Senator and Presidential hopeful Rand Paul (R-KY) recently released his tax reform plan. The plan eliminates most of the current taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code and replaces it with two taxes: a 14.5 percent tax on all individual income with a large standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and personal exemption and a 14.5 percent VAT on a business’s profits and payroll. In total, this tax would cut federal revenues by about $300 billion a year or $3 trillion over the next decade. Since it moves closer to a consumption base, it would significantly reduce the cost of capital and would lead to a 9.4 percent larger GDP in the long run.
One striking feature of the tax plan is that it eliminates payroll taxes. Under current law, there are two payroll taxes on an individual’s income. A 12.4 percent payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. that funds social security and a 2.9 percent payroll tax to fund Medicare. The Social Security tax only applies to income up to $117,000 and the Medicare tax applies to all wage income. There is an additional 0.9 percent Medicare surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on income over $200,000 ($250,000 married filing jointly).
Usually these taxes are off the table in any tax reform plan because of their link to both Social Security and Medicare. Senators Rubio and Lee didn’t change payroll taxes in their tax reform plan. Messing with these taxes usually means that you need to mess with entitlement spending, which is even more politically difficult than tax reform, believe it or not.
However, if you look closely he really isn’t getting rid of the Social Security or Medicare taxes. His plan actually shifts the revenue from current payroll taxes to the revenue from a portion of his new business VAT. This shift will mean that individuals will end up paying about the same amount of payroll tax, but it will be collected in a different way.
To understand how this happens, it is important to understand how Social Security and Medicare payroll taxes currently work.
Under current law, payroll taxes (except the Medicare Surtax) are equally split between employee and employer. An employer needs to pay 7.65 percent on its payroll and then each employee needs to pay 7.65 percent on their wages.
Although these taxes are legally shared, both sides of these payroll taxes are ultimately born entirely by the worker. The employee-side of the payroll tax is paid directly by workers and the employer-side payroll tax is born by workers through reduced wages.
Take for example, an individual that earns $40,000. When this individual earns his income, he needs to pay 7.65 percent or $3060 in taxes. However, before the individual was paid $40,000 the employer paid the employer-side payroll tax on his behalf. The employer, in order to cover the payroll tax liability reduced the worker’s pay by precisely the amount of the employer-side of the payroll tax of 7.65 percent ($3,060). Another way to think about this is that, the worker’s pre-tax income would have been $3,060 higher or $43,060 in the absence of the employer-side payroll tax. The total tax wedgeA tax wedge is the difference between total labor costs to the employer and the corresponding net take-home pay of the employee. It is also an economic term that refers to the economic inefficiency resulting from taxes. on this individual’s income is $6,120.
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Payroll Taxes under Current Law vs. Paul plan |
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Current Law |
Rand Plan |
|
|
Total Labor Cost |
$43,060 |
$43,060 |
|
Employer-Side Payroll Tax |
$3,060 |
$6,243 |
|
Wage |
$40,000 |
$36,816 |
|
Employee-Side Payroll Tax |
$3,060 |
$0 |
|
Total Tax Wedge |
$6,120 |
$6,243 |
|
After-Payroll Tax Income |
$36,940 |
$36,816 |
Under the Rand Paul plan, these payroll taxes go away. However, the new business transfer tax would impose a 14.5 percent tax on all of a business’s payroll. Economically, this would work like the current employer-side payroll tax. The business would reduce an employee’s compensation by precisely the amount they need to pay on their payroll. For the exact same worker the business would now to pay 14.5 percent tax on its payroll of $43,060 or $6,243. The worker ends up being paid $36,816 or about $3,000 less in pre-tax income. But with no employee-side payroll tax, the total tax wedge under the Rand plan would be $6,243, which is slightly more than under current law.
It is also important to point out that because the Paul plan would eliminate current payroll taxes, it effectively eliminates the $117,000 cap on the Social Security payroll tax. Under current law, individuals only need to pay the 12.4 percent Social Security tax on the first $117,000 of wages. The business transfers tax, however, applies to 100 percent of payroll, whether it’s paid to an individual earning less than the $117,000 cap or more. This may end up increasing Social Security funding.
This swap isn’t the most important part of the Senator’s tax reform proposal, but it certainly provides a good lesson on the difference between economic and legal incidence of taxation. We can change who sends the check to the IRS, but we may not be able to change who ultimately bears the burden of the tax.
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