The Big Tax Bite You Don't Even Think About

The annual deadline for filing income tax returns came and went last week with surprisingly little of the usual fanfare and political grandstanding. Lest one be tempted to think that the quiet surrounding Tax Day was mostly due to the good economic times, a more convincing explanation may lie in the widespread ignorance that the largest levy that three-quarters of American families now pay is not the income tax, but the regressive payroll tax.

If Texas Gov. George W. Bush and Vice President Gore genuinely want to lower taxes for the majority of working Americans, then they must reckon with this reality. Instead, Bush has made the centerpiece of his economic agenda a large cut in the federal income tax rate, while Gore proposes a more modest and targeted set of income tax cuts and credits.

In so doing, both candidates are missing a major opportunity to demonstrate their awareness that, in the new economy, the great winners are the wealthy and highly paid knowledge workers who have significant assets in the financial markets, and not those whose main source of income is wages. If any group needs tax relief in the new economy, surely it is these workers with no capital assets, many of whom don't earn enough to pay income taxes and thus would not benefit from current tax proposals.

One would never know it from the economic rhetoric of either candidate, but the federal income tax burden for most Americans has shrunk to its lowest level in four decades. The Congressional Budget Office, for example, estimates that the middle fifth of American families--with an average income of $ 39,100--saw their federal income tax burden decline from 8.3 percent in 1981 to 5.4 percent in 1999. Similar decreases occurred for almost all other income groups. Given this significant trend, is it much of a surprise that Bush's proposal for a massive income tax cut is gaining such little traction?

By contrast, the payroll tax--which is listed on many paychecks as "FICA" (for Federal Insurance Contributions Act) and is intended to fund Social Security and Medicare--has increased from a rate of 3 percent in 1960 to 7.65 percent today. Employers pay an additional 7.65 percent for salaried workers, but most economists agree that the full 15.3 percent burden ultimately falls on workers through reduced wages. Self-employed workers and independent contractors, who make up an ever-growing proportion of the work force, pay the entire 15.3 percent themselves.

With little public notice, Congress has legislated a fundamental shift from progressive income taxes to regressive payroll taxes over the past several decades. Whereas the latter accounted for 12 percent of total federal revenues in 1960, they now account for 33 percent. This subtle swap has skewed our nation's tax system and economic incentives in favor of the well-to-do, yielding greater disparities between the haves and have-nots, even amid our nation's longest economic boom.

It would be difficult to imagine a more regressive tax. Unlike the income tax, which taxes higher incomes at higher rates, applies to all forms of income, exempts low-income workers altogether and has no upper limit, the payroll tax is based on a flat rate, applies only to wage income, kicks in from the first dollar earned and exempts wages above $ 72,600. (There is no such ceiling on the Medicare portion of the payroll tax, but this only accounts for 2.9 percent of the 15.3 percent total rate.)

The cumulative effect of these features is a perversely distorted tax that allows the wealthy to pay a dramatically lower effective rate than the majority of working Americans. Consider an average worker who makes $ 35,000 a year, a highly paid executive who makes $ 500,000 a year and a trust funder or investor who lives entirely off capital gains. Under the twisted logic of payroll tax, the ordinary worker (and his employer) pay the full rate of 15.3 percent, while the high-powered executive pays an effective rate of 4.7 percent, and the trust funder nothing at all.

Is this a sensible way to fund a national retirement system?

Conventional wisdom holds that the payroll tax cannot be touched because it funds Social Security, the supposed third rail of American politics. But this conventional wisdom rests on a myth that individuals receive from Social Security what they originally paid in via their payroll taxes. The reality is that Social Security operates as a pay-as-you-go system, in which today's workers fund today's retirees. Accordingly, there is no reason new revenue sources could not replace payroll taxes and be earmarked just as firmly for Social Security.

The very nature of the new economy provides a compelling rationale for cutting payroll taxes and exploring other funding mechanisms for Social Security. While financing Social Security on the back of wages may have made sense during the industrial era, it no longer does in an age when capital seems to have a permanent advantage over labor, and when a large disparity has emerged between the compensation of highly paid workers who have substantial capital assets, and that of the rest of the work force, which relies entirely on wages.

The most effective way to provide payroll tax relief to those left behind in the new economy would be to exempt a certain amount of wages at the bottom--say the first $ 10,000 earned--from payroll taxes altogether. Those who already support large-scale tax cuts presumably believe that we could cut payroll taxes by an equal amount and use federal surpluses to ensure the future of Social Security. But the more fiscally prudent course would be to replace the lost payroll taxes with new sources of revenue, and apply these new revenues directly to the Social Security trust fund.

Several potential streams of replacement revenue come to mind: modest increases in the capital gains tax rate; auctions of new segments of the electromagnetic spectrum; claiming a share of the revenue from the commercial applications of government research and development; instituting an array of pollution fees; or closing various corporate and individual tax loopholes. Any of these options would suffice to finance a significant reduction in the payroll tax, thereby correcting one of the most unfair features of our nation's tax structure, and reversing one of the most troubling trends in our otherwise wondrous new economy.

A key lesson of American presidential campaigns is that the big new ideas usually come from the underdogs, not from the front-runners. While Bush and Gore remained silent on the growing burden of the payroll tax, Gary Bauer, John McCain and Bill Bradley did not. Throughout their campaigns, each called for payroll tax relief of some sort. If three such diverse political figures dared to raise this heretofore untouchable issue, then maybe its time has finally come.