Payroll Tax Has Become a Monster. It Needs to be Replaced | Opinion

When the Roosevelt Administration was fashioning the New Deal, Washington established a well-intentioned tax to help pay for Social Security. The "payroll tax" was simple-enough to administer: money could be taken directly out of each worker's paycheck. And since most incomes fell below the taxable threshold of $3,000, nearly every worker was subject to a small withholding. The burden on taxpayers was minimal, and it funded 1 percent of the federal government's income.

Today, it's 35 percent. Over the last eight decades, the payroll tax has metastasized into something out of Dickens novel, piling more and more of the tax burden on those who can afford it least. Some presidential hopefuls now threaten to make it worse.

It's already the biggest tax 80 percent of Americans pay. It targets middle- and working-class families, with low-income families paying the most as a percentage of income. It's the funding source for Social Security and Medicare, but it's so regressive and destructive that lawmakers and candidates in this election cycle should be looking to replace payroll taxes, not use them as a cash cow.

Imagine you're an employer faced with a choice—either maintain your current workforce or make a massive investment in an experimental technology that may allow you to produce the same product with half the workforce. Imagine that, before taxes, both options would drain the same aggregate resources from your bottom line. Incredibly, today's payroll tax actually incentivizes employers to choose the technological option for one simple reason: Businesses don't pay a special tax on machines – only a payroll tax on human employees. Further payroll tax hikes, which many are proposing or enacting, will only exacerbate the problem.

The economic effects are palpable, though hidden amid more visible indicators of a prosperous economy. We're supposed to be at near "full employment" today, though the disappointing jobs report for May showed job creation dipping to a nine-year low. It rebounded again in June, but official unemployment statistics are wildly misleading. Since the Great Recession, net job growth has occurred only in the 20 percent most prosperous zip codes. Everywhere else, there are fewer jobs today than there were in 2007.

How do you square that circle? Tens of millions of Americans who have given up looking for a job are no longer classified as part of the workforce, so they're left out of unemployment measures. Cyclical change aside, U.S. prime-age workforce participation has been declining steadily since the 1990s (since the 1960s for men). Today, almost 40 percent of working-age adults—over 100 million Americans—are out of work. Some are happily retired or otherwise choose not to work. But a majority likely would re-enter the workforce given a reasonable opportunity, which they lack.

Phasing out the payroll tax could change that. Some would oppose it, because it directly funds Social Security and Medicare. But any tax could provide that funding, and an alternative funding mechanism could break the vicious cycle the payroll tax creates, hurting the people and exacerbating the problems Social Security and Medicare are designed to help. The payroll tax inflates hiring costs, which depresses job growth, which increases joblessness, which results in additional government dependency costs and a wave of health problems.

Here's an alternative: Eliminate the "Dickens" tax and replace it with a value-added tax, a carbon tax, an energy inefficiency tax, or other non-labor taxes. Any of those alternatives—or any combination—would move federal incentives from bad behavior (job cuts) to good behavior (more hiring, less waste) by taxing pollution, waste, and consumption. The non-profit Get America Working! estimated that the shift could generate up to 45 million full-time equivalent jobs, shrink government dependency costs, grow the funding base for entitlements, and help drive down carbon emissions—all without raising net taxes or deficits one dime.

If FDR were alive today, he'd be aghast at what the payroll tax has become – a Dickensian policy that keeps American workers paying more, and keeps more Americans out of work. No one should dispute that Washington needs to strengthen Social Security and Medicare, but not by worsening the very problems they were created to address. If candidates in this election cycle want to do something big to connect with voters' real priorities, they should work to make it easier for employers to choose people over machines. Millions of Americans want to go back to work. Here's a way for Washington to open the door: Eliminate the payroll tax, and replace the revenue with non-labor taxes.

Eugene Ludwig is the founder and CEO of Promontory Financial Group, a global risk management and regulatory compliance consulting firm. From 1993 to 1998, he served as President Bill Clinton's Comptroller of the Currency.

The views expressed in this article are the author's own.​​​​​