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
An Eleven Percent Flat-Rate Income Tax
"Federal income taxes equal about 15 percent of national income."
Surprisingly, the amount of revenue the federal government collects from the personal income tax is only 12.5 percent of total national income.26 If corporate income taxes are included, federal income taxes take 15.1 percent of income. Thus, in principle, government would have just as much money if it levied a 15.1 percent, across-the-board tax on all income. However, when coupled with two other changes we propose, the government’s revenue needs can actually be met with an across-the-board rate of 11.2 percent.27
This proposal consists of three elements: (1) replace federal personal and corporate income taxes with a single 11 percent tax on all income; (2) rebate the 11 percent tax to the lowest one-third of income earners, provided they acquire health insurance and establish pension, retirement savings and individual development accounts; and (3) apply the Social Security (FICA) payroll tax to all wage income.
Implementing a Flat Rate Income Tax. One reason why marginal tax rates under the current system are so high is that today’s deductions, exemptions and loopholes result in nearly half of all personal income not being taxed at all. [See Figure I.] The tax rate can be quite low if we apply it to all income. How would the flat income tax be collected, mechanically? One method is to continue as we do under the current system, with individuals reporting and paying taxes on their personal incomes and corporations reporting and paying taxes on corporate income. Reforms suggested by Robert Hall and Alvin Rabushka are also worth considering.28
However, the flat tax proposal crafted by Hall and Rabushka and popularized by Congressman Dick Armey29 is different from the one described here in two important ways. First, the Armey flat tax has generous personal allowances that have the effect of exempting about half of all taxpayers from paying the tax. We believe this is politically unwise. It would create a situation in which half the population has no interest in keeping the rate low. Under our proposal, everyone pays the tax. And beyond the 11 percent rebates (described below), everyone will pay for an increase. For example, if the rate were raised from 11 to 12 percent, the additional 1 percent would apply to everyone’s income. A second difference between this proposal and the Armey flat tax is that the Armey flat tax exempts saving and investment.30
Gains and Losses from a Flat-Rate Income Tax. In order to take advantage of this new tax, taxpayers would have to give up all the many opportunities now available to them to reduce their taxable income. 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 employee income. There would no longer be tax-free municipal bonds. And individuals would no longer have access to tax deductions and tax-free growth in their IRA and 401(k) accounts.
Make no mistake about it. Giving up these tax loopholes would be painful. But in return for this sacrifice there would be a very attractive gain. Taxpayers would get to keep 89 cents of each additional dollar of income they earn.
"Nearly half of all income is not taxed by the current system."
Rebates for Below-Average Income Families. The one-third of households with the lowest incomes pay virtually no federal income taxes. So an 11.2 percent flat tax would represent a significant tax hike for this group. To offset this tax increase and maintain the progressivity of the current system one could rebate the 11.2 percent to these families either in cash or in one of the following two ways.
First, families could receive a rebate equal to 5.6 percent of income provided they have proof of health insurance coverage. Insurance coverage would include Medicare, Medicaid, employer coverage and individually purchased insurance. Interestingly, there are about 13 million people, about one-third of the uninsured, who qualify for Medicaid and SCHIP (state health insurance programs for children) but who have not enrolled.31 There are also nine million employees and employee dependents who are eligible for employer plans but do not enroll, or about one in five of the uninsured.32 We would expect all these people to obtain coverage quickly in order to reclaim their 5.6 percent. In fact, we believe this proposal would insure more people overnight than the number of uninsured that have been insured by all federal and state programs combined over the past decade.
"Lower-income earners could apply half their rebate to purchase health insurance."
Those who do not have health insurance, or an opportunity to enroll at low cost, would have two choices. They could apply their 5.6 percent rebate to the purchase of health insurance or they could do nothing. In the latter case, the funds would be added to safety net health care programs that deliver free care to low-income, uninsured individuals.
Note: Although not part of this proposal, there would be an opportunity here to rationalize our otherwise arbitrary, unintegrated approach to low-income health care through tax and spending subsidies. Specifically, we could combine all funds that are available and offer a lump sum to the uninsured that they could apply to the purchase of private health insurance or that would be allocated to a safety net in the community where they live.33
"The other half of their rebate could fund a pension."
The second 5.6 percent rebate would be reserved for pension funds, retirement accounts and Individual Development Accounts (IDAs). As in the case of health insurance, people who (along with their employers) deposit at least 5.6 percent of income into an IRA, 401(k), and so forth, could claim the rebate outright. Those who are retired would receive an automatic cash rebate. But those of working age could claim the rebate only if the funds are placed in an IDA or retirement account. The idea behind IDAs is that people should be encouraged to accumulate human and nonhuman capital. Funds in these accounts would grow over time and could be withdrawn for such human capital expenditures as college tuition, vocational training, and so forth, but could not be used for consumption until the time of retirement.34
Why not give the rebate in cash and let families spend the money as they choose? We could. However, tax reform gives us an opportunity to solve important social problems. When people fail to obtain health insurance and provide for their own retirement they create external costs for others. The rebates described here solve social problems by internalizing the externalities.
Some may object that conditional rebates may cause hardships for some families. Consider a low-income family that currently has no health or retirement accounts. This proposal threatens to reduce this family’s disposable (cash) income by 11.2 percent. That may be a harsh blow, even if it ultimately leads to health insurance and a pension. To ease the transition burden for this and similarly situated families, we could phase in the withholding of rebates (for noncompliance) over time.
Extending the Payroll Tax to All Wage Income. The Social Security payroll tax applies to all wage income up to $90,000 in 2005. Some people propose to raise the amount of income subject to the tax (or even eliminate the cap altogether). But higher-income individuals would not get any additional retirement benefits in return for these higher taxes.
"All wage income would face a 26 percent tax rate; all capital income would be taxed at 11 percent."
Tacked onto the current tax system, such a proposal would be unwise. High-income taxpayers would, as a result, face more than a 50 percent marginal tax on wages, but only a 15 percent tax on dividends and capital gains. This would create powerful incentives (for people who are in the best position to take advantage of those incentives) to convert wage income into dividends or capital gains income. It would also create unhealthy incentives to avoid wage income in other ways.
In our reformed system the case for removing the cap is much stronger. Note that with the above reforms we would be left with an 11 percent tax on all income and a 15 percent payroll tax on wage income below the cap. That would mean that workers who earn less than $90,000 would face a total marginal tax on wages of 26 percent, where as those earning more would face a rate of only 11 percent.
That result might make sense if people were funding their own retirement benefits, but in fact they are not. Payroll taxes collected from today’s workers pay benefits for today’s retirees. That being the case, it is hard to justify a regressive funding mechanism. Accordingly, we consider applying the FICA tax to all wage income in our reformed system.
That leaves us with an 11 percent tax on all capital income and a 26 percent tax on all wage income.
"Even with reform, future tax burdens will rise."
Economic Effects of the Reform. The simulation reported in Table A-I in the appendix assumes an initial flat-rate tax of 11.2 percent on all income. Because of the rising cost of elderly entitlements, this rate would rise to 13.3 percent by 2030 and almost 14 percent by mid-century. With efficiencies and greater compliance, however, the actual required tax rates would be lower.
As noted above, we do not try to estimate the microeconomic gains from lower compliance costs and greater allocative efficiency in the use of resources. That said, the macroeconomic impact of this proposal is less than many might suppose — with only about a 1 percent gain in national income and real wages by 2030.
Part of the problem is that even with the lower tax rates, the reformed system still encourages consumption rather than savings. Also, unreformed elderly entitlements program continue to drive up tax burdens through time. [See Table II.] All taxes as a percent of national income (even with a flat federal income tax) will climb to 46 percent by 2030 and 48 percent by mid-century.
Distributional Effects of the Reform. Some critics complain that flat-rate tax proposals would shift the burden of taxation from the rich to the nonrich. That certainly does not happen here. Families in the lowest one-third of the income distribution would see no increase in taxes. There would, however, be a forced shift in consumption of that income — through much wider extension of health insurance, retirement savings and human capital accounts.
"By mid-century the federal government will need 45 percent of national income."
Table III shows the effects of this proposal on the standard of living of people at different age and income levels. The welfare change is calculated by asking by what percentage would one need to increase a person’s annual consumption and leisure under the current system in order to achieve the same level of wellbeing that is achieved with tax reform. The table has two remarkable features. First, despite some fairly radical changes in the tax system, the long run impact on moderate and high-income taxpayers is less than 1 percent in most cases. Put another way, the change in the distribution of the tax burden is very small indeed. Second, to the degree there is an impact, low-income households would gain the most from these reforms in every generation.