If Congress is committed to serious reductions in
today's record tax burden, it should design a tax plan that truly
would herald the end of the "era of big government" and begin real
reforms of the tax system and Social Security. The extraordinary
amount of tax revenues now collected by the federal
government--approaching a peacetime high of 21 percent as a
proportion of economic output--has given this Congress the largest
surplus since the end of World War II. While these dollars pile up
in the Treasury, Congress and President Bill Clinton dither about
how the resulting budget surpluses should be allocated. The White
House is holding out for Social Security reform, but Congress
remains torn between minuscule tax cuts and the President's mantra,
"Social Security first."
In
truth, the record-high $1.4 trillion in anticipated ten-year budget
surpluses provides more than sufficient resources to give this
Congress and the next the opportunity to do both: make substantial
cuts in taxes and begin meaningful reform of Social Security. The
imminent collapse of Social Security and the harmful economic
effects of the current tax system put Congress under a duty to
act.
The
importance of this duty can hardly be underestimated. Federal tax
laws work against savings and investment, burden all taxpayers with
rules that annually cost society billions of dollars in unnecessary
compliance expenses, routinely shift the payment of taxes to low-
and moderate-income households, and distort economic
decision-making. The defined-benefit, publicly funded retirement
system causes low- and moderate-income workers permanently to lose
thousands of dollars in potential retirement income. It totters
dangerously on the brink of bankruptcy; indeed, it promises future
workers a significantly lower standard of living than today as
payroll taxes rise and retirement benefits fall in an effort to
keep Social Security solvent.
If
Congress and President Clinton can take the bold, decisive action
necessary this year to set a new course for the country's tax and
retirement policies, all Americans will reap enormous economic
benefits, including more freedom to plan for far greater long-term
financial security. This year, Congress can break free of the
narrow view of the opportunity it has been handed and take two
clear steps: (1) move toward more fundamental tax reform by
reducing taxes on labor and capital, while making the tax code more
fair, and (2) begin to reform the government-controlled Social
Security system by giving Americans the freedom to use some of
their payroll taxes to invest in personal, private savings
accounts.
Earlier this year, The Heritage Foundation
published "A New Framework for Cutting Taxes," which outlines a
long-term plan for tax and Social Security reform. The goal of this
plan is to make tax policies in the United States more fair, more
simple, and more flat while establishing retirement policies that
give all Americans, particularly low- and moderate-income families,
more freedom to create greater wealth and income for
retirement. With the unexpected
surplus forecast for the next ten years, Congress clearly can take
steps this year toward this goal.
As a
supplement to Heritage's earlier, comprehensive plan for tax and
Social Security reform, this paper presents two additional,
although less economically desirable, options for using the budget
surplus to bring about these critical policy changes. The Appendix consists of tables that
summarize these two new options, as well as a version of the
original Heritage plan updated to take into account the most recent
surplus estimates from the Congressional Budget Office. More
specifically, the tables present:
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Plan A, the Heritage
Plan (Table 1), calls for the
creation of personal savings accounts (PSAs) for all workers using
5 percentage points of their Social Security payroll tax. It also
calls for the immediate elimination of the marriage penalty, the
imposition of a top capital gains tax rate of 10 percent, the
immediate repeal of federal death taxes, expansion of education
savings accounts, repeal of the Federal Unemployment Tax Act (FUTA)
surtax, and reform of Section 125 ("cafeteria plan") rollover
provisions for health care expenses. The income tax changes equal
$574.3 billion over ten years. The creation of PSAs that equal 5
percentage points of payroll taxes puts $1.9 trillion in payroll
taxes under the control of the workers who earned them.
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Plan B (Table 2) allocates
approximately 60 percent of the surplus to beginning Social
Security reform and 40 percent to income tax reform. The plan calls
for $574 billion in income tax cuts over ten years, from
eliminating the marriage penalty to repealing the FUTA surtax. The
ten-year difference between the surplus and the income tax cuts,
$792.7 billion, would be reserved for reforming Social Security's
retirement program through the creation of personal retirement
accounts financed by reductions in the payroll tax.
-
Plan C (Table 3) allocates 70
percent of the surplus to Social Security reform and 30 percent to
income tax reform. The plan incorporates many of the proposals in
Plan A but substitutes the cut in the capital gains tax (from 20
percent to 15 percent) proposed by House Speaker Newt Gingrich
(R-GA) and the phaseout of federal death taxes proposed by
Representatives Jennifer Dunn (R-WA) and John Tanner (D-TN) for
Plan A's 10 percent capital gains tax rate and the immediate repeal
of death taxes. The amount of the surplus remaining after these
income tax changes ($937 billion over ten years) is allocated to
restructuring Social Security's retirement program.
DESCRIPTIONS OF THE PLANS
Marriage Penalty Reform
Plan A: Reduces marriage
penalties by allowing married taxpayers to choose the filing status
(married joint or single) that most reduces their tax payments.
This option is available widely in the
states: Ten states allow married couples to file separately when
paying state income tax; an additional 21 states have rate
schedules that reduce or eliminate the marriage penalty.
In nearly half of all married-couple
households, these taxpayers will find that filing as single
taxpayers will result in lower taxes. Common income (such as
interest on a savings account or dividends) would be apportioned
between the two taxpayers according to the percentage of total
income that each earned from their jobs.
The standard deduction or the itemized
deductions would be treated in a similar fashion. These married
taxpayers would recombine their income when determining whether
they are eligible for tax credits.
Plan B: Same as Plan
A.
Plan C: Same as Plan
A.
Capital Gains Tax Cuts
Plan A: Cut the tax rates
on long-term capital gains from 20 percent to 10 percent, and from
10 percent to 5 percent for those taxpayers who pay taxes at the 15
percent rate. Additional changes to the complex holding rules
beyond those enacted this session also should be made.
Congress reduced the top capital gains tax
rate from 28 percent to 20 percent in the Taxpayer's Relief Act of
1997, which resulted in significant increases in federal revenues
as investors sold appreciated assets that they had "locked up"
because of the higher tax rate. This tax cut should be expanded to
provide for a top rate of 10 percent.
By cutting the tax rate by an additional
50 percent to a top rate of 10 percent, Congress would add new
revenues as more taxpayers "unlocked" more of their appreciated
assets. And by further simplifying the complex holding-period
rules, Congress would reduce the cost taxpayers currently face when
complying with tax law. Both reforms lead to a fairer, simpler, and
flatter tax code.
Plan B: Same as plan
A.
Plan C: Cut the tax rates
on long-term capital gains from 20 percent to 15 percent, and from
10 percent to 7.5 percent for those taxpayers who pay taxes at the
15 percent rate. In addition, Congress should make additional
changes to the complex holding-period rules above those enacted
this session.
Repeal Federal Death Taxes
Plan A: Repeal the
estate, gift, and generation-skipping taxes effective January 1,
1999. An analysis by The Heritage Foundation, using the WEFA
Group's U.S. Macroeconomic Model, finds that repealing the estate
tax would have a large and beneficial effect on the economy. Specifically, Heritage's
analysis predicts that, if the tax were repealed this year, over
the next nine years:
-
The U.S. economy would average as much
as $11 billion per year in extra output, and an average of 145,000
additional new jobs could be created;
-
Personal income could rise by an
average of $8 billion per year above current projections; and
-
Federal revenues would grow following
repeal because tax receipts generated by extra economic growth
would more than compensate for the meager revenues currently raised
by the inefficient estate tax.
Richard Fullenbaum and Mariana McNeill,
former economists with DRI/McGraw-Hill, confirm these results in a
recent, important study for the Research Institute for Small &
Emerging Business. In a simulation of
estate tax repeal using the WEFA U.S. Macroeconomic Model, they
find that private investment would rise by an average of $11
billion over the seven years following repeal. Consumption
expenditures would rise by an average of $17 billion (after
inflation), and an average of 153,000 new jobs would be created in
this more buoyant economy.
Plan B: Same as Plan
A.
Plan C: Phase out death
taxes over a ten-year period by reducing estate and gift tax rates
by 5 percentage points per year. This policy change would yield
many of the same economic and fiscal benefits expected from
immediate repeal. Representatives Jennifer Dunn and John Tanner are
the original sponsors of this legislation.
Expanded Education Savings Accounts
Plan A: Expand the scope
of education savings accounts to cover not only higher education
expenses but also primary and secondary education costs.
Senators Paul Coverdell (R-GA) and Robert
Torricelli (D-NJ) and House Speaker Gingrich proposed such a
sensible approach earlier in the 105th Congress. The measure (H.R.
2646), as passed by both the House of Representatives and the
Senate, would expand education savings accounts to cover primary
and secondary education expenses and would increase the annual
contribution limit to $2,000 per student.
Ideally, both the annual contribution
limit and income cap should be eliminated. In the end, all families
should have the ability to save for quality education for their
children from kindergarten through graduate school.
Moreover, the coverage of tax-free
education savings should be expanded to include new and innovative
education investment plans. A number of states and several private
interests, for example, have established prepaid tuition plans.
These programs allow families to lock in future college tuition at
or below today's rates.
Such prepaid tuition plans are attractive
to families because they guarantee a predetermined amount of future
education. Thus, prepaid tuition plans not only help families to
save for college; they also eliminate the uncertainty of
ever-increasing college tuition costs. All these plans, both public
and private, as well as other innovative education investment
options deserve the full support of Congress and the President.
Plan B: Same as Plan
A.
Plan C: Same as Plan
A.
Repeal the FUTA Surtax
Plan A: Repeal the
payroll tax increase Congress imposed on workers last year. In
fact, the third-largest tax increase in the Taxpayer's Relief Act
of 1997 was the extension of a little-known payroll surtax in the
Federal Unemployment Tax Act that was scheduled to expire at the
end of 1998. Believing incorrectly that Congress needed to increase
revenues to balance the budget, Members voted to extend the FUTA
surtax through 2007 and raised the ceiling on federal trust funds.
As a result, the tax burden on American workers has hit an all-time
high, and surplus unemployment taxes pile up to be used for
purposes completely unrelated to the unemployment system.
Revenue from the FUTA tax is designated
for the administration of the Unemployment Insurance (UI) system.
The current FUTA tax rate of 0.8 percent on the first $7,000 of
wages has two components: a permanent tax rate of 0.6 percent and a
temporary surtax of 0.2 percent. Passed in 1976 to restore depleted
federal UI trust funds, the surtax was set to expire in 1987. Since
1987, it has been extended five times--despite having accomplished
its goal--and now is set to expire at the end of 2007. Repeatedly
extending the temporary surtax has caused federal UI trust fund
balances to balloon from $4.9 billion in 1987 to $19.1 billion in
1997. Because of last year's extension of the surtax, trust fund
balances are forecast to explode to $41.6 billion at the end of
fiscal year (FY) 2003. Like Social Security payroll tax revenue,
FUTA surtax revenue in federal trust funds is converted to federal
government bonds and spent as general revenues. The money is not
set aside for the UI system.
Senator Wayne Allard (R-CO) has introduced
legislation (S. 2170) to repeal the FUTA surtax. Representative
Clay Shaw (R-FL) has introduced the Employment Security Financing
Act of 1998 (H.R. 3684) that not only would repeal the surtax; it
also would significantly reform the way in which the Employment
Security system is financed. Together, these two bills would allow
workers and businesses to keep $8.1 billion more of their
hard-earned money over the next five years--at the cost of just 1.6
percent of the projected budget surplus. They also would allow
Congress to honor the promise it made in 1993 to repeal the
temporary FUTA surtax and take a small step toward lowering the tax
burden on American jobs.
Plan B: Same as Plan
A.
Plan C: Same as Plan
A.
Reform Section 125 Rollover
Provisions
Plan A: Correct a flaw in
current tax policy by modifying Section 125 of the Internal Revenue
Code to allow workers to roll over up to $500 of unused funds in
flexible spending accounts (FSAs), or cafeteria plans, year after
year, tax-free. The immediate results of such a change would be an
increase in the direct purchasing of medical services from doctors
and other providers, a change in the dynamics of the current
insurance market, and an increase in personal savings for future
health care spending or retirement.
As more funds were saved through such
rollover FSAs and cafeteria plans and became available for
retirees' health care coverage, the future demands on Medicare
would decline. The change in revenue to the federal Treasury in the
meantime, based on calculations by the Joint Committee on Taxation,
would amount only to an average revenue decrease of $700 million
per year, or $6.8 billion over ten years.
Revising Section 125 would result in
immediate benefits for a significant portion of the American
workforce. According to the Bureau of Labor Statistics, as of 1994,
21.7 million private-sector employees chose to take advantage of
employee-provided FSAs--14.8 million employed in medium to large
establishments and 6.9 million in small establishments. In
addition, 50 percent of state and local government employees had
FSAs.
FSAs and cafeteria plans are gaining
popularity in the marketplace. They have been proved to meet the
needs of a diversified pool of workers. If FSA funds can be rolled
over tax-free, they will become a great boon, stimulating employee
savings and enhancing employee security.
Plan B: same as Plan
A.
Plan C: same as Plan
A.
Create Private Social Security Investment
Accounts
Plan A: Heritage analysts
have calculated the amounts needed to fund a 5 percentage point
payroll tax cut that would be devoted to PSAs. These amounts are
shown in Table 1; the details of
this plan are contained in the July 1, 1998, Heritage study, "A New
Framework for Cutting Taxes."
Workers who exercised the choice of
creating their own PSAs would receive the income from those
accounts in exchange for the Social Security retirement benefits
associated with the portion of their taxes they placed in a private
account; however, they would receive the Social Security benefits
financed by the rest of their payroll taxes.
The insurance elements of Social Security,
such as disability and benefits for the dependents of workers who
die before retirement, would not be affected. All Americans,
regardless of whether they had opened a private savings account
with a portion of their payroll taxes, would be entitled to a
minimum benefit from traditional Social Security.
The Heritage plan calls for Congress to
authorize a diversion of a worker's payroll tax of 5 percentage
points into a private retirement savings account that met certain
federal requirements. General federal revenues would be used to
make up the resultant shortfall in trust fund receipts. The
reduction in Social Security benefits would be based on the number
of years during which the individual elected to place a part of his
payroll tax in a private account.
Although the Heritage plan involves a
significant "cost" to the Treasury from the perspective of the
annual unified budget accounts, it leads to a reduction in the
long-term unfunded liability of the Social Security trust fund.
Taken together, the total liabilities of the federal government
that would have to be paid by future taxpayers (specifically, the
national debt plus the unfunded liabilities of Social Security)
would be cut sharply. Meanwhile, workers could look forward to a
higher income during retirement, thanks to the better returns
likely to flow from private accounts.
Plan B: Uses the difference between the
annual surpluses and the income tax cuts to jump-start Social
Security reform. One option would allow workers to invest a portion
of their current payroll taxes that equaled the surplus not used
for income taxes. Plan B would permit $792.7 billion over ten years
(or 2.07 percentage points of the current payroll tax) to be
devoted to PSAs.
Plan C: This plan would permit $$937
billion over ten years (or 2.45 percentage points of the current
payroll tax) to be devoted to PSAs.
--William W.
Beach is John M. Olin Senior Fellow in Economics and Director
of the Center for Data Analysis at The Heritage
Foundation.