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Cut Taxes for Poor? Cut the Payroll Tax

May 12, 2010
David Surdam
Omaha World-Herald
October 7, 2008

David Surdam, UNI Associate Professor of Economics

Republican and Democratic politicians love to fiddle with taxes. Depending upon one's preference, raising the income tax is either "soaking the rich" or "acting with fairness and equity."

Politicians currently are focusing on this tax while largely ignoring other taxes. This focus is too narrow, as it is seemingly irrelevant to many Americans. The tax debate also needs to include scrutiny of payroll taxes.

You may have heard that the top 1 percent of workers pay almost 40 percent of total federal income taxes, while the bottom 50 percent of workers pay about 3 percent of such taxes.

Some commentators wax indignant, perhaps because they earn high incomes. There's nothing wrong with bleating about one's personal tax bill; it's as American as Mom and apple pie.

According to the Tax Foundation, income earners in the top 1 percent have been paying an increasing share of income taxes. However, given the stock-market downturns of 2007-08, there may be a reversal in this trend.

But if the bottom half of workers pay little in federal income taxes, how can you give them tax relief? Here is where the error of focusing on income taxes and ignoring payroll taxes arises.

The unspoken reality is that the federal payroll taxes for Social Security, federal disability insurance and Medicare account for the largest tax bills for the vast majority of Americans.

According to the Urban-Brookings Tax Policy Center, more than 85 percent of American "tax units" incurred higher average tax rates for the combined payroll tax than for the income tax. Why don't low-income wage earners complain about the payroll tax?

Workers see the 6.2 percent FICA (Social Security) and 1.45 percent Medicare tax bites on their paycheck. They also may know that their employers pay a matching amount.

Today's bad news: Workers in truth are paying almost the entire combined 15.3 percent payroll tax.

Social Security's original advocates wanted workers to think their employers were giving them something for nothing. Most economists believe that employees actually bear the burden of their employers' payroll tax share -- because instead of paying the employees' 7.65 percent in payroll taxes to the government, employers could have paid that money to employees in the form of higher wages.

With so many workers paying no federal income taxes, it's easy to see why payroll taxes are the bigger bite.

You could argue that the FICA and Medicare taxes are regressive, because as your income grows above a threshold level, the tax rate goes to zero.

The FICA tax is technically a regressive tax, but that misses a key facet. The amount that you and your employers paid to the program loosely corresponds to the amount you will receive in your monthly Social Security check. There is no such correspondence between benefits and income taxes paid.

By examining the taxes separately, politicians run into immediate rhetorical problems. Any income-tax cut must benefit those actually paying taxes -- the higher-income earners -- unless a politician means increasing the "negative" tax, such as the Earned Income Tax Credit, for workers making modest incomes.

If politicians really wanted to give tax relief to the middle class and the poor, they could reduce payroll taxes. Doing so, though, might jeopardize the financial solvency of Social Security and Medicare.

But this solvency is essentially an illusion. Tax revenue collected by the government is fungible.

Now, "fungible" is a funny, slightly unpleasant-sounding word. Consider a family with several money jars: One money jar is labeled "Gasoline," while another is labeled "Groceries."

If you deplete the gasoline fund, you can pull money from the grocery jar. If Social Security or Medicare runs short of money, the government can reach into another of its money jars.

For years, the government used surpluses in the Social Security Trust Funds to mask the size of revenue shortfalls in the federal budget. In the future, the flow may be reversed.

Voters might better think of the federal income and payroll taxes in tandem. There are other taxes to consider, but understanding these basic facts may help readers sort through the ongoing political rhetoric.

Retrieved from the UNI College of Business Administration web site