Social Security Reform: How about a National Sales Tax?

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The race is on: The day following his reelection, President Bush announced his intention to press for Social Security reform, but he has yet to state his preferences. Among the many methods to be floated by experts, besides creating individual accounts, is whether to establish a national sales tax. Laurence J. Kotlikoff believes such a consumption tax will go a long way toward securing Social Security's long-range solvency. Kotlikoff chairs the economics department at Boston University and is the coauthor of The Coming Generational Storm: What You Need to Know About America's Economic Future (Boston: MIT Press, 2004). Kotlikoff provided this commentary to Aging Today through Americans for Fair Taxation, a conservative advocacy group in Houston, Texas. Not so fast, says Dean Baker, codirector of the progressive Center for Economic and Policy Research, Washington, D.C., and coauthor of Social Security: The Phony Crisis (University of Chicago Press, 1999).



With Iraq on the front burner, domestic policy got short shrift in the 2004 presidential campaign. Notwithstanding recent tax cuts, the U.S. 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 walking time bomb with no obvious means-apart from highly regressive payroll tax hikes-of covering two-fifths of its future benefit commitments.

To his credit, the President addressed tax and Social Security reform, albeit briefly and separately, during the campaign. He indicated that a national retail sales tax is worth exploring and suggested letting workers invest some of their Social Security taxes in private accounts.

Senator Kerry objected. A sales tax, he said, would raise the tax burden on the middle class, and privatizing Social Security would leave elders' retirements subject to volatile financial returns. As a student of the tax and Social Security systems, I see where Senator Kerry is coming from, but I also see a way to combine both reforms to meet his concerns.

The three-part plan I favor, which has been endorsed by more than 150 top academic economists in the United States, is called the Personal Security System (PSS). 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 Democrats as well as Republicans can support.

Democrats like John Kerry should love part 1. The payroll tax is highly regressive. It taxes only wages, and only up to $87,900 in 2004. For Bill Gates, who makes $87,900 in minutes, payroll taxes are a pittance. With a retail sales tax, though, 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, 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 eliminating the payroll-tax ceiling, taxing wealth at the payroll tax rate, and taking advantage of the expanded tax base to lower the payroll tax rate. What more could a Democrat want?

But what if Gates saves his earnings and his wealth and spends it later? This delays, but doesn't reduce, his tax payments since the interest earned on this savings 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 older people 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. …