Rethinking the 'other' payroll tax

Pete Souza/White House

President Barack Obama pauses after signing H.R. 3765 – “Temporary Payroll Tax Cut Continuation Act of 2011,” in the Oval Office, Dec. 23, 2011.

Article Highlights

  • The payroll tax “holiday” produced no noticeable gains in employment growth in 2011

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  • Eventual extension of the payroll tax rate reduction for a full year remains very likely

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  • Expanded levels of income-related premiums for Medicare B and D will erode the original “universal” nature of the Medicare entitlement

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Congress returns for its next session later this month (despite rising popular demand to just stay away), with a long list of unfinished business items. Topping it is President Obama's demand that Congress extend for a full year the "temporary" two-month reduction in the payroll tax rate for financing Social Security's retirement benefits. Hill Republicans are likely to end their resistance to the so-called tax cut, for political reasons, regardless of strong policy reasons against doing so. Ironically, it might be time to consider moving away instead from another arm of the payroll tax - for Medicare, not Social Security.

In late 2010, a lame duck session of the previous Congress reduced the longstanding 6.2 percent "FICA" tax rate imposed on the covered wages of workers to only 4.2 percent - for all of calendar year 2011. The payroll tax rate for employers remained at 6.2 percent.

As part of a larger fiscal policy compromise, the primary rationale for the payroll tax rate reduction was that it might help stimulate employment growth (by raising take-home pay and indirectly reducing the net cost of hiring, or retaining, employees). The short-term budgetary shell game included making up for the loss of foregone payroll tax revenue with new injections of equivalent amounts of general revenue funds into the Social Security trust funds to make them whole (in other words, more borrowing from the rest of the federal budget, to paper over the one-year payroll tax reduction). Future social security benefits for current workers would not be reduced to reflect their lower tax contributions.

"More fundamental concerns involve whether continuing general revenue financing of Social Security will begin to erode the traditional link between the taxes that a worker 'contributes' to Social Security and the benefits he or she eventually receives."--Thomas Miller

The payroll tax "holiday" produced no noticeable gains in employment growth during 2011. It essentially traded more debt for temporarily lower taxes. But the President and his Capitol Hill allies insisted on more of the same, in late 2011. After extensive political posturing on both sides of the partisan divide in Washington, including respective calls for greater fairness to middle-class workers and the need for budgetary offsets to pay for the tax cut, Congress barely managed to resolve the issue by agreeing in late December to a temporary extension for the first two months of 2012.

Eventual extension of the payroll tax rate reduction for a full year remains very likely. It constitutes good short-term politics, if not sound long-term economics. Better incremental alternatives might include lowering the FICA tax rates on employers, to reduce more directly their visible costs in hiring new workers and retaining current ones.

But more fundamental concerns involve whether continuing general revenue financing of Social Security will begin to erode the traditional link between the taxes that a worker "contributes" to Social Security and the benefits he or she eventually receives. If the payroll tax holiday for current workers turns into a permanent entitlement within the tax code, the political imagery of Social Security as universal social insurance in which each worker "earns" future benefits by contributing a fraction of his or her earnings over time will begin to morph toward a more means-tested "welfare" program increasingly competing for its share of current general revenue.

Standing by, off stage, is the more complex and contorted financing of Medicare, which still relies in part on payroll tax revenue, too. Its Hospital Insurance Trust Fund (Medicare Part A) has been financed since its inception by a payroll tax on wage income (currently 1.45 percent for employees and their employers, respectively) However, the original indexed ceiling on taxable wages first was increased, and then removed entirely in the early 1990s (delinking it from the Social Security taxable earnings cap indexed to average wage growth).

In the larger context of total Medicare spending, the portion financed by payroll taxes has diminished. Expenditures for Medicare Part B (outpatient services) and the newer Part D (prescription drugs) both are funded through a combination of general revenue and beneficiary premiums. They have grown more rapidly over the last decade and promise to do so far into the future. Payroll tax revenue for Part A amounted to less than 40 percent of non-interest revenue for the entire Medicare program, below general revenue's 44-percent share. Under a different measure of financing mandated by the 2003 Medicare Modernization Act, a fiscal forecast that more than 45 percent of Medicare funding soon will rely on general revenue has been "triggered" in every annual Medicare Trustees report since 2007 (though ignored by the Obama administration).

More recently, the Affordable Care Act (ACA) further transformed the relatively simple structure of the traditional wage-based Medicare payroll tax. Beginning in 2013, a higher tax rate (2.35 percent) will apply to workers with wage or self-employment income in excess of $200,000 per year (or married couples filing jointly with more than $250,000 in work-based income). This split-level tax rate is decoupled from the tax rate on employers, is not indexed for future years, and introduces new complications in accounting for spousal earnings for estimated taxes. The ACA also imposes an unprecedented additional tax (3.8 percent) in 2013 on "investment" income for high-earning individuals and married couples. Describing its calculation and incidence defies a shorthand summary here, but the new tax further separates Medicare-related "taxes" from work-based Medicare benefits.

At one time, flat tax enthusiasts might have whimsically suggested that the Medicare payroll tax could provide a foundation for a broad-based, single-rate consumed-income tax approach to fundamental tax reform. The post-ACA version now threatens to make the rest of the Internal Revenue Code look fairer and simpler!

Medicare payroll taxes have lost any direct link to the level of health benefits available to beneficiaries (once the latter have established sufficient taxable work history for Medicare eligibility). Expanded levels of income-related premiums for Medicare Parts B and D will further erode the original "universal" nature of the Medicare entitlement.

Hence, future efforts at more comprehensive tax reform should avoid the current distractions of Social Security payroll tax cuts and focus more on rationalizing and simplifying the future financing of Medicare. Moving away from the Part A payroll tax and toward a greater combination of general revenue support and income-related beneficiary premiums (and cost-sharing) for the hospital insurance side of Medicare would constitute better tax policy. It also would facilitate more transparent budgetary policy, expose long-term unfunded liabilities, help collapse the artificial financial silos that discourage integration of Medicare health benefits, accelerate the overdue transition to defined contribution financing of Medicare, and help re-target subsidies toward the neediest beneficiaries.

Cutting the payroll tax cut, or even eventually eliminating it, might make more sense - if it happens on the Medicare, rather than Social Security side, of FICA.

Thomas P. Miller is a resident fellow at AEI

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