Wednesday, July 22, 2009

The Regressive Tax that does the Work

The federal government’s two main revenue sources are the individual income tax and the payroll tax. The more rapid growth of the payroll tax (which includes Social Security and Medicare taxes) relative to the individual income tax may be one reason politicians increasingly call for “taxing the rich.”

Officially known as a “contribution,” the Social Security tax brings in almost as much revenue as the individual income tax, and is catching up. By June 2009, annual revenues for the payroll tax collections had reached almost 90 percent of individual income tax collections.

The Social Security part of the payroll tax is about 12 percent of the first $106,800 of employee earnings in a year. The Medicare part is about 3 percent of all payroll earnings (regardless of whether and how much employees make over $106,800).

As a result, people earning over $106,800 pay a lesser percentage of their earnings in payroll taxes than do people earning less than $106,800.

The highest-earning third of United States households pay more individual income tax than payroll tax. But the other two-thirds are paying more payroll tax than income tax.

Higher earners are still responsible for a disproportionate fraction of total taxes, but their share becomes less disproportionate as payroll taxes grow and individual income taxes shrink. In other words, thanks to these revenue trends, an adjustment of relative tax rates for high and low earners may be needed in order to restore the previous amount of fairness (or unfairness) that was present in the overall tax system a few years ago.

One approach might be to cut the payroll tax, so its revenues fall in proportion to the loss of individual income tax revenue experienced by the Treasury during this recession.

Another approach — which President Bill Clinton used, and which then-candidate Barack Obama discussed during the presidential election — might “uncap” more of the payroll tax. That is, some part (or all) of the Social Security tax rate could apply to incomes over $106,800. The approach in the House’s health care bill seems to be to put individual income tax surcharges on people earning over $250,000 a year.

Various groups are opposed to the income tax surcharges, and for some good reasons — the surcharges will harm our economy and may bring little revenue. But opponents to the surcharge will have more political success if they recognize the changing roles of the payroll and income taxes in our economy, and how those changes fuel some of the “populism” in Congress.

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