A Stealth Tax on Wages

A Stealth Tax on Wages

The White House is trying to radically restructure the federal government’s revenue-raising activities.


With nearly $1.8 trillion in tax cuts rammed through in just three years, the Bush Administration is now addressing the more fundamental business of restructuring the tax code itself. That means not just chopping existing taxes–mainly on the affluent–but shifting the whole focus of the federal government’s revenue-raising activities.

One former Administration official who may be gazing wistfully at the new agenda is Paul O’Neill, who spent much of his brief tenure as Treasury Secretary pushing for an attack on the tax code and the Social Security system rather than the series of cuts that the White House prioritized instead. This year, the Administration is finally pressing forward in the direction O’Neill had favored, with a series of initiatives that would eliminate much if not most taxation of savings and investment, and instead aim the tax collector’s net squarely at workers’ wages.

Health Savings Accounts already became law in December as part of the legislation that created a Medicare drug benefit. HSAs allow individuals to shelter up to $2,600 a year for health expenses, and families $4,500–amounts that will rise with inflation. The second ingredient, expected to be a focal point of Bush’s soon-to-be-released 2005 budget, is a portfolio of three new tax-exempt savings accounts. Retirement Savings Accounts (RSAs) would take over from traditional IRAs and could not be tapped until the saver is at least 58. The same would apply to Employer Retirement Savings Accounts (ERSAs), which would replace employer- sponsored savings accounts such as 401(k)s. Money contributed to Lifetime Savings Accounts (LSAs), the most radical of the new structures, could total up to $7,500 a year per family member and could be withdrawn at any time for almost any purpose.

The third element of Bush’s program is partial privatization of Social Security–essentially, using a portion of the payroll taxes that fund the current system to create voluntary individual retirement accounts. Four new bills offering different versions of such a scheme were introduced in Congress last year. Aides say Bush plans to set partial privatization front and center in his re-election campaign, and he mentioned it prominently in his January 20 State of the Union address.

All three components of Bush’s tax strategy rely on tax-advantaged private savings accounts to pay for services that formerly came from the government or employers–in this case, employee health care and retirement benefits. In all three plans, as well, individuals could pass on the assets to their heirs when they die. Taken together, these changes will allow affluent Americans to shelter hundreds of billions of dollars a year from taxation, effectively rolling back much of the progressive structure that was implemented beginning with the income tax ninety-one years ago.

How does this work? With more and more capital income–from savings and investments–shielded from taxation, that leaves generally less affluent workers to shoulder most if not all of the burden of paying for government out of their wages. “One of the goals long-term is to have the lowest taxation on capital income as possible,” explains Eric Engen, a resident scholar at the American Enterprise Institute–“not just another tax decrease across the board.”

But Bush’s piecemeal approach to eliminating taxation of saving and investment is bound to make the tax code more complicated, not less–which some say might be just what the Administration has in mind. Conservative economists have long promoted consumption taxes as a way to encourage saving, even though they fall most heavily on lower-income workers. Leonard Burman, a senior fellow at the Urban Institute, says the Bush tax strategy is a first step to replacing the income tax with consumption taxes. “They’re going in through the back door, moving to wage taxation by messing up the income tax code so that it’s unfair and inefficient–not just unfair.” That will open the way for the White House to eventually propose junking the whole system in favor of a consumption tax, he predicts.

The consequences for lower-income households are ominous. “If someone inherits, say, $1 million and lives off the investment income, that won’t be taxed,” says Peter Orszag, a senior fellow at the Brookings Institution who has analyzed the three proposed savings accounts. “Yet someone who works hard and sweats it out and earns $1 million over a lifetime will pay a heavy tax burden.” Or, as a Congressional committee staffer close to the debate puts it, “If only wages are taxed, that takes us back to a system where the poor are taxed and the rich escape taxation.”

The workers most likely to take full advantage of the benefits are the already affluent. HSAs can be used to cover healthcare policies only when hefty deductibles of $1,000 a year for individuals and $2,000 for families apply. And Bush’s proposed three-pack of new savings accounts would have none of the contribution limits and other rules that currently keep tax-exempt savings from benefiting only the rich.

Bush’s tax overhaul agenda also threatens to blow an even wider hole in the federal budget. The HSAs could skim $6.4 billion off the income tax uptake over ten years, according to the Joint Committee on Taxation. A report issued early last year by the Tax Policy Center, jointly run by the Urban Institute and the Brookings Institution, estimated that LSAs could drain away $200 billion to $300 billion in revenues over ten years, or an estimated 0.3 percent of what is expected to be the Gross Domestic Product in 2013. RSAs would suck out another $50 billion, or 0.5 percent of GDP, by 2028. The losses in capital gains, interest and dividend taxes would shrink if the White House decides to hold annual LSA and RSA contributions to $5,000 instead of $7,500, as it is reportedly considering, but would still be substantial.

Payroll taxes siphoned into millions of individual Social Security accounts could suck up another $1 trillion over ten years. The problem for low-income workers is what they will do if their personal accounts do not make up for the retirement income they will lose if basic Social Security benefits are cut–which most of the proposals now being circulated would do in some form.

Bush’s tax transformation could fail to fly. Record federal deficits topping $400 billion projected for each of the next two fiscal years could make it hard for Congress to find room for the three proposed new savings accounts. They could also hamper Bush from using payroll tax revenues to create his Social Security accounts.

Democratic leaders in Congress are already flagging some major problems with the savings accounts, especially the fact that savers would pay taxes on their contributions when they make them, rather than later on, when they start to withdraw assets. That could provide a temporary boost to revenues over the next five years, helping Bush to claim he fulfilled his State of the Union pledge to halve the deficit in that period, but draining revenues in later decades.

And the Bush White House tends to get its way on Capitol Hill. The Treasury reportedly is still ironing out details on the three savings accounts. One possibility is to offer a government match to low-income workers, giving them a greater incentive to save and combating the impression that the new accounts are primarily a tax break for the rich. That could win Democratic lawmakers–and presidential candidates–over to some version of the plan.

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Katrina vanden Heuvel
Editorial Director and Publisher, The Nation

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