I The Problem With Income Tax Reductions
Over the years, pundits have attempted to sell the American public on the virtues of reducing income taxes. Generally, the argument is along the lines that income taxes are too high, and that reducing them will spell greater economic benefits for everyone. Recently, President Bush has been the most successful proponent, passing (and misleadingly characterizing with averages instead of medians) several reductions of the rate of taxation of income.
The major problem with this approach is that 74% of Americans pay more in Social Security taxes than they do in income taxes, an issue that seems to slip below the radar of a number of supply-side boosters. Tax relief for the greatest number of Americans, then, comes not from reducing their income tax liability, but their Social Security tax liability.
II The Problem With Social Security Taxes
The current Social Security tax structure is unfair and regressive. By instituting a cap on taxable income, creating a de facto exemption for higher income earners, and failing to extend exemptions to the majority of Americans earning less than the cutoff, the effect is that low and middle income earners are subsidizing upper income earners.
This is even more prevalent when the payroll side of the tax structure is considered. For every dollar under the cap that employers pay their employees, they must also pay the payroll tax. For every dollar above the cap, there is no extra cost; together, these both depress wages and salaries for those who most need a higher income and increase the likelihood that upper income earners will receive higher compensation - thus reducing the amount available to lower and middle income earners.
III Exemptions for Initial Income
Of the many proposals for reforming Social Security taxes, the one with the greatest impact on the greatest number of people is that proposed by Robert Reich, the former Secretary of Labor under President Clinton. Mr. Reich proposes exempting the first several thousand dollars of income from Social Security taxes. Every thousand dollars exempted would reduce the individual liability by sixty-two dollars (see table 1).
By creating a blanket exemption, the financial well being of those Americans near the bottom would be greatly enhanced; the middle class would benefit as well, as the dollar amount they would receive would be the same as someone earning only slightly more than the amount of the exemption.
IV Cap Adjustment and Rate Reduction
Creating an initial income exemption, while returning money to those who most need it, would create a budgetary shortfall of billions of dollars. In order to recoup this lost revenue, the earnings cap would have to be raised; Mr. Reich proposes raising it to $126,000 to raise a similar amount of revenue.
Reducing the rate of the Social Security tax easily extends the benefits of the initial income exemption. Although the benefit to lower income earners would be marginal, the benefit to middle income earners would be enhanced; each reduction of ½ of a percentage point translates into five dollars per thousand earned above the amount of the initial exemption (see table 2). Though seemingly small, when combined with the initial exemption and taken at several thousands of dollars of income above the exemption, the benefits quickly add up.
V A Sample Proposal
Combining these three approaches to reducing the tax liability for low and middle income Americans and their employers would be a powerful economic stimulus. The question, then, is what would be the result of such a combination? Assuming that such a proposal were to be put forth, it would likely be something along the lines of an initial income exemption of ten thousand dollars coupled with a reduction of the rate from 6.2% to 5.5% and raising the taxable earnings cap to $150,000 (see table 3).
Using census figures for 2001 showing median personal income at $21,934 and median household income at $42,228, the median reductions of tax liability would be $703.54 and $1,395.60, respectively. There would be, due to raising the earnings cap, a turnaround pointat which tax liability increases. Simple calculations show this point to be $108,072.73, where tax liability is the same under both the current and proposed systems; after this point, new tax liability increases to $2306 at the $150,000 cutoff.
Appendix A: Tables
Table 1: Reduction of Tax Liability at Various Initial Income Exemptions
Table 2: Value of Rate Reductions at Various Incomes
|Income Beyond Exemption||1/4||1/2||3/4||1|
Table 3: Effective Tax Reductions of Sample Proposal Tax Change at Various Incomes
|Gross Income||Current SS Liability||Proposed SS Liability||Net Reduction|