If Republicans and Democrats are serious about tax reform in 2013, they should throw away the tired old playbook and consider bolder ideas to fundamentally change the flawed tax code. One such idea would be to eliminate the payroll tax.
The payroll tax -- 12.4 percent, split between workers and their employers to help finance Social Security -- is one of the worst taxes on the books for several reasons. A basic economic principle is that when the government taxes something, the nation gets less of it. Because the payroll tax makes it more expensive and administratively burdensome for businesses to hire workers, it's a drag on employment. Also, even the employer's share of the tax is effectively passed on to workers in the form of lower salaries and benefits. In addition, because the tax is capped at $110,000, it disproportionately reduces the take-home pay of lower- and middle-class Americans.
Scrapping the payroll tax could be the basis of a larger compromise on taxes. During the presidential campaign, Mitt Romney proposed a tax reform plan that would get rid of deductions and loopholes while lowering rates. The Obama administration, citing a Tax Policy Center analysis, argued that such a plan would be regressive, because deductions, loopholes and credits in the current tax code disproportionately favor lower income groups. But removing the burden of payroll taxes from middle-class and lower-income Americans would be such a progressive step that it would create more space to simplify the tax code.
There are two main objections to scrapping the payroll tax. The first is the theoretical idea that payroll taxes are a dedicated revenue stream for Social Security. In practice, it just isn't true. All government expenditures ultimately come from the same place. Payroll taxes help subsidize other government functions, and the government will use other tax revenue and borrowing to pay for Social Security when revenues are short.
The other objection is the massive revenue hit to the federal government. In 2010 (the last year before the recent payroll tax holiday), social insurance taxes raised $865 billion in revenue, according to the Congressional Budget Office. But there are a number of ways to recoup that revenue. As stated above, eliminating the payroll tax would make it easier to get rid of a lot of credits, loopholes and deductions. Also, if lower-income Americans aren't paying payroll taxes, they can pay a bit more in income taxes. This would also deal with a conservative complaint that the income tax system needs to be reformed so everybody has at least some skin in the game. Furthermore, if businesses react as expected to the tax changes by raising salaries and hiring more workers, it would expand the tax base.
Obviously, this is a very theoretical, bare-bones proposal that would require a lot more quantitative analysis. But if properly fleshed out, it could be a bold way to create a simpler tax code that maintains progressivity and encourages employment.