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Sunday, October 20, 2019
HomePolicyTed Cruz, Rand Paul, Payroll Taxes, and the Value-Added Tax

Ted Cruz, Rand Paul, Payroll Taxes, and the Value-Added Tax

Ted-Cruz-SC-Republican-Debate
Ted-Cruz-SC-Republican-Debate

Texas Sen. Ted Cruz defends his tax plan and policy proposal at the sixth Republican debate hosted by FOX Business Network in North Charleston, S.C., on January 14, 2016. (Photo: AP)

My views on the value-added tax are very simple and straightforward. If we completely eliminated all income-based taxes, I would be willing to accept a VAT (or even a national sales tax) as a revenue source for government.

But unless that happens, I’m unalterably opposed because it’s far too risky to give politicians two major sources of tax revenue.

Just look at what happened in Europe (and Japan). Before the VAT, the burden of government spending wasn’t that much higher in Europe than it was in the United States. Once VATs were adopted, however, that enabled a vast expansion of the welfare state.

vat-and-govt-spending-in-eu

VAT and government spending in the European Union.

This is why I’m worried about the Rand Paul and Ted Cruz tax plans. On paper, both plans are very good, dramatically lowering income tax rates, significantly curtailing double taxation, and also abolishing the corporate income tax.

But I don’t like that they both propose a VAT to help make up the difference. It’s not that I think they have bad intentions, but I worry about what happens in the future when a bad President takes office and has the ability to increase both the income tax and the value-added tax. When the dust settles, we’re France or Greece!

By contrast, if we do some type of tax reform that doesn’t include a VAT, the worst thing that could happen when that bad president takes office is that we degenerate back to the awful tax code we have today. Which would be unfortunate, but not nearly as bad as today’s income tax with a VAT on top.

Bad since I’ve already addressed this issue, let’s focus on a part of the Paul and Cruz tax plans that has received very little attention.

Both of them propose to get rid of the payroll tax, which is the part of your paycheck that goes to “FICA” and is used to help fund Social Security and Medicare.

Alan Viard of the American Enterprise Institute has a column in U.S. News & World Report that explores the implications of this repeal.

Would you like to see the FICA item on your pay stub go away and be able to keep the 7.65 percent that the payroll tax takes out of your paycheck? If so, Republican presidential candidates Rand Paul and Ted Cruz have a deal for you – each of them has proposed getting rid of the tax. The senators’ plans would also eliminate the other 7.65 percent that the government collects from your employer, which you ultimately pay in the form of lower wages.

That sounds good, right? After all, who wouldn’t like to keep 15.3 percent of their income that is now being siphoned off for entitlement programs.

But here’s the catch. As Alan explains, other revenue sources would be needed to finance those programs, particularly Social Security.

The payroll tax finances two large benefit programs – 6.2 percent goes to Social Security and 1.45 percent goes to Medicare Part A. If the payroll tax went away, we would have to find another way to pay for those benefits. Paul and Cruz would turn to a value added tax, known as a VAT. …using it to pay for Social Security would have repercussions for the program that the candidates haven’t thought through. …once the payroll tax was gone, Social Security would no longer be a self-financed program with its own funding source. Instead, it would draw on the same general revenues as other government programs.

Viard thinks there are two problems with using VAT revenue to finance Social Security.

First, it means that there’s no longer a limit on how much money can be spent on the program.

…having a separate funding source for Social Security has been good budgetary policy. It’s kept the program out of annual budget fights while controlling its long-run growth – Social Security spending is limited to what current and past payroll taxes can support.

Second, replacing the payroll tax with a VAT eliminated the existing rationale for how benefits are determined.

And that will open a potential can of worms.

…what would happen to the benefit formula if the payroll tax disappeared and Social Security was financed by general revenue from the VAT? Paul and Cruz haven’t said. …One option would be to switch to a completely different formula, maybe a flat monthly benefit for all retirees. …that would be a big step, cutting benefits for high-wage workers and posing tricky transition issues.

I imagine there are probably ways to address these issues, though they might wind up generating varying degrees of controversy. But I’m more concerned with an issue that isn’t addressed in Viard’s article.

I worry that eliminating the payroll tax would make it far harder to modernize Social Security by creating a system of personal retirement accounts. With the current system, it would be relatively easy to give workers an option to shift their payroll taxes into a retirement account. If the payroll tax is replaced by a VAT, by contrast, that option no longer exists and I fear reform would be more difficult.

By the way, this is also the reason why I was less than enthused about a tax reform plan proposed by the Heritage Foundation that would have merged the payroll tax into the income tax.

Yes, I realize that genuine Social Security reform may be a long shot, but I don’t want to make that uphill climb even more difficult.

The bottom line is that I don’t want changes to payroll taxes as part of tax reform, particularly when it would only be happening to offset the adverse distributional impact of the VAT, which is a tax that shouldn’t be adopted in the first place!

Instead, let’s do the right kind of tax reform and leave the payroll tax unscathed so we’ll have the ability to do the right kind of Social Security reform.

P.S. Some of you may be wondering why Senators Paul and Cruz included payroll tax repeal in their plans when that leads to some tricky issues. The answer is simple. As I briefly noted above, it’s a distribution issue. The VAT unquestionably would impose a burden on low-income households. That would not be nice (and it also would be politically toxic), so they needed some offsetting tax cut. And since low-income households generally don’t pay any income tax because of deductions, exemptions, and credits, repealing the payroll tax was the only way to address this concern about fairness for the less fortunate.

P.P.S. Since we have a “pay-as-you-go” Social Security system, with benefits for current retirees being financed by current workers, some people inevitably ask how those benefits will be financed if younger workers get to shift their payroll taxes into personal retirement accounts. That’s what’s known as the “transition” issue, and it’s a multi-trillion-dollar challenge. But the good news (relatively speaking) is that coming up with trillions of dollars over several decades as part of a switch to personal accounts will be less of a challenge than coming up with $40 trillion (in today’s dollars) to bail out a Social Security system that is actuarially bankrupt.

P.P.P.S. It goes without saying (but I’ll say it anyhow) that class-warfare taxation is Obama’s (and Hillary’s) ostensible solution to Social Security’s shortfall.

Written by
Contributing Economist

Daniel J. Mitchell is a Senior Fellow at the Cato Institute, and a top expert on tax reform and supply-side tax policy. Mitchell’s articles can be found in such publications as the Wall Street Journal, the New York Times, Investor’s Business Daily, and the Washington Times. He is the author of "The Flat Tax: Freedom, Fairness, Jobs, and Growth," and co-author of "Global Tax Revolution: The Rise of Tax Competition and the Battle to Defend It."

Latest comments

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    this part is a bit confusing to me, there is a quote …”having a separate funding source for Social Security has been good budgetary policy. It’s kept the program out of annual budget fights while controlling its long-run growth – Social Security spending is limited to what current and past payroll taxes can support.” If social security has been kept out of the annual budget fights, why is it there was no COL this year and why is it always the first one threatened to be cut while welfare is given no such threat? Social security and (medicare) has been a major target every time the budget issue comes up, it’s all we hear about. I’m sure i’m not alone in saying this, stop sending money to foreign countries and let them hate us for free, stop paying farmers to grow or not grow crops, get rid of this ethanol crap, all it does is cause mechanical issues and start paying back the money (with interest) the feds stole from the social security account to begin with, it wasn’t supposed to be a slush fund for the fed to start with.

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    I feel that a electronic transaction tax would be better .That would eliminate record keeping for the average citizen and remove them from any possible penalties or criminal negligance . the tax should be on all transactions between individuals or between business and should include money transfers that move out of or into the country.The tax should be started.The old tax system should remain intact untill the method has been perfected . There should be no exemptions for business or charities no loop holes. Start small with one tenth of one percent per electronic transaction . ignore cash transactions because eventualy it will be deposited in a bank . The cost of software and monitoring would need to be studied . The burden of bookeeping would fall entirely on corporations that are already staffed and accustomed to handling records. The goal would be to reduce the current system that is dependent on the antiquated fill in the form and define the profit merry go round. A universal sales tax would not be fair because businesses never pay sales tax .

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