On Social Security, McCain Redefines "Middle Class"

In an entertaining interview with the Pittsburgh Tribune-Review this week, presidential candidate John McCain makes it clear that he won’t fix Social Security through payroll tax hikes. In particular, McCain argues that it’s a lousy idea to increase the cap (currently $102,000) on the amount of any individual’s wages that can be subject to payroll taxes in a given year:

Trib: Do you favor raising the cap?
McCain: Pardon me?
Trib: Do you favor raising the cap?
McCain: No, and I think by doing so, as Sen. Obama wants to do, you are obviously putting a very, very big increased tax on … middle income Americans who filing jointly and in other ways will be paying a very big increase.

McCain’s response here is wrong in two important ways. First, as a CTJ analysis showed a couple of years back, only about 6.5% of Americans would be affected by a proposal that simply eliminates the cap on the federal payroll tax.

But more importantly, McCain’s characterization of Obama’s position on Social Security is flat-out wrong. What Obama has said is that he’d allow the payroll tax to apply to an individual’s wages above $250,000, which is a very different thing from simply removing the cap and taxing wages above $102,000. Here’s the Washington Post’s nice explanation of Obama’s position:

Under current law, income up to $102,000 a year is taxed for Social Security. Obama would create a “doughnut hole” by not imposing new Social Security taxes on income between $102,000 and $250,000. His aides said income exceeding $250,000 would be taxed at a rate of 2 percent to 4 percent, rather than the 6 percent tax that people pay toward Social Security on income below the $102,000 cutoff, which is matched by their employer’s paying a 6 percent tax.

And as a recent CTJ analysis points out, the Obama proposal would only affect 1 percent of Americans– none of whom could be described as “middle class.” As for the alleged “very, very big” tax increase on these middle-class Americans… well, suppose you have a “middle class” friend whose salary was $275,000 (remember, income from sources other than wages don’t count toward the payroll tax, so what matters is each individual’s salary). That means that under Obama’s plan, he would face a tax on his wages exceeding $250,000. His income exceeds $250K by $25,000, so his tax hike would be 2% of $25,000. That would be a $500 tax hike. If this sounds like somebody you know– and if you consider this person “middle class”– then McCain’s characterization seems apt. Otherwise, his description of the Obama plan is screamingly, almost libelously wrong.

The $500 tax hike described above certainly would count as a “very, very big” tax hike for an average middle-income family– but, unfortunately for McCain’s truthiness, there’s simply no way the Obama plan would ever apply to anyone who could reasonably be considered middle-class. Period.

To be perfectly clear about the way the Obama plan would work, a two-earner married couple would not pay more tax just because their combined income exceeded $250,000. Each spouse’s salary must exceed $250K to get hit by the Obama plan. And capital gains, dividends, etc., don’t count toward the $250K: what matters is your salary.

One could charitably attribute McCain’s false statement to fuzziness in his understanding of exactly how the Obama plan would work. One could also say charitably that perhaps “middle class” has a very different meaning in Arizona than in the rest of the nation. But a more realistic interpretation would be that candidate McCain is willfully misrepresenting the truth in the hope that scare tactics are still a good substitute for honest policy debates.

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Tax Cuts, As We All Know, Increase Revenues??

One of the most difficult tradeoffs policymakers have to make is in the level of taxes to collect vs. the level of services to provide. High taxes are generally politically unpopular, though if accompanied by a strong mix of valued government services, they are often considered to be worth the price. In contrast, a government that collects relatively little in taxes may be popular among its citizens come tax time, but the meager level of government services that comes with low taxes is rarely celebrated. Of course, since the federal government is free to run a deficit, sometimes this tradeoff can be delayed, as current spending can be paid for with higher taxes (or significantly reduced spending) at a much later date. Nonetheless, the tradeoff can never be avoided entirely. None of this is controversial.

Enter John McCain. According to Senator McCain,

“tax cuts, starting with Kennedy, as we all know, increase
revenues”.

If true, the Senator from Arizona has found a way around one of the most dreaded problems facing our lawmakers. No longer must we weigh the pros and cons of higher taxes vs. better services. No, in McCain’s world, lower taxes and better services are a natural pair. In fact, according to McCain, the tradeoff between taxes and services that policymakers have wrestled with for centuries is not only unnecessary, but also nonexistent:

“historically, when you raise people’s taxes, guess what, revenue goes down”. – Senator John McCain

Lower taxes aren’t just the easy way to get more revenue – they’re actually the only way!

The Laffer Hypothesis: Show Me The Money?

If only it were that easy. What McCain is referring to is the infamous “Laffer Curve”, or “Laffer Hypothesis”. Under this hypothesis, it is asserted that U.S. tax rates are so high that investment and overall economic activity has been greatly stifled. So stifled, in fact, that since individuals and businesses are paying so much of what they earn to the government, the incentives to take risks and work hard have been effectively removed from the economy – as a result, markedly less taxable economic activity is being than would otherwise be the case. With less taxable activity, there is less tax revenue. Under these extreme circumstances, lowering tax rates should actually boost economic activity to the degree that tax revenues will increase.

Unfortunately for McCain, the evidence against the Laffer Hypothesis is staggering, and few if any serious economists believe the hypothesis to be applicable to the U.S. tax code in its current state. The Department of the Treasury authoritatively showed this to be the case in this 2006 report. That report shows that in each of the four years following the 1981 and 2001 tax cuts, revenue markedly declined. In contrast, following the 1993 tax increases, revenue increased. Simple as that. It seems that the tradeoff does in fact exist: if you want more money to go to funding government services, you’re going to have to pay more in taxes. This really shouldn’t be all that surprising.

Not Just No Revenue … No Growth, Either!

While the Treasury report just cited is more than enough to refute the Laffer Hypothesis on its own, there is also a wealth of literature examining the hypothesis’ premises. Specifically, that literature looks at the merits of what is known as “supply-side economics”, or the school of thought that cutting taxes for businesses and wealthy investors (the “suppliers”, as opposed to the “consumers” in the economy) will markedly improve economic growth. In the American political landscape, this rationale for tax cuts has been equally if not more important than the issue of what will happen to government revenues.

Unfortunately, however, this rationale has been proven to have little if any merit. Ironically, not only have so-called “pro-growth” and “pro-investment” tax cuts been demonstrated to be incapable of raising revenues, they have also been shown (at least in their most recent manifestations) to be incapable of promoting growth or investment. The Center for American Progress (CAP) and the Economic Policy Institute (EPI) recently teamed up to add to the body of literature on this point with their report, “Take a Walk on the Supply Side: Tax Cuts on Profits, Savings, and the Wealthy Fail to Spur Economic Growth“.

In their report, CAP and EPI find that investment growth, as well as overall economic growth, were much stronger in the years following the 1993 federal tax hike, than in the years following the 1981 and 2001 tax cuts. Numerous other indicators suggest a similar finding: median household income, wages, employment growth, and of course, the federal budget, were all in much better shape following the 1993 tax hike than during either of the periods that followed “pro-growth” tax cuts.

Of course, tax policy isn’t the only determinant of economic performance. But if the supply-side argument has any merit, we shouldn’t have seen the economy surge so dramatically following “anti-growth” tax hikes, and fizzle in an equally dramatic fashion in the wake of “pro-growth” tax cuts. At the very least, we would have expected these opposing sets of tax policies to have brought these three periods closer into line with each other. Simply put, when the supply-siders got their chance in 1981 and 2001, they failed to produce results, and dug the nation deep into debt.

Backed by the Politicians, Refuted by the Experts

But aside from all the empirical evidence regarding the Laffer Hypothesis (the CAP/EPI report, as well as another EPI Report from Harvard Economist Jeffrey Frankel already cover that ground more than adequately), the other important point for today’s debate is what to make of various politicians’ inexplicable belief in this thoroughly disproved hypothesis. The allure of putting more money into the taxpayer’s pocket (via tax cuts) while at the same time putting more money into the government’s coffers (through increased economic activity and the associated higher tax revenues) is apparently irresistible, as evidenced by the following quotes taken from Frankel’s paper:

“The increase in revenues should be financed not by new and higher taxes, but by lower tax rates that would produce more money for the government by stimulating higher earnings by corporations and workers”
- President Ronald Reagan

“Some in Washington say we had to choose between cutting taxes and cutting the deficit. That was a false choice. The economic growth fueled by tax relief has helped send our tax revenues soaring. That’s what’s happened”
- President George W. Bush

“The deficit would have been bigger without the [2001] tax relief package”
- President George W. Bush

“It’s time for everyone to admit that sensible tax cuts increase economic growth, and add to the federal treasury”
- Vice President Cheney

More quotes of a similar vein can be found in Frankel’s paper. Also contained in that piece are valuable quotes directly from each of these administrations’ chairmen of the President’s Council of Economic Advisers. The statements of these highly trained economists reflect a remarkably different opinion on the Laffer Hypothesis:

“The height of supply-side hyperbole was the ‘Laffer curve’ proposition that the tax cut would actually increase tax revenue because it would unleash an enormously depressed supply of effort . [this has been] proven to be wrong”
- Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan

“Although the economy grows in response to tax reductions, it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity”
- Glenn Hubbard, chairman of the Council of Economic Advisers under President George W. Bush

“Subsequent history failed to confirm Laffer’s conjecture that lower tax rates would raise more tax revenue. When Reagan cut taxes after he was elected, the result was less tax revenue, not more”
- Greg Manikew, chairman of the Council of Economic Advisers under President George W. Bush

The conflict between these two sets of quotes reflects deep divisions between the politicians and the experts with which they surround themselves. John McCain fits this pattern perfectly. Since McCain is not President (at least not yet), he does not have his own Council of Economic Advisers to refute his wild claims regarding tax cuts. He does, however, have Douglas Holtz-Eakin as his Senior Policy Adviser. Holtz-Eakin is a Princeton-trained economist and former head of the Congressional Budget Office. He also is on record as explicitly rejecting the Laffer Hypothesis.

But McCain isn’t taking Holtz-Eakin’s word for it. Aside from the quotes from John McCain cited earlier, further deference to the Laffer Hypothesis from the McCain camp has been evidenced by the candidate’s choice of Arthur Laffer, the chief proponent of the Laffer Hypothesis, as one of the campaign’s special economic advisers.

This whole asinine situation brings to mind McCain’s previous admission that “the issue of economics is something that I’ve never really understood as well as I should”. Perhaps, given his inadequacies in the subject area, he would be better off deferring to those who do understand it. More “pro-growth” tax cuts targeted to the most fortunate members of society, like McCain’s, are the exact opposite of what is needed.

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