Last year’s unsurprisingly dismal budget numbers contain a surprising revenue story. While overall federal revenue fell precipitously, payroll tax revenue barely dipped at all. This divergent tale of two taxes has one conclusion but many implications. America’s tax system, decidedly tilted toward upper income earners, is precariously balanced. It is not only volatile in economic downturns – it is unsustainable long term.
The Congressional Budget Office recently reported that overall federal revenues fell 16.6 percent in fiscal year 2009. While corporate income tax revenues fell 54.6 percent and income tax revenues fell 20.1 percent, payroll tax revenue funding Social Security and Medicare slipped just 1 percent.
This dramatic difference is underscored by its impact. If all federal revenue had fallen just 1 percent, the federal government would have taken in an additional $394 billion, and the 2009 deficit would have fallen nearly 30 percent – from $1.4 trillion to $1 trillion. These differences matter.
How can this gulf be explained? Some will say the Stimulus Bill’s tax cut reduced income tax revenue. True, but it is hardly significant compared to the overall revenue drop. Congress’s nonpartisan Joint Committee on Taxation (JCT) estimated just a $19.9 billion 2009 loss from the Stimulus’s Making Work Pay tax credit. Even if accurate, and if all the credit’s cost came from lost income tax revenue (rather than increased spending), income tax revenue in 2009 would still have fallen by 18.5 percent.
A reason to doubt that the entire credit’s cost was lost revenue is that the tax credit began phasing out for taxpayers with an adjusted gross income above $75,000. That income threshold is important. According to the JCT tax, those who make below $75,000 comprise of 78.5 percent of all tax returns but pay just 3.4 percent of all federal income taxes and 42.8 percent of all payroll taxes.
Conversely, those who make above $75,000 file 21.5 percent of all tax returns, but together they pay 96.6 percent of all federal income taxes. Also, this bracket pays 57.2 percent of all payroll taxes.
These figures show how top heavy the progressive U.S. income tax system has become. Supported by top earners, the income tax system resembles an inverted pyramid, which rests on an ever-smaller point.
Because of the income tax system’s progressive nature, taxes burden higher earners at an increasing rate. Contrastingly, the payroll tax falls on lower earnings and continues at a flat rate (ending at an income threshold for Social Security). The effect is that although upper earners pay a disproportionate share of payroll taxes too, it is far less than their income share. The reason is, in the case of income taxes, when incomes fall, less income is taxed and at lower rates.
The income tax’s inherent volatility is widely known – though rarely reported. Earners routinely migrate up and then down the income ladder as they age. These earners’ top marginal rates change with this migration. That the same pattern would be replicated by other factors affecting earnings – such as a recession – is hardly surprising.
Profound implications come from this. For one, if there is a moment when income moves away from earners in a recession, then something similar must happen if earners were to move away from income – as in the case of excessive marginal rates. Should rates be deemed too onerous, individuals may substitute other goods for income – nonmonetary goods, such as more leisure – as well as undertake more complicated tax deferral and avoidance actions. The resulting effect would be similar to that of the economic downturn’s revenue drop.
These dynamics question a tax strategy premised on ever increasing top marginal rates. The more projected revenues are based on higher progressive rates, the less secure is the fiscal superstructure resting on it. Our tax system is already exceedingly dependent on top earners earning top dollars. However, the goose plucked today should not be counted on to be so well feathered tomorrow.
Simply put, if projected revenue does not materialize, then the entire system will continue to reel. The money has to be found somewhere. The payroll tax shows durability and potential for growth. As surging federal spending spurs surging federal deficits, the revenue potential of more than three-quarters of America’s earners will not go unnoticed by Washington’s spenders for long.
J.T. Young served in the Department of Treasury and the Office of Management and Budget from 2001-2004 and as a Congressional staff member from 1987-2000.