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How to Fix Taxes and Social Security

By Laurence J. Kotlikoff
Sunday, November 7, 2004; Page B07

With his reelection won, President Bush says he will move forward on two big domestic issues: the tax system and Social Security. Both are much in need of our attention; there was little serious discussion of either during the presidential campaign.

Notwithstanding recent tax cuts, our tax system places a huge burden on middle-class Americans, reducing not just their take-home pay but also their incentives to work and save. And Social Security is a time bomb: There are no obvious means, apart from highly regressive payroll tax increases, for covering about two-fifths of its future benefit commitments.

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To his credit, the president did address both matters, albeit briefly and separately, during the campaign. He indicated that a national retail sales tax is worth exploring, and he suggested letting workers invest some of their Social Security taxes in private accounts. Sen. John F. Kerry objected. A sales tax, he said, would raise the tax burden on the middle class. And privatizing Social Security would leave retired people subject to volatile financial returns. As a student of the tax and Social Security systems, I see where Kerry was coming from. But I also see a way to combine both reforms to meet those concerns.

It is embodied in a three-part plan called the Personal Security System (PSS), which has been endorsed by more than 150 top U.S. academic economists:

• Part 1 replaces Social Security's payroll tax with a federal retail sales tax.

• Part 2 eliminates any further Social Security benefit accrual, paying (with the sales tax receipts) only the benefits now owed current retirees and current workers.

• Part 3 sets up an individual account system, but one that Democrats as well as Republicans can support.

Most Democrats should love Part 1. The payroll tax is highly regressive. It taxes only wages, and only up to $87,900. For Bill Gates, who makes $87,900 in minutes, payroll taxes are a pittance. But with a retail sales tax, Gates would pay taxes on every dollar he earns, as well as on his entire $61 billion in wealth, the minute he spends these funds.

Mathematically speaking, a retail sales tax is equivalent to taxing all wages plus all wealth, because both are ultimately spent on goods and services. Hence, replacing the payroll tax with a sales tax is the same as (a) eliminating the payroll tax ceiling, (b) taxing wealth at the payroll tax rate, and (c) taking advantage of the expanded tax base to lower the payroll tax rate. What more could a Democrat want?

But what if Bill Gates saves his earnings and his wealth and spends them later? This delays, but doesn't reduce, his tax payments, because the interest earned on this saving is also taxed when spent. What if Gates gives his money to his kids? Again, there's no tax avoidance; the kids pay the tax when they spend the gifts or inheritance.

How about the elderly who live off Social Security? Won't they be hurt by having to pay higher sales taxes at the store? No, because their Social Security benefits are adjusted annually for price increases, including those arising from higher sales taxes. The same would hold for other transfer recipients were their benefits adjusted for inflation. Congress could go even further and rebate all sales taxes up to the poverty level.

Part 2 phases out the existing Social Security system, which served us well for decades but is well past its prime. Why keep in place a retirement system with 2,528 rules that no one understands, that discriminates against working women, that redistributes income capriciously, that is two-fifths underfunded and that requires highly regressive payroll tax hikes to sustain?

Part 3 replaces the current Social Security system with a fully funded modern alternative. Specifically, the contributions that workers formerly made to Social Security are split 50-50 between spouses and invested in individual accounts. The government provides matching contributions for low earners. All account balances are invested in a single, global, market-weighted index fund, providing all workers the same fully diversified portfolio and rate of return. The government fully guarantees the downside; workers can only gain from investing in the market. At retirement, balances in this Personal Security System are gradually sold off and converted to inflation-indexed pensions. The Social Security Administration handles all paperwork, investing and pension conversions. Wall Street plays no role and collects no fees.

Yes, contributions to PSS accounts are compulsory, but the accounts themselves are private property. If workers feel they are already saving enough on their own, they are free to reduce their non-PSS saving. Thus, the PSS system provides a floor for their retirement saving.

This plan gives Democrats and Republicans most of what they seek via tax and Social Security reform, and it provides a great boost to the economy. Most important, it gives our children a transparent, efficient and equitable retirement system that won't drive them broke.

The writer is chairman of the economics department at Boston University and co-author of "The Coming Generational Storm."


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