The Inequality Cliff

In his post-mortem on the fiscal cliff negotiations, David Leonhardt argues that President Obama’s incentives throughout were to reduce inequality. In that light, he writes, the deal was a success.

As part of this week’s deal, Mr. Obama did make several major compromises. He accepted much less in overall tax revenue than the government would have received absent any deal. He allowed a payroll-tax cut, which applied to most households, to expire. And he yielded both on aspects of the estate tax and on the level at which the top marginal income-tax rate would start, moving it to $450,000 for couples, from $250,000.

 

Still, using inequality as a yardstick, he won much of what he had wanted. By holding firm to a top rate of 39.6 percent — up from 35 percent — he locked in a substantial tax increase for the very richest, who have received the biggest pretax raises in recent years.

 

On average, the top 0.1 percent of earners — whose incomes start at $2.7 million and go much higher — will pay $444,000 more in taxes in 2013 than they otherwise would have, according to the Tax Policy Center. The increases stem from both the fiscal deal and the new taxes in the health care law.

And yet the fiscal compromise also made the tax code less fair. On January 1st, with no action from Congress, payroll taxes rose dramatically, impacting over 163 million workers. So, while the federal income tax was made mildly more progressive, payroll taxes were made significantly more regressive as the 2010 holiday lapsed.

If voters preferences were clearly expressed, the payroll tax holiday would be extended. It's a popular program. Of all the provisions of the "fiscal cliff," extending the payroll tax holiday would do the most to boost the economy. A report from the Economic Policy Institute found that the increased payroll taxes will bring in $114 billion over ten years to the Social Security trust, but cost over a million jobs and cut nearly a percentage point off GDP growth, the largest blow of any of the fiscal cliff policies. JP Morgan, in revising their estimates for 2013 growth down, estimated that the payroll tax cut now may be even more stimulative than in 2008, because cash-strapped lower income households are even poorer after four years of anemic growth. It taxes an already weak job market, particularly hitting low wage earners over high earners. Hendrik Hertzberg argues that eliminating the payroll tax altogether would make a huge dent in youth unemployment by funneling cash into the hands of young people who hold worse jobs.

All told, the payroll tax holiday's expiration was the biggest and costliest portion of the fiscal cliff, yet received almost no attention. The Tax Policy Center provides a useful graphic breaking down impact of the fiscal cliff. It highlights the outsized impact of the payroll tax cut on low and middle income Americans. 

If it both reduces inequality and boosts growth the most, why do Very Serious People hate the payroll tax cut enough to bar it from consideration? Why, despite the president's focus and the public's interest, has it fallen by the wayside? DC's been vigorously debating whether to let the Bush tax cuts expire on those making over $250,000 a year (now $400,000) instead of a debating the merits of raising taxes on working Americans to fix a distant debt crisis. Why?

An unholy trinity of powerful lobbyists, like Fix the Debt, conservative ideologues, and nervous Democrats have seen their interests align in making inequality worse. Though raising payroll taxes is bad economics, bad policy, bad philsophy, it's the preference of the vastly more influential policy preferences of elites rather than the American public, as Mijin Cha demonstrates.

Washington insiders, even Democrats, fear the payroll tax cut makes Social Security vulnerable to benefit cuts. The only problem is that the trust fund is an accounting gimmick. Prominent Democrats fear that cutting the payroll taxes, which fund the Social Security trust, imperil the program. Kowtowing to optics, they sacrifice the working class on the altar of fiscal responsibility. But their policy complaints lie in optics alone. There is no reason, beyond politics, why Social Security should be in jeopardy should the trust run out. Spending beyond the trust isn’t the end of the world and the long-term (think 2030) shortfall is minuscule. As the population ages, Social Security weathers the demographic shift with remarkable ease. But the successful framing of conservative opposition has made the payroll tax a sacred horse amongst the Very Serious People. 

Our projection of Social Security's eventual shortfall, which could easily be remedied by higher taxes.

Conservatives have a cannier reason to oppose the payroll tax cut. They understand that payroll taxes, which widen the tax base, also provoke increased hostility at the government, enabling their anti-tax zealotry to gain new momentum. They’re right, if only because raising payroll taxes forces government to become less and less fair and efficient. Perhaps that's why Grover Norquist, who vocally and vehemently opposes nearly every other tax, supported increasing the payroll tax during the fiscal cliff negotiations. Even while arguing for increased taxes, conservative ideologues then get to return to their constituents and complain that Washington is taxing them more.

Progressives must fight back. The renewed attention on the payroll tax cut after the fiscal compromise is heartening. As Demos President Miles Rapoport wrote, the fiscal compromise had many good progressive components, like the extension of unemployment insurance, the EITC and the child tax credit. But rampant inequality demands a muscular public policy response. If we're reforming the tax code to make it fairer, raising income taxes on top earners isn’t enough. Elevating payroll taxes due to fears about conservative attacks on Social Security is irresponsible and unfair to working people that need the break the most. We went off the inequality cliff years ago, with the gap dividing rich and poor reaching its highest level in over a century. Yes, allowing some of the Bush tax cuts to expire is better than extending them, but it’s just not good enough to tax the rich more.

So, Mr. President: the rich have gotten their tax hike, now it’s time to spend that capital to lift the bottom up. That should entail smart investment, not mild tweaks in tax policy. But if Congress is debating broad tax reform, the payroll tax is a good place to start. As Obama contemplates further spending cuts in exchange for a debt ceiling increase in the coming weeks, he should remember that spending cuts will escalate the still growing divergence between classes, while greater government support for working people would make it better.