindrance to programmatic reform than keeping the payroll tax as high as possible.
It is also possible to pursue targeted payroll-tax reductions. One approach would be to reduce the payroll tax owed by parents with dependent children. This would take the pressure off of increasing the child tax credit and thus also free up resources within the income-tax-reform plan for other priorities. The lost revenue from this tax cut could be replaced in the trust fund with general revenue on a temporary basis. In some sense, this is no different from raising the child tax credit and paying for it with higher income taxes.
It also makes no sense to impose the payroll tax on senior citizens who have already earned their Social Security and Medicare benefits. Taxing their wages provides no added benefit in most cases, even as it discourages longer working lives among the elderly. Similarly, imposing the full payroll tax on teenagers just entering the work force is counterproductive, because it reduces employment among young people, who need the job skills.
The federal budget over the past five decades has been transformed. Three-fifths of all spending now goes to automatic benefit and transfer programs. As the spending side of the budget has shifted, so have federal taxes. For most Americans, the payroll tax is now far more consequential than the income tax. This is one reason it is difficult to cut taxes for the middle class when making changes only to income taxes.
Reforming and cutting the payroll tax would certainly complicate tax reform because of the connection to financing Social Security and Medicare. But, in the end, it will not be possible to provide sustained tax relief for the middle class if the taxes that are tied to the major entitlements are presumed to be set as necessary to keep the programs afloat and the entitlement spending is off limits too for political reasons. If that’s the reality, then rising taxes on the middle class is a foregone conclusion.
Conservatives should resist this way of thinking. A broad-based tax reform is emerging again as an important item on the national agenda. It’s time to broaden the lens even more and bring into the discussion the tax that is most consequential to the middle class.
— James C. Capretta is a senior fellow at the Ethics and Public Policy Center and a visiting fellow at the American Enterprise Institute