January 5, 2003

Dem's Risky Tax Scheme

by Andrew Biggs

Andrew Biggs is a social security analyst at the Cato Institute.

Leading congressional Democrats have proposed a temporary "payroll tax holiday," a rebate of Social Security and Medicare taxes on a worker's first $10,000 in wages. But that feel-good scheme is unlikely to boost the economy, and would set a harmful precedent for Social Security.

The way to solve Social Security's problems is personal retirement accounts. They would cut taxes for all workers and strengthen the program for the future.

Democrats see the payroll-tax rebate, which would send $765 a year to each worker, as an attractive counter to President Bush's focus on income-tax cuts. Sen. John Kerry (D-Mass.) says: "It's fair, it's affordable and it will immediately put money into the pockets of most Americans - including the millions of middle class Americans not helped by the President's tax giveaway. Most important, it will help our economy now - not a decade from now."

A payroll-tax holiday would disabuse Americans that surplus Social Security taxes are "invested" rather than used to cover up deficits elsewhere in the budget. But Kerry's promises are false.

First off, half the total payroll-tax cut would actually flow to employers, which is why business groups support the plan. And what workers do receive won't help the economy much, because they're unlikely to spend it. University of Michigan economists Matthew Shapiro and Joel Slemrod found that "virtually all" of last year's $300 tax rebates went into personal saving, with only around 20 percent consumed.

More important is the way the rebate would undermine the critical link between contributions and benefits that has kept Social Security a contributory social-insurance plan rather than a mere "welfare" program. This link ensures the system neither shortchanges retirees nor fails to live within its means.

Worse yet, under the plan, general tax revenues would paper over funding losses to Social Security, tempting lawmakers to make a temporary holiday permanent. A bipartisan consensus has long opposed financing Social Security with general revenue, but the payroll-tax holiday opens the door.

The three personal-account plans from the president's Social Security commission carry less than half the yearly price tag of the payroll-tax holiday. The payroll-tax cut's full $130 billion annual cost could fund Social Security accounts investing roughly 4.5 percentage points of the 12.4 percent Social Security tax.

Assuming modest investment returns, this account - investing just one-third of the Social Security payroll tax - could pay almost three-quarters of an average worker's promised retirement benefits. As workers with accounts retired, the financial burden on Social Security would be lifted.

The payroll-tax holiday, by contrast, simply drains money from Social Security just when it most needs to be saving it.

Opponents will counter that the proposed payroll-tax holiday is temporary, while the transition to personal accounts would continue for decades. True, but the payroll-tax holiday could easily be extended - especially if Congress gets in the habit of using general tax revenues to cover the hole in Social Security's finances.

Moreover, there is no easier or cheaper way to fix Social Security than through personal accounts: Whatever the costs, we might as well start sooner rather than later.

Personal accounts could also reduce joblessness. The Organization for Economic Cooperation and Development notes that the "tax wedge" on labor - the difference between what the employer pays out, and what the worker takes home - is major drag on employment. And the payroll tax is the biggest tax paid by 75 percent of American households. With personal accounts, workers would see their contributions not as taxes but as deferred compensation, reducing the tax wedge and helping businesses attract new employees.

The payroll-tax holiday is a dubious idea that would give low-wage workers a modest temporary boost, but at the expense of the Social Security program they will depend upon in retirement. Using those same funds for personal retirement accounts would build wealth for those same workers, while strengthening Social Security to bear baby boomer retirements and the aging of the population.

With the political stars finally in alignment for reform, now is the time to act.

This article originally appeared in the New York Post on January 5, 2003.