Tax and Social Security Reform: Thinking Outside the Box
Thursday, September 29, 2005
by Hans Fehr, John C. Goodman, Sabine Jokisch, Laurence J. Kotlikoff
Table of Contents
- Executive Summary
- Introduction: Five Radical Reforms
- The U.S. Tax System: The Case for Reform
- Elderly Entitlements: The Case for Reform
- Modeling the Effects of Tax Reform
- An Eleven Percent Flat-Rate Income Tax
- A Flat Rate Consumption Tax
- Combining Tax Reform and Social Security Reform
- About the Authors
The U.S. Tax System: The Case for Reform
"These tax reforms would maintain the progressivity of the current system; individuals with the lowest incomes would gain the most."
In the modern world, capital can travel around the globe on an electronic highway at the speed of light. Many labor services can travel almost as fast, as American companies discover they can outsource jobs to places as remote as Pakistan and India. At the same time, we are living with a tax system that was designed in the technological dark ages.
The more mobile resources are, the harder it is to tax them. Thus as we move further into the 21st century it will become increasingly difficult to collect taxes from people without offering them an equivalent benefit. Yet the need for tax dollars to benefit people other than the taxpayer is expected to soar with the retirement of the baby boom generation.
If America is going to successfully compete in an increasingly mobile global economy and at the same time meet our commitments to senior citizens, we need radical reform. In particular, we cannot continue with a tax system that imposes high costs on the private sector per marginal dollar of revenue raised. What we need instead is a system that minimizes the cost of meeting our revenue needs.
Three defects of the current system stand out as especially glaring and in need of reform: (1) tax rates are too high, (2) the tax code is too complex, and (3) the system is biased in favor of consumption and against saving.
"The tax code is too complex and the system is biased in favor of consumption and against savings."
Current Marginal Tax Rates. Families with below-average incomes pay very little in the way of federal income taxes. For instance, the bottom 50 percent of all income earners pay less than 4 percent of federal income taxes.5 Yet at the margin these families can face a 15 percent federal income tax rate on top of a 15 percent (FICA) payroll tax (employer and employee combined) and, say, a 4 or 5 percent state and local tax, depending on their income and where they live. All told, moderate-income families give up a third of the last dollar they earn. Factor in state sales taxes and federal income taxes and you get marginal rates close to 40 percent.
Marginal effective tax rates are also very high for higher-income families. Take the top 1 percent of earners, who pay more than a third of all income taxes, although they earn less than a sixth of taxable income.6 Although they max-out on their Social Security payroll taxes, these individuals still face a 35 percent federal income tax rate, a 2.9 percent Medicare tax, a 4 to 8 percent state and local income tax rate, as well as state sales and federal excise taxes (which, as indicated above, effectively tax wages plus wealth). They also see their itemized deductions clawed back as they earn more money. All told, highly paid workers face a roughly 50 percent marginal effective tax rate on earned income.
"It often imposes marginal effective tax rates above 50 percent on the wages of modest-income families."
Interestingly, however, the highest tax rates are not paid by the highest income earners. They are often paid by people who earn only modest incomes. Consider the wife of a man who is in the 35 percent income tax bracket. Even if she earns only the minimum wage, she will be taxed at her husband’s federal, state and local income tax rates. And even though her husband has maxed out his Social Security contributions, she must start all over — paying (together with her employer) 15.3 percent on every dollar of wage income, even though these payments will probably add little to the couple’s retirement benefits. In all, this working wife will face a marginal tax rate well above 50 percent. This is a stellar example of public policy imposing huge costs on a class of taxpayers in return for small revenue gains. And considering that second earner spouses usually have a lot more discretion about labor force participation than primary earners, this tax policy is especially wrong-headed. It imposes the highest marginal tax rate on the marital partner who can most easily avoid paying it (by not working).7
Very-low earners also face high effective marginal tax rates. While they may pay only 10 percent in marginal federal income taxes, add in payroll taxes, state sales taxes and federal excise taxes, and you’re up to a roughly 30 percent effective rate.
"The marginal effective tax rate on retirees who continue working can easily reach 80 percent."
Even higher tax rates are faced by many senior citizens with only modest incomes. Consider a 63-year-old who claims early retirement Social Security, but continues to work (and pay taxes) part-time. Above a certain threshold, this worker will lose $1 of Social Security benefits for every $2 of wages, an effective tax of 50 percent. Add to that the worker’s federal income tax rate, which could range from 10 to 35 percent; an (employer and employee combined) payroll tax rate of 15.3 percent; a state and local income tax rate of 4 or 5 percent; the marginal taxation, under the federal income tax, of Social Security benefits; and state sales taxes and federal excise taxes. And this worker can easily face a total marginal tax rate in excess of 80 percent!8
The example of the senior citizen worker illustrates how the income tax system often interacts with entitlement spending programs to create extremely high effective marginal tax rates. The picture is typically worse for low-income families (say, in the range of $15,000 to $30,000 of annual income) who qualify for the Earned Income Tax Credit (EITC) as well as various welfare benefits. As these individuals earn additional income, they must forfeit tax and welfare benefits at very high rates. In fact, effective marginal tax rates in excess of 100 percent are not uncommon.9
The system is especially harsh on married female workers at the top and bottom of the income ladder. As noted above, women who are married to high-income men face severe tax penalties if they work, even for modest wages. At the other end of the income spectrum, poor women who marry face an additional loss of EITC and welfare benefits. The incentives at the top are for women not to work. The incentives at the bottom are for women not to marry. Neither outcome is good for society.10
"Lifetime marginal tax rates exceed 50 percent for almost all full-time working house-holds."
Lifetime Marginal Tax Rates. Going to work, earning a living, and spending your income affects taxes and benefits not just in the current year, but in all future years as well. If you save and invest some of your current earnings and spend the proceeds in the future, you will raise your future capital income taxes as well as consumption taxes. You will also limit your ability to qualify for future income- and asset-tested government tax credits and welfare benefits. Earning more today will also affect the calculation of your future Social Security benefits as well as the federal income tax assessed on those benefits. For these reasons, it makes sense to consider the lifetime consequences of earning an extra dollar of income today.
In an earlier NCPA publication, Jagadeesh Gokhale, Laurence Kotlikoff and Alexi Sluchynsky produced estimates of lifetime marginal tax rates.11 Their finding: Almost all full-time working households face marginal net tax rates on earnings in excess of 50 percent! That is, American households will eventually hand over half or more of every dollar they earn to state and federal governments in taxes paid net of benefits received. Moreover, the lowest-income households face the highest marginal net tax rates:
- The marginal net tax rate on households earning 1.5 times the minimum wage is 81 percent; families at this income level keep less than one-fifth of the income they earn.
- At two times the minimum wage the marginal net tax rate is 72 percent; these families keep less than 30 cents out of each dollar they earn.
At higher income levels, marginal net tax rates decline as income rises, reflecting the surprising finding that, measured on a lifetime basis, marginal net tax rates tend to be regressive, imposing the highest burdens for extra work on those with the lowest lifetime earnings.12
"High marginal tax rates distort economic incentives to marry, work or save."
Incentive Effects of High Marginal Tax Rates. One consequence of high marginal tax rates is that people will choose to produce less income. If you reduce the rewards from working, there will be less work. This is especially true for marginal labor populations: second-earner spouses, senior citizens and teenagers, for example. A second consequence is that high tax rates affect lifestyle decisions. As noted, both at the top and bottom of the income ladder, couples are penalized if they marry.
A third consequence is the distortion of economic decision-making, whether that decision involves choices by households deciding how much to work or save, or whether it involves choices by firms as to how much and in what manner to produce. With high marginal tax rates, decisions are often excessively driven by the desire to avoid taxation rather than to equate true marginal economic benefit to true marginal economic cost.
A fourth consequence of high marginal tax rates is that they increase the attractiveness of tax evasion — the failure to report taxable income. There have been a number of studies examining the scope of the underground (or “shadow”) economy and how it is influenced by changes in tax policy:
- An International Monetary Fund (IMF) study estimated that the underground economy in the United States was about 10 percent of gross domestic product (GDP).13
- According to the National Bureau of Economic Research, a 10 percentage point increase in the tax burden would cause the underground economy to rise by 3 percent of GDP.14
- A study by the Federal Reserve found that a 0.7 percent increase in the tax rate leads to a 1.5 percent rise in underground activity.15
Although these studies focus on the total tax burden, the higher the marginal tax rate associated with a given tax burden, the greater the incentive for nonreporting at the margin.
Other Social Costs. Today’s graduated income tax system is a morass of deductions, exemptions, allowances, credits and other loopholes. As a result, it is costly to comply with:
- Between 1955 and 2000, the income tax law grew from 172,000 words to 982,000 — an increase of 472 percent. Federal tax regulations grew from a combined 744,000 words to 6,929,000 — an increase of 831 percent.16
- The IRS estimates that taxpayers spend more than 5.7 billion hours on paperwork.17
- Administrative costs for the government and the cost in taxpayer time and expenditures for the individual income tax amounts to about 10 percent of federal income tax collections.18 However, this estimate excludes the cost of tax planning, tax audits and litigation, as well as foregone economic activity.
"It is costly to comply with the complex income tax code."
Every tax imposes deadweight costs on the economy. How big are these costs? Edgar K. Browning estimated that deadweight losses are typically 9 percent to 16 percent of tax revenues, Charles J. Ballard and colleagues estimated that they typically range between 15 and 50 percent of tax revenues, and Charles Stuart concluded they probably exceed 50 percent.19 Looking at the 1993 federal income tax increase, Martin Feldstein found that per dollar of revenue raised, it imposed economic losses equal to 300 percent of the revenue raised.20
The economic drag of a tax system is greatest at the margin. The Joint Economic Committee of Congress concluded that “40 cents in lost economic welfare per dollar of tax would be a reasonable estimate.”21
Bias Against Saving and Investment. In addition to generating high marginal tax rates and incredible complexity, the tax system suffers from a third defect: It is biased in favor of consumption and against saving and investment.
"The current system taxes consumption once, but taxes savings several times."
Consider the fact that a dollar earned and consumed is a dollar that is taxed only once by the personal income tax system. But a dollar that is earned and saved is likely to be taxed many times. For example, investment income is taxed first at the corporate level by the corporate income tax. When the remainder comes to you in the form of dividends or interest, it is taxed a second time. If you sell the business, you can be taxed a third time through a capital gains tax on income your investment is expected to generate in the future. And after you die, your investment can be taxed a fourth time through the inheritance tax.
One way to address this problem would be to move to a system that is neutral between consuming today and saving, in order to consume at some future date. This system, favored by many economists, is consumption taxation. Consumption taxation not only provides no incentive to consume early, it also discourages consumption. Take Warren Buffet. When Buffet uses his wealth to invest, he adds to the nation’s capital stock, which in turn raises the productivity and therefore the wages and after-tax income of workers. However, when Buffet consumes his income, there are no spillover effects for society as a whole. So it makes sense to tax that activity.
"People pay a consumption tax based on what they take out of the economy, not on what they put in."
Put another way, when Warren Buffet invests, you and I benefit. When he consumes, only he benefits. Therefore, from a purely selfish perspective we should not be indifferent about the choices he makes. The idea 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.
Experience of Other Countries. Most countries in the world have, or have had, income tax systems with multiple rates and numerous exemptions, deductions, exclusions and other complicated loopholes. In a few cases, countries have replaced these systems with a system that taxes income at a single low rate. Hong Kong is a stunning economic success story in the modern era. Many attribute its success to its policies of free trade and a 15 percent flat tax. More recently, Russia replaced its tax system with a 13 percent flat-rate income tax in 2000, apparently leading to increase government revenue and contributing to economic growth.22 Seven other central and eastern European countries have also adopted a flat tax: Estonia (1994), Latvia (1995), Serbia (2003), and Ukraine, Slovakia, Georgia and Romania (2004).23