WHAT SAYS JACK?
In his 1978 HarvardUniversity honors thesis, The Ideology and Politics of Old Age Insurance in the United States, Jack Lew submitted his ideas on Old Age & Survivors Insurance (OASI) -- Social Security. Long before he was tapped to become the Secretary of the Treasury in the Obama administration, he was looking critically at some of the most fundamental issues facing the American economy.
As with scientists, it may be true that young economists experience their greatest insights before growing their first gray hair. Lew correctly observed that the threat of communism was overestimated. He alleged that the funding mechanism for OASI was a regressive tax that poorly served the US economy. And he suggested that progressive income taxes should replace payroll taxes to fund both Social Security and Medicare.
GRADE HIS PAPER
Was he right? To determine whether or not OASI funding and payroll taxes in general are regressive, several aspects must be examined: the perspective of individual workers; the aggregate perspective of consumers; and the flow of cash throughout the economic system. And what would be the impact of replacing the existing payroll tax with a progressive income tax to fund these benefits?
Payroll taxes are indeed regressive when viewed from the perspective of employed individuals. They fall most heavily upon those who work and earn their income by the sweat of their brow. They only minimally affect those who earn their income passively, through rents, royalties, dividends, interest, or capital gains. If this structural inequity were not enough, the incremental burden of the Social Security payroll tax is entirely removed from those whose earnings exceed $117,000.
WHAT DID HE MISS?
When the OASI program is viewed from the perspective of aggregate consumer spending, the picture changes. Retirees realize increases in their income, so they will view payroll taxes as quite progressive. Retired elders as a demographic have lower incomes than their younger counterparts, and their old age benefits from Social Security reduce income inequality. However, the same demographic enjoys relatively higher levels of wealth, and in this view adding income is actually regressive. But given that the marginal propensity to spend is greater for retired elders than it is for their younger and employed benefactors, OASI is modestly progressive with respect to aggregate spending.
A look at the cash flows of the Social Security funding system should make us worried. Maybe even a little embarrassed. The OASI Trust Fund, from its very inception, has received more in payroll taxes and other income than it has paid out in total benefits and expenses. The balance in the fund at the end of 2012 stood at $2,600,000,000,000 -- and it's still rising. This money doesn't just sit there, but is instead swapped for treasury securities. But there's a middleman in the form of the Federal Reserve, which removes the cash from the trust fund and distributes it to its member banks to lend to corporations and others. In recent years, the securities swapped out for the cash have yielded a pitifully low return. This redistribution does not promote income or wealth equality, but rather promotes the collection, formation, and deployment of capital within the economy.
When capital formation is, in effect, subsidized by the transfer of cash by the Federal Reserve from the SS trust fund to banks and corporations, the balanced competition between capital and labor is disrupted. In a healthy economy, capital and labor compete fairly and evenly. Profits and labor costs are natural enemies. Capital investment aimed at efficiency and/or capacity expansion reduces the labor content of products and services. This increases the aggregate supply of labor in the economy. Wages decline and unemployment rises as a consequence of this indirect but very real subsidy of capital flowing out of the OASI trust fund. And it's very regressive.
THE REAL PROBLEM WITH SOCIAL SECURITY
What's worse than subsidizing capital formation? Taxing employment! Every time an employer wants to fill a job, it must pay a big surcharge to the federal government. Payroll taxes, starting from dollar one at a rate of 15.3%, raise the price of labor and discourage its use in favor of automation, which requires capital, which in turn is subsidized. Herein lies the real problem with OASI funding. Raising the price of any commodity will reduce its demand, and labor is no exception. This being true, we would expect to see stubborn unemployment even as corporate profits grow unabated, and we observe these very things in today's economy. The payroll tax that funds Social Security is literally and directly a job killer!
THE OBVIOUS SOLUTION
Here's where Jack Lew got it right. To fund OASI, simply ditch the payroll tax in favor of a progressive income tax! It could be done, even three decades after Lew's thesis. And with a few tweaks, it could be done without increasing the federal deficit. Here's the form that such a solution might take.
First, eliminate all federal payroll taxes. Second, tax corporations at a rate of 30% of income based upon generally accepted accounting principles (GAAP) net of dividends paid to US taxpayers. Third, tax individual incomes from any source, net of a universal $20,000 standard deduction, at progressive rates of 20%, 25%, 30%, 35%, and 40%, with each rate corresponding to 1/5 of earners -- quintiles. Now we're about $130 billion short of revenue neutrality -- that point at which the deficit doesn't change. To recognize that the American economy has favored wealth and capital for centuries -- and failed to adopt Jack Lew's solution in 1978 -- a modest tax of 15% on the nonresidential value of individual estates over $500,000 would bring the figures into balance.
What would be the result of such a system? The American economy would enjoy faster growth, reduced income inequality, greater stability, less unemployment, and more efficient government. Let's examine the reasons.