Tax and Social Security Reform: Thinking Outside the Box

Studies | Social Security | Taxes

No. 275
Thursday, September 29, 2005
by Hans Fehr, John C. Goodman, Sabine Jokisch, Laurence J. Kotlikoff

Executive Summary

This study examines the effects of fundamental tax reform as well as combining tax reform with fundamental Social Security reform.

Tax reform consists of replacing personal and corporate federal income taxation with: (1) an 11 percent flat-rate income tax, or (2) a 14 percent flat-rate tax on personal consumption, or (3) a 14 percent value-added tax (VAT), or (4) a 16 percent federal retail sales tax with the same effective tax rate as the tax on personal consumption and the VAT. The first reform taxes all income at one low rate. The next three reforms tax all consumption at one low rate.

Under each tax reform, the new tax is rebated to the lowest one-third of income earners. While we don’t model the form of these rebates, they could be provided as vouchers for the purchase of health insurance, contributions to personal retirement accounts, or contributions to Individual Development Accounts (IDAs). We also remove the cap on the Social Security payroll tax, but keep the benefit structure in place so that the tax rate on all wage income is the same.

A complaint about previous tax reform proposals is that they undermine the somewhat progressive features of the current fiscal system. The reforms considered here enhance progressivity. The bottom one-third of the income distribution of each age group gains the most under each reform proposal.

All four tax reforms entail very low tax rates for three reasons: (1) the additional payroll tax revenue from eliminating the payroll tax ceiling is used as general revenue, (2) the income and consumption tax bases are comprehensive, and (3) the reforms do not exempt large fractions of the population from taxation, as occurs, for example, under former Congressman Dick Armey’s flat tax proposal. Under the Armey flat tax, half the population would escape the tax and the other half would have a significant amount of untaxed income.

An Eleven Percent Flat-Rate Income Tax. Under this proposal all income is taxed only once, at its source, when it is realized, at one low rate. Everyone would pay the tax, regardless of income, and there would be no deductions, exclusions or exemptions. This would mean no more deductions for home mortgage interest, charitable contributions, and state and local taxes. It would also mean that employee benefits, including health insurance and pension contributions, would no longer be excluded from taxable income. Moreover, there would no longer be tax-free municipal bonds. Nor would individuals would be able to make tax-free deposits and realize tax-free growth in their IRA and 401(k) accounts. In return, people would get to keep 89 cents of each additional dollar of income they earn.

A Fourteen Percent Flat-Rate Tax on Personal Consumption. The theory behind a consumption tax is that people should be taxed based on what they take out of the economy, not on what they put in. The reason: when they save and invest, those dollars add to the capital stock and raise workers’ productivity and family incomes. The act of saving, in other words, creates benefits for other people.

This proposal is identical to the previous proposal with one exception: we do not tax income that is saved. Households would be able to deduct their saving, regardless of the form of that saving, but would have to pay tax on all of their dissaving, regardless of its form. Since all income is eventually consumed, all income under this proposal would eventually be taxed.

A Fourteen Percent Value-Added Tax (VAT). A second way to tax consumption is with a value-added tax (VAT). This approach taxes business sales minus the costs of a) intermediate inputs and b) net investment in plant and equipment. Since the value of sales at each stage of production incorporates the costs of intermediate inputs used, what is really being taxed is the additional value that has been added. Across all businesses, taxing value added minus net investment is the same as taxing national income minus net investment. But net investment equals net saving (since what is saved is invested), and income not saved is consumed. Hence, the VAT represents an indirect way to tax consumption.

An advantage of the tax is its ease of administration. Instead of 129 million individual tax returns, the tax would require only 20 million business establishments to file returns. A disadvantage is that the tax tends to be hidden and therefore not transparent. Consumers are usually unaware of how the tax affects the prices of items they buy. Workers are usually unaware of how the tax affects their take-home pay.

The VAT considered here would not be restricted to what most people regard as “business” enterprises. The tax would also apply to schools, hospitals, churches, nonprofit charities and even state and local governments. Under the current system, the federal government collects employee income tax revenue from all of these entities. If we were to abolish the income tax on wages, we must collect an equivalent amount in the form of a VAT. The mechanics are doable, even though they will strike many people as novel.

Some foreign countries exempt certain economic sectors from the VAT. But every exemption means a higher tax rate.

A Sixteen Percent Retail Sales Tax. The most direct and transparent way to tax consumption is with a retail sales tax. Unlike the VAT, this tax would be visible to consumers when they purchase goods and services. Even fewer entities would need to file returns than under a VAT. Think of the stages of production for a loaf of bread. A VAT would be collected from the farmer, the miller, the baker, the wholesaler and so forth. A sales tax concentrates the entire collection at the point of final sale. The advantage is lower cost of administration. A possible disadvantage is increased incentives for evasion and avoidance on the part of retailers and their customers.

Like the VAT, a retail sales tax would have to be collected from the nonprofit sector and state and local governments. Although this is doable, most state governments exempt these sectors from their own sales taxes. Any exemptions, however, require a higher tax rate. The 16 percent retail sales tax rate effectively equals the 14 percent rate of the previous two consumption tax proposals. The difference between the two rates reflects the way in which they are expressed.

Incorporating Social Security Reform. Social Security reform has two provisions: (1) phasing out the old system by paying workers in retirement only those benefits they have accrued as of the time of reform, and (2) instituting mandatory personal retirement accounts. Tax reform can be combined with Social Security reform. For example, if one were to raise the flat consumption tax rate to 17 percent, one could devote three percentage points to personal retirement accounts, matched by one percent contributions from both employees and their employers. These five percent accounts will grow over time and completely replace the current pay-as-you-go system in about four decades.

Simulating the Impact of Reform. The current tax system imposes huge and unnecessarily burdensome compliance costs on taxpayers. It also distorts incentives, leading to a misallocation of resources and encouraging the growth of an underground economy. We do not attempt to estimate the gains from reducing those distortions in this study. Instead, the model used here is well-geared to assessing the macroeconomic consequences of tax reform, including estimates of the required tax rates, the impact on saving and investment decisions, real wages, real interest rates, and the welfare consequences for broad classes of taxpayers grouped by income and age.

Economic Consequences of Tax Reform. Our simulations show that moving to a consumption tax, whether implemented as a personal consumption tax, a value-added tax, or a retail sales tax, would cause a substantial increase in the nation’s capital stock. This, in turn, would raise wages and real output compared to the current system. Specifically,

  • National income would be 6 percent higher than otherwise by 2030, and 9 percent higher by 2050.
  • Real wages would be 4 percent higher by 2030 and 6 percent higher by 2050.

As noted, low-income families proportionally gain the most from these reforms and there are especially large payoffs for future generations:

  • For those born in 2000, the lifetime gains are almost 14 percent for the bottom third of the income distribution, 4 percent for those in the middle and 2.4 percent for those at the top.
  • For those to be born in 2030, the lifetime gains are 18 percent, 6 percent and 3 percent, respectively.

Economic Consequences of Tax Reform Plus Social Security Reform. In some ways, Social Security reform is even more important than tax reform because it avoids dramatic increases over time in payroll taxes that would otherwise be needed to pay benefits to the elderly. Overall:

  • Taxes as a percent of national income will rise from 36 percent today to 46 percent by 2030 and 50 percent by the end of the century in the absence of any reform.
  • With the package of reforms proposed here, however, taxes will peak at 42 percent of national income in 2030 and recede to 33 percent by the end of the century.

Lower taxes mean more disposal income, which, in turn, leads to more personal saving and more capital accumulation. Moreover, the expansion of capital leads to higher real wages:

  • Without reform, real wages at mid-century will be 10 percent lower than otherwise because of elderly entitlements.
  • With the set of reforms proposed here, real wages will be 4 percent higher than otherwise by mid-century and 10 percent higher by the end of the century.
  • Without reform, average take-home pay for workers will be 26 percent lower by 2050 and 31 percent lower by the end of the century because of elderly entitlements.
  • With the set of reforms considered here, take-home pay will be almost 4 percent higher than otherwise by 2050 and almost 15 percent higher by the end of the century.

Moreover, combining consumption tax and Social Security reform creates very large and very progressive benefits for future generations:

  • For individuals born in 1980 and newly entering the labor market today, families in the bottom third of the income distribution can expect a 13 percent increase in their lifetime standard of living, compared to less than 1 percent for those in the middle and less than 2 percent for those at the top.
  • For those to be born in 2030, the gains (relative to what otherwise would have happened) are 54 percent for the bottom third, 27 percent for those in the middle and 11 percent for those at the top.

Conclusion. To remain competitive in the modern international economy and to avert the crushing burden of unfunded elderly entitlements, we need both tax reform and Social Security reform. Some have supposed that these are two completely separate endeavors. In fact, the two reforms may be easier to adopt and implement if they are combined.

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