Round 1 of the fiscal cliff negations is concluded.
Although round 1 indefinitely extended income tax reductions for most Americans, middle-income taxpayers will see their federal taxes increase as temporary FICA tax reductions end. The FICA tax (the tax that supports Social Security and Medicare) is the primary federal tax that middle-income workers must pay. To support the Social Security program, FICA taxes earned income up to $110,100 at a rate of 12.4 percent; the tax is divided equally between employers and employees.
Round 2 is coming up.
Politicians are contemplating "entitlement reform" in round 2. Social Security is the largest entitlement program. If reform follows the established bipartisan model, it will balance tax increases and benefit cuts. A leading proposal to reduce benefits would alter the cost-of-living adjustment using the "chained CPI." Social Security benefits are initially set on the basis of earnings history, marital status and retirement age and then are adjusted annually to reflect changes in living costs.
The chained CPI is expected to reduce Social Security benefits by 0.3 percent per year. This would be a 3.7-percent cumulative reduction by age 75, and a 6.5-percent cumulative reduction by age 85. (The longer one receives Social Security benefits, the greater the cumulative reduction.)
Progressives are concerned. Although the elderly are the least likely age cohort to be poor, this is largely a consequence of Social Security. At present, approximately 9 percent of elderly people are poor, but the near-poverty rate (the proportion of people within 125 percent of the poverty standard) is 5.7 percent. Beyond this, Social Security benefits are modest, providing only about$1,200 per month to the average retiree. Yet Social Security provides 100 percent of the income for more than one third of beneficiaries and half of the income (or more) for 65 percent of beneficiaries. Benefit reductions are likely to have more and more seniors facing poverty and privation.
Although President Obama has considered the chained CPI, he has also advocated raising the FICA tax cap to $250,000. President Obama's proposal does not go far enough. This is an opportunity for bold action to capture the high ground in bipartisan tax reform and channel former President Reagan. The classic Washington tax reform expands the tax base while reducing tax rates. One of President Reagan's praiseworthy achievements was the Tax Reform Act of 1986, a bipartisan reform that reduced marginal income tax rates while increasing the tax base. President Obama could propose a parallel reform for Social Security.
For too long progressives have focused on the income cap that limits FICA tax collections while overlooking the tax's larger problems. FICA is a regressive tax on earned income. In other words, it is a tax on work that has lower-income people paying higher tax rates. By increasing the FICA tax cap, the problems of the present system are perpetuated. Even if the cap is removed entirely, FICA remains a tax on work.
A better alternative is to expand the tax base, not merely by increasing the FICA tax cap but by taxing other income sources. By doing so, President Obama could preserve and protect Social Security while reducing tax rates. This reform is pro-labor, pro-employment and pro-growth; it will stimulate job creation by reducing the cost of employees for business.
If you think this proposal is a pipe dream, recall the evolution of the part of the FICA tax that finances Medicare. When the tax was initiated in the 1960s, it was a capped tax on earned income (structured exactly like the current tax that supports Social Security). In the 1990s the cap was removed, making this part of the FICA tax a flat tax on earned income. However, elements of the Affordable Care Act are making the rate structure somewhat more progressive and expanding the tax base by taxing income sources other than earned income.
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