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Payroll tax cut on its last legs

Before Representatives and Senators slipped out of Washington, D.C., for their extended election year recess frenetic campaigning district work period, we got one hint about what not to expect in January.

House Minority Leader Nancy Pelosi (D.-Calif.) said that the payroll tax holiday should be allowed to expire at the end of this year.

What? A member of the Democratic leadership saying it's time to drop a tax cut that was one of President Obama's most widely recognized legislative victories?

You do remember in late December 2011 how he stood down the Republicans who led the fight against the 2 percentage point cut in the employee portion of the payroll tax. And how public opinion backed the prez and put pressure on the GOP to fold compromise. The tax cut was finally OK'ed retroactively for all of 2012 in February.

Now after all that, the tax cut from 6.2 percent to 4.2 percent of workers' wages and which has been reflected in paychecks for almost two years is going to unceremoniously disappear on Dec. 31?

It seems so.

Bigger tax fish to fry, or to try to catch: The payroll tax cut has kind of gotten lost in the larger fiscal cliff (or Taxmageddon, if you're into hyperbolic rhetoric) issue.

Obama didn't include continuation of the payroll tax holiday in his 2013 budget.

And now both Democrats and Republicans are quietly saying that they don't need to waste their time on this temporary tax cut, but rather focus on overhauling the entire federal tax code. This idea has been popping up more and more, most recently with renewed interest in -- and campaign mentions of -- the Simpson-Bowles deficit reduction/tax reform plans.

They're right. But I'm not convinced they can, or will, do it.

A quick review: Before looking ahead at how the payroll tax might be a part of tax reform, here's a quick review of the earlier fight.

The main argument for the cut was that it was a necessary stimulus mechanism. Many workers, especially the working poor, need the money. And their extra spending money will help keep the economy moving, albeit at 2 percent, incrementally.

Payroll taxes

Unfortunately for folks on this side of the fight, the payroll tax cut didn't work out quite as they'd hoped.

On the other side were Republicans generally who opposed the payroll tax holiday. Democrats said that opposition was because the president proposed it, although some Dems also weren't thrilled with tax holiday idea.

Opponents argued that without taxes from somewhere else, the cut would add to an already huge federal deficit.

Then there's the issue of Social Security's long-term viability. Without continued FICA taxes, future benefits could be cut.

"Taking real tax revenue away from Social Security and issuing debt in its place – the policy now in effect – is the worst of all worlds, both for the program and for the budget," said Charles Blahous, a senior research fellow at the Mercatus Center at George Mason University and public trustee for Medicare and Social Security.

Payroll tax advocates also argued that it eases the regressivity of the Social Security tax. The payroll tax is flat and applies to most workers (more on this in a minute) equally.

Taking 6.2 percent or even the current reduced 4.2 percent Social Security tax hurts a lower wage earner more than a high income worker. Some low income workers pay more in employment tax than income tax (as Mitt Romney learned after his 47 percent remarks).

But, and here's the "most workers" I mentioned earlier, the Social Security portion isn't applied to earnings that exceed an annual threshold. For 2012, this wage base tax cutoff is $110,100.

A friendly suggestion: And that leads to my suggestion. Make the Social Security tax permanently progressive.

Don't collect the employee portion on a worker's first $50,000. Then collect 4.2 percent on wages between $50,001 and the wage base. Above the wage base threshold, collect the full 6.2 percent.

Apply these rates to both the employee and matching employer tax payments.

The Medicare tax can stay as it is: 1.75 percent collected from all workers regardless of income, matched by employers.

No, I haven't crunched numbers.

Yes, I realize that lower income workers are the ones more likely to depend more on Social Security than higher income workers so why should the lower income sector be let off the hook? Two reasons.

First, if they had a bit more money before they retired, perhaps they would be encouraged to contribute to other retirement vehicles such as 401(k)s or IRAs for which they might see a more direct benefit.

Secondly, we could change or eliminate the Earned Income Tax Credit, which was created to help these folks who lose so much of their paychecks to FICA taxes. The EITC is a crucial part of the safety net for the poor, but it's also hard for eligible taxpayers (and sometimes even tax pros) to understand and for the IRS to administer, which makes it rife with abuse.

And yes, from a political standpoint we'd need to revisit taxation of Social Security benefits for higher income earners or a second cap to cut off the contributions if these folks were to contribute more to the federal retirement system.

But we need to start thinking of other ways to get people more money to spend now, to shore up the Social Security system, to contribute to retirement on their own and to make some major changes in our complicated income tax system.

Payroll tax changes should be a part of this plan.

Meanwhile, start saving the extra 2 percent you're collecting now from the payroll tax cut. It looks like it won't be around much longer.

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