Professor Kotlikoff agrees with President Bush's tax reform

By: Laurence J. Kotlikoff

Chairman, Department of Economics

Boston University

Co-Author, The Coming Generational Storm

October 7, 2004

750 Words

Getting to Yes on a National Sales Tax and Social Security Reform

With Iraq on the front burner, domestic policy is getting short shrift in the presidential campaign. Two issues ‑ the tax system and Social Security - deserve much more attention. 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 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, in recent weeks. 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 the elderly's 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, which has been endorsed by over 150 top U.S. academic economists, is entitled 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.

John Kerry 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 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 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 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, PSS balances are gradually sold off and converted to inflation-indexed pensions. The Social Security Administration handles all paper work, investing, and pension conversions. Wall Street plays no role and collects no fees.

This plan gives Democrats and Republicans most of what they seek via tax and Social Security reform and 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 Fair Tax Act, HR 25, is the FINAL SOLUTION to our tax problems.

See the Fair Tax at: www.fairtax.org

Then go to: www.congress.org and tell your congressmen that you want the Fair Tax Act, HR 25, passed into law ASAP!!!!