About two-thirds of taxpayers pay more in Social Security and Medicare payroll taxes than they do in income taxes[9]. While the EITC is a highly effective means to reduce poverty and encourage work, it is cumbersome in practice, may discourage marriage, and erases work incentives as it is phased out.
Since the EITC has the effect of offsetting a portion of the cost of payroll taxes, another approach would be to reduce payroll taxes. Currently, workers pay a 6.2% Social Security payroll tax and a 1.45% Medicare payroll tax with both matched by an equal tax paid by their employer, resulting in a combined payroll tax of 15.3% per worker.
While a critical program for retirement security, Social Security has evolved over time to produce growing disincentives for workers.[10] A reduction in the payroll tax would have an even broader and more powerful impact to encourage work.[11] Although a reduction in the payroll tax is a simpler, broader, and more effective way to encourage work than the EITC, it also comes with a much bigger price tag. A 1% reduction in the Social Security payroll tax would reduce revenues by roughly $700 billion over ten years. That reduction would reduce future Social Security benefits for workers and the revenue loss would boost the Federal debt and accelerate the Social Security Trust Fund’s insolvency, which is already running a cash deficit and will be exhausted by 2035.
To preserve workers’ Social Security benefits and maintain current revenue levels and not accelerate Social Security and Medicare trust funds’ insolvency, the loss of revenue from a payroll tax cut could be offset by revenue from a carbon or consumption tax.[12] Both options tax consumption, dampen inflation, and do not have the detrimental effects of higher income taxes, which discourage work, savings, and investment that are critical for long-term growth. While consumption taxes are regressive, using the revenues to offset a payroll tax cut would help address the regressive impact of a consumption tax while encouraging work and long-term economic growth.
Another option would be to offset the loss of revenue through reforms in “tax expenditures,” the estimated $1.9 trillion annual cost of various allowances, credits, and deductions that complicate the federal tax code, increase compliance costs, distort investment decisions, and reduce revenues to the Treasury[13].
A variant of cutting payroll taxes would be to reward work by using the revenue from a consumption tax or reforms in Federal tax expenditures to finance individual “add-on” retirement accounts for workers.[14] There are a number of ways to design add-on retirement accounts. As one example, companies could be given the option or be required to devote 1% of their Federal Insurance Contributions Act (FICA) taxes for an employee to a 401(k) retirement plan owned by the employee. The Social Security Trust Fund would be made whole from the proceeds from either a consumption tax or reforms to tax expenditures.