Thursday, May 19, 2011

Save Our Social Insurance and the Economy: Repeal FICA (and SETA)

Lately, people have been discussing the future of our entitlement programs as the newly minted congress demands budget cuts and tax reform. Representative Paul Ryan has laid out a plan that involves cutting back on Social Security and ending Medicare as we know it, all while cutting taxes for the wealthiest Americans. Not only are such measures unnecessary, but they would actually make the already unfair system we have devised for funding the programs even more draconian.

The FICA (Federal Insurance Contributions Act) tax is one of the most misunderstood elements of the federal tax system. It is also, in the writer’s humble opinion, both a plague on the American economy, and an unfair regressive tax on the American worker. The FICA tax is made up of two main components, the Social Security portion which is 6.2%, and the Medicare portion which is 1.45%. However, your employer is also required to match your contribution, bringing the total payment to the government to 15.3% of your wages. Most economists would argue that even though half of the tax is paid by your employer, that portion is really money that you would otherwise receive as compensation. In fact, because of a separate piece of legislation, the SETA (Self Employment Tax Act), people who work for themselves do indeed pay the entire 15.3%. (Actually, the net effective tax is slightly less because, in the interest of fairness, the 15.3% is applied to only 92.35% of net earnings to account for the fact that an employees share is calculated against roughly 92.35% of total earnings if you add the employer’s portion of tax paid to total wages.)

The FICA and SETA taxes are regressive taxes, meaning that you actually pay less as a percentage of total income as your level of income rises. This is because the Social Security portion of the tax stops being applied on any dollars earned over a certain ceiling. As of 2011, this is $106,800, and is supposed to rise at the same rate as average national wages. This leads to a perverse situation, where even when you add the federal income tax, a working person’s total effective tax rate is actually higher at around $100,000 than it is at $200,000 (see chart below). Also, FICA and SETA are only applied on “earned” income. This means that income from interest, stock dividends, and capital gains is not subject to the taxes at all. Of course, this type of income usually increases as total income increases, making FICA and SETA even more regressive. Another loophole that makes this even more unfair is that a portion of the tax collected isn’t even used to fund Social Security & Medicare. It is actually borrowed back to the government to spend on everything else it wants to do, instead of collecting it through the regular federal income tax (more on that below).

Total Effective Federal Tax Rate by Annual Income

Some would argue that because Social Security benefits are eventually paid back on a progressive basis, that this offsets the unfairness of the tax collected to fund it. That would be true if Social Security were a savings plan. However, it is not a savings plan, it is an insurance plan. The US Supreme Court ruled in Flemming v. Nestor (1960), that no individual has any accrued property right to benefits from Social Security. Therefore, you cannot look at these programs as forced savings, they are not. Current workers are taxed in order to provide benefits to older generations in exchange for the promise that they will eventually receive the same care themselves. Part of the whole idea behind Social Security and Medicare is that their existence not only benefits individuals, but society has a whole. It is therefore unfair to tax low and middle income people at higher rates than wealthy individuals. If you are a wealthy business owner who derives 100% of your total income from interest and dividends, you pay $0 in FICA or SETA taxes. I have yet to hear a proper explanation from any serious person on how that is considered fair.

You often hear reports in the media that because of the rising rate of Social Security and Medicare expenses, the trust funds will become insolvent sometime between the next 25 and 75 years. While this may be true, the result of such an event is completely benign. The statement is misleading at best, and in my opinion, purposely used as a scare tactic to convince the current generation to accept lower (or zero) benefits in the future. Amazingly, this argument is usually also tied to some plan that lowers income taxes even further for the rich (apparently 0$ in FICA and SETA is too much).

The trust fund becoming insolvent means that at some predicted point in the future, the total amount collected through FICA and SETA will not be enough to pay the estimated benefits. Sounds scary right? What will we do? The answer is simple… nothing. The government will continue to pay benefits the same way it pays for everything else it does, by creating dollars.

Throughout the history of Social Security and Medicare, the FICA and SETA taxes have collected more than is required to fund the programs in any given year. The difference between the amount collected and the amount paid is used to purchase US treasuries. The idea is that US treasuries are the safest investment in the world, and the nominal amount of interest collected can be used to pay for future benefits. If that sounds strange to you, it should. US treasuries are issued by the government in order to account for the amount of dollars they are creating to pay for other spending. This is really just a shell game where the government is telling you they are taxing to pay for Medicare and Social Security, but really spending it on whatever else they feel like. What is the point of the government borrowing excess tax dollars back to itself? Why continue to add to the balance of the trust funds, if it is considered a crisis when the balance of the funds begins to pay out? Well, the point is that you are collecting the taxes from the working poor and middle class instead of the rich, brilliant, eh?

I propose that we put an end to these unfair regressive taxes. The effect on the economy would be swift and profound. This is exactly the sort of jump-start we currently need. Not to mention, the politician who ends FICA taxes would immediately become a hero to the working class. What will we replace the taxes with you ask? I think the better question is why do we assume that FICA would need to be replaced by anything in the short term? Why can’t we continue to pay for our social insurance programs the same way we pay for everything else? Yes, if the deficit becomes too large while we move into full employment, then we would indeed need to cut spending or raise the regular federal income taxes, probably both. However, that currently doesn’t seem to be on horizon, and what does that have to do with keeping an unfair regressive tax on production? Our current system punishes work and rewards the idleness of both rich and poor. So, in the long term then, the question becomes why wouldn’t we structure the tax system in a way that rewards production? I believe we can, and at the same time retain our safety net for future generations. How can we accomplish this you ask? See future posts.