To really cut middle class taxes, fix the Social Security tax rate

The American middle class is clearly overtaxed. But the federal income tax is not the primary problem.

Political Cartoon - The Bitter Draught of Taxes. (Public domain)

WASHINGTON, October 13, 2017 — President Trump has proposed a massive tax cut designed to stimulate the American economy with the goal of increasing economic growth to 4 percent annually. His proposal will simplify the tax code as well as bring tax relief to all Americans, especially those in the middle class. Middle class Americans pay a relatively low income tax, but they still carry a heavy tax burden.

According to the Congressional Budget Office (CBO), middle class households earning between $32,000 and $140,000 per year pay an average of 3.4 percent of their income in federal income taxes. For a household with an income of $100,000 per year, that comes to $3,400 a year in income tax. A 10 percent tax cut would amount to only $340 per year. That’s hardly tax relief.

On the other hand, a household like this one that earns almost all of its income as W-2 reportable wages also pays $6,200 per year in Social Security tax. An employer also pays $6,200 per year for each employee. The effective annual Social Security tax burden on that household is thus $12,400.

Opponents of the president’s plan argue that Trump is cutting taxes for the wealthy since most of the tax cuts go to the highest income earners. That is mostly true. The top 1 percent of income earners pay almost half of the federal income taxes collected. The top 20 percent pay about 84 percent of all federal income taxes.

That means the bottom 80 percent of American households pay only 16 percent of the income taxes annually. It is difficult to cut income taxes for a household that doesn’t pay them.

But including the Social Security tax, the middle class bears a heavy total federal tax burden. In addition to high Social Security taxes, the middle class also pays Medicare taxes, sales taxes, state income tax, property taxes, and some excise taxes. The American middle class is overtaxed, but the federal income tax is not the primary problem. To provide real middle-class tax relief, other taxes should be reduced. Can that be accomplished?

Suppose the Social Security tax burden is shifted. Suppose the employer paid 9.3 percent and the employee paid only 3.1 percent. That means that every middle class working American would see a 3.1 percent reduction in his or her Social Security tax. For a household that earns $100,000 per year, the tax cut would mean a $3,100 increase in take-home pay. That’s much better than a $340 federal income tax cut.

But then, corporate taxes go up to cover the increase in the Social Security tax rate. Isn’t that bad for economic growth?

Trump has said that the corporate federal income tax rate must be reduced. In the U.S., the current rate is 35 percent, which is one of the highest corporate tax rates in the world. The high corporate tax burden tends to reduce domestic business expansion and slow economic growth. Since the primary goal of tax reform is to increase growth, corporate taxes must be lowered.

This would more than offset the proposed increase in the corporate Social Security tax burden. But some argue that lower corporate taxes won’t necessarily stimulate growth. Rather, the lower rate will just make corporate stockholders wealthy without benefiting the middle class.

That’s a bunch of poppycock.

Suppose a company has a cost of capital of 7 percent. They have just discovered an opportunity to expand their business. If they invest $1,000,000 via this expansion they calculate, they can earn $100,000 in before tax profits. If their tax rate is 35 percent, they net $65,000, which is a 6.5 percent return. But if capital cost 7 percent and the return is only 6.5 percent, the investment is not made. The business does not expand. The economy does not grow.

If, however, the corporate tax rate were reduced to 20 percent, then the $100,000 pretax profit yields an $80,000 net, which is an 8 percent return on investment (ROI).  With a capital cost of 7 percent, this investment would be made because it would be profitable. The business would expand and the economy would grow.

In some instances, the increased corporate profit may not be directly invested by the corporation. Instead, opponents argue, the corporation may buy back some outstanding shares or increase shareholder dividends. That is true. But both of those actions result in stockholders having more capital to invest – capital that those stockholders will still re-invest in the economy. Other businesses expand. The economy grows.

If the Trump administration really wants to help the middle class, it should propose shifting the Social Security tax burden so workers pay less tax; and reduce the corporate tax rate so the economy expands, which increases the demand for labor. This will stimulate wage increases and provide more opportunities for all Americans.

Actions such as these would bring genuine and noticeable tax relief to middle class Americans while also helping to increase economic growth. That would benefit us all.

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