Voodoo Taxation

Should the Bush income tax cuts be made permanent? Answering this question is likely to be one of the first orders of business for the new Congress. Opponents complain that the tax cut is a giveaway to the rich. Fat cats are going to get fatter. Defenders of the tax cut answer that the rich pay a lot of the taxes, so an across-the-board tax cut is going to help the rich. It’s inevitable.

Both sides are only about half right.

Talking about a giveaway makes it sound like the U.S. Treasury is going to write checks to the richest Americans. But that’s not true. In fact, after the tax cuts are put in place, the rich will pay more taxes in the future.

How can that be? The real confusion here is between tax rates and tax revenue. You can cut rates and collect more revenue. And you don’t have to believe in the Laffer Curve or voodoo economics. You just have to believe in growth, whether it’s caused by lower tax rates or other causes.

Between 1981 and 1990, the income tax revenue increased more than 60 percent even though rates were lower, because incomes grew. Incomes were sufficiently higher at the end of the decade so that even at lower rates, more revenue was collected. (The budget deficits of the 1980s occurred because spending grew 85 percent from 1981 to 1990.)

And even with lower tax rates, the rich shouldered a bigger share of the revenue burden. In 1981, the richest 1 percent of taxpayers paid 18 percent of the money collected by the income tax. By 1990, even with dramatically lower tax rates for the rich, the top 1 percent paid 25 percent of the taxes. Today, that number is close to 40 percent.

When opponents of the tax cut complain that the rich are going to get half a trillion dollars, what they mean is that the rich are going to pay less in taxes in the future than they would have if rates were left unchanged. That may be true. But given the usual growth in income, even with lower rates, the rich will end up paying more in taxes than they do now. It’s not literally a giveaway to the rich.

But fans of the tax cut also are dishonest. When they say that the rich should get a large share of the benefits from a tax cut because they pay such a large share of the taxes, they talk about only the income tax. But what about payroll taxes? A true across-the-board tax cut shouldn’t be limited to the income tax. It also should include the payroll tax that is paid by every worker, rich or poor.

What we should do is get rid of the payroll tax and create a tax bracket for low-income workers that leaves their total tax burden lower than it is now under the payroll tax. Fund Social Security benefits out of general revenues.

Then we can talk about an honest across-the-board tax cut. Fans of the tax cut might settle for a smaller tax cut if it had to be truly across the board. And opponents of the current tax cut might support it if it helped low-income Americans.

But if Social Security receives its funding from general revenues, the elderly will have to depend on the will of Congress to keep benefits intact. If you think that’s scary, I’ve got some bad news for you— that’s exactly the world we’re in right now. The payroll tax hides the reality.

The Social Security trust fund and the “lockbox” are accounting fictions. When the baby boomers retire, we’ll turn to those trust funds and find out there are no real assets there, just government bonds that will have to be paid for out of—you guessed it—general revenue. With or without a payroll tax, Congress can lower benefits or raise the retirement age. It is the political cost of such moves that ultimately protects our Social Security benefits.

Getting rid of the payroll tax will lead to a less polemical debate about tax cuts and a more honest, fair and transparent tax system. It’s probably a little too honest and transparent for a politician, but I can dream, can’t I?

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