For two decades, a major goal of tax reform has been to boost savings and investment by lowering taxes on income from the investment of capital---capital gains, profits, dividends, and interest. And some economists have cheered this on. Even the latest bipartisan budget deal holds out the promise of a cut in the capital-gains tax rate and more generous tax advantages on individual retirement accounts.
But with investment robust and the stock market at an all-time high, it may be a good time to start considering an alternative: encouraging investment in human capital by easing back on the payroll tax. When it comes to labor, tax policy has proceeded in the opposite direction. In essence, the current tax code levies a higher tax on investment in human capital, such as training and education, than it does on investment in physical capital. The maximum capital-gains tax rate, for instance, is 28%. Nominally, the earnings of a middle-income family are taxed at that same 28% rate. But the family's total tax bill reflects an effective federal rate that's closer to 40%. The reason: In addition to income taxes, workers are faced with a large payroll tax bite, mainly for Social Security.
HUMAN TOUCH. The total payroll tax now stands at 15.3%--up from 9.6% in 1970--on the first $65,400 in wages. While technically, half the tax is paid by workers and half by employers, almost all economists agree that workers bear the brunt: The employer share is ultimately paid by workers through reduced wages. This added load means that lower- and middle-income workers who get more training or education end up paying a high marginal tax rate on their increased wages, certainly no reason to refuse a raise but no big reward. Simply put, the tax system now gives workers little incentive to invest in themselves.
Just as lowering capital-gains taxes increases the incentives for investment in physical capital, so lowering payroll taxes would provide incentives to invest in human capital. Employees would keep more of the increased wages that result from their enhanced skills. In today's knowledge-based economy, it may well be that such investment in human capital is more important than buying more equipment.
The payroll tax also places a tremendous burden on the self-employed and small businesses, which must find the cash to pay their share of the payroll tax regardless of profitability. Over time, throttling back on the Social Security tax might spur more small-business creation than a capital-gains tax cut. And as employers dig deeper into the labor pool, they have an incentive to invest more in training. "It makes people who were once considered unemployable considered employable," says Mark Zandi, chief economist at Regional Financial Associates Inc.
Of course, there are two big obstacles to reducing Social Security taxes. The U.S. savings rate remains lower than those of major industrial nations. Many economists believe that more savings are essential to sustain economic growth. Yet the concern may be misplaced: Corporate America has managed a capital-spending boom lately, despite 15 years of low savings.
GO FOR GROWTH. Then there's the matter of how to keep paying for Social Security after a payroll tax cut. The political problems in removing this obstacle are daunting, but there are ways to make up any funding shortfall. One possibility is to tap general revenues. It's an accounting fiction that payroll tax money goes into a "trust fund" that then pays out benefits anyway. Also, savings from adjusting the consumer price index downward could help offset a modest payroll tax cut.
In the long run, government projections show that faster economic growth can cure many of Social Security's fiscal problems. And perhaps the best way to get the economy growing faster is to give people and companies more incentive to invest in human capital and training rather than machines. That may be the road to prosperity.