The Furtive Tax

Linda Sugin in The New York Times, April 13, 2013

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By LINDA SUGIN

APRIL 15 is dreaded as the deadline for filing income tax returns, but in fact every day is tax day for most working people. That’s because more than half of all Americans pay more in payroll tax than in income tax. That includes nearly everyone in the bottom half of the income distribution.

We don’t file annual payroll tax returns because payroll taxes have one rate and they aren’t adjusted for individual differences that affect taxpaying ability. Your bill remains the same regardless of how many children you support, your medical or education expenses, or your charitable contributions. No standard deduction or personal exemption either: payroll taxes apply to the first dollar.

Since they were introduced in 1937, payroll taxes have risen from two cents to more than 15 cents for every wage dollar earned. Although the tax is technically split between employers and employees, economists agree that workers suffer the whole cost of the tax. Without it, workers could expect to have higher wages, not just lower taxes.

The social insurance rhetoric surrounding the payroll tax might lead you to think that you are paying for your future retirement benefits. That’s not how it works, though: current taxes pay for current benefits. The Social Security “trust fund”? That’s an accounting mechanism, not an actual pot of money.

Workers saw their take-home pay rise for two years on account of a partial payroll tax holiday, but that expired at the end of 2012, when there was virtually no support in the fiscal cliff negotiations for extending it, even though it was good for the economy.

Payroll taxes produce 40 percent of total federal revenue, but they are largely invisible. This is unfortunate because they play an important role in the overall balance of the federal tax burden, which falls much more heavily on income from work. Income from investments is not subject to the payroll tax, and it is also more lightly taxed than wages under the income tax.

Because people with high incomes earn a much greater percentage of their total income from investments — and, crucially, because much of that investment income is wealth accumulation that has not been liquidated — tax law favors the rich far more than most people realize. The money that has been gained on investments that have appreciated but have not yet been sold is not taxed and may permanently escape tax under current law.

This might sound reasonable — why should I pay taxes before I cash out? — but it is actually where the tax system is especially inequitable. Poor people with no savings cannot benefit from the tax preferences for investment, and middle-income workers often pay tax at a higher rate than rich investors, a problem made famous by Warren Buffett.

The ideal level of progressive taxation in our federal system is a vexing issue of philosophy and economics, and reasonable people can (and certainly do) differ about how graduated the rates should be. But even if we cannot agree about what would be fair, we should still be troubled by the substantial disparity in the taxation of individuals at the same income level. At every income level, workers pay significantly more tax than their counterparts who earn an equal amount through their investments.

At $70,000 total income, the worker pays almost $20,000 in federal taxes, roughly half in payroll tax and half in income tax. The investor with $70,000 in capital gains pays less than a fifth of that. This is not just an abstract discussion; it means that the 25-year-old trust funder is paying less in tax than his counterpart who fixes computers for a living.

Tax fairness depends on overall burdens, not just who does and who doesn’t pay how much income tax. The federal tax system has become overwhelmingly skewed to burden work. Why? Because the link between payroll taxes and retirement security is political fiction. The average person retiring today cannot expect to collect in Social Security what he paid in taxes.

Removing or raising the $113,700 earnings cap over which you do not have to pay payroll taxes would reduce the tax’s regressivity, but it would not address our unequal treatment of earners with different sources of income.

April 15 is as good a time as any to think about how we can readjust the federal tax burden so that both workers and investors pay their fair share to finance the many and varied federal programs — including retirement security — that we deem worthy of our tax dollars.

Linda Sugin is a law professor at Fordham University.