Taxes and Spending for Beginners

The Baseline Scenario:

Over the long term, we are projected to have large and growing federal budget deficits. Assuming that is a problem, which most people do, there seem to be two ways to solve this problem: raising taxes and cutting spending. Today, the political class seems united around the idea that spending cuts are the solution, not tax increases. That’s a given for Republicans; Paul Ryan even proposes to reduce the deficit by cutting taxes. But as Ezra Klein points out, President Obama and Harry Reid are falling over themselves praising (and even seeming to claim credit for) the spending cuts in Thursday night’s deal. And let’s not forget the bipartisan, $900 billion tax cut passed and signed in December.

The problem here isn’t simply the assumption that we can’t raise taxes. The underlying problem is the belief that “tax increases” and “spending cuts” are two distinct categories to begin with. In many cases, tax increases and spending cuts are equivalent — except for the crucial issue of who gets hurt by them.*

Social Security is probably the simplest example of this equivalence. The Social Security Trust Fund is scheduled to be exhausted around the late 2030s, but from that point the program’s revenues (from the payroll tax) will be sufficient to pay something like 75 percent of currently scheduled benefits for several decades.

So, you might say, we have two ways to fix this: tax increases (either increase dedicated taxes or take money from general revenues, which will require raising some other tax) or benefit reductions. Needless to say, most Social Security proposals, such as that put forward by the recent deficit commission, largely involve benefit reductions, although they also include modest increases in the payroll tax.

Plan A would simply be to cut benefits across the board by 25 percent starting in the late 2030s, so the amount being paid out equals the amount coming in from payroll taxes. This looks like a spending cut — we’re closing the fiscal gap by reducing spending — so Republicans and moderate Democrats should like it.

What if, instead, we leave benefits exactly where they are and impose a 25 percent tax on Social Security benefits? This looks like a tax increase, where we’re closing the fiscal gap by increasing taxes, meaning “bigger government” (cue the charges of “socialism”). But this tax increase is equivalent in every way to the spending cut above; it’s just another way of framing Plan A.

If a 25 percent across-the-board benefit cut is the “conservative” solution, then the “liberal” solution, Plan B, is to increase the payroll tax by 33 percent, from 12.4 percent to about 16.5 percent.** This is harder to see as a spending cut, but for most people it is equivalent to a spending cut. We pay more during our working years and get back the same amount when we retire; since cash is cash, this is equivalent to paying the same amount while working and getting back less in retirement.

In short, both Plan A and Plan B can be broken down into two components: (1) keeping currently scheduled benefits intact and (2) increasing taxes on someone to pay for it. The difference between them has nothing to do with cutting spending or raising taxes — it has to do with whose taxes get increased.

Under Plan A, we are imposing a tax on seniors equivalent to 25 percent of their Social Security benefits. This is a regressive tax because the richer you are, the smaller Social Security is as a component of your income. We are also raising all of the revenue from seniors, so it’s a large tax increase on a small base.

Under Plan B, by contrast, we are imposing an incremental tax on all wage earners equivalent to 4.1 percent of their wages. This is still slightly regressive because of the cap on earnings subject to the payroll tax, but it’s a lot less regressive than the tax in Plan A. It’s also a small tax levied on a broad base, so it is less of a shock to individual households.***

Now, there are still valid arguments to be made in favor of Plan A. You could argue that increasing the payroll tax rate will hurt the economy because businesses won’t hire as many workers. This is true, but it’s also true that increasing taxes on seniors will hurt the economy because they will buy less. You could also argue that progressive taxes are bad and taxes should be as regressive as possible, and hence Plan A is better than Plan B. I wouldn’t agree with you, but you could argue that.

But you can’t argue that Plan A is better than Plan B because Plan A cuts spending and Plan B raises taxes. When you’re dealing strictly with cash going back and forth between households and the government, that distinction is nonsense.

Most Social Security proposals are more complicated to think about than Plan A and Plan B because they involve changes in the full benefit age, the benefit calculation formula, the index used for cost of living adjustments, and so on. But they all can be boiled down to the following: relative to current taxes and currently scheduled benefits, who gets more cash and who gets less cash? That’s all that matters — not whether they increase taxes or cut spending.