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June 19, 2008

Obama's Latest Proposal to Increase Taxes

By Nicholas J. Kaster

Barack Obama has unveiled his plan for saving Social Security and it consists, unsurprisingly, of a massive tax increase. In addition to his plans for raising tax rates on capital gains and dividend income and repealing the Bush tax cuts, Obama now proposes to increase the amount of income subject to Social Security payroll (FICA) taxes.

Under current law, Social Security taxes (6.2% for both employers and employees) are imposed on income up to $102,000, which is indexed for inflation in future years. Obama claims that it is “unfair” for middle-class earners to pay the Social Security tax "on every dime they make," while millionaires and billionaires pay it on only "a very small percentage of their income."  For some time, Obama’s website has stated that he “supports increasing the maximum amount of earnings covered by Social Security” as part of a plan to strengthen the system’s long-term solvency.

This would have the effect of raising taxes on millions of upper middle class voters; thus, last week, Obama made a more politically palatable clarification. Rather than simply raising the income level subject to FICA taxation, Obama would impose the tax only on those making more than $250,000.

If Obama has his way, therefore, Social Security payroll taxes would resemble a “donut hole” – i.e., only incomes up to $102,000 and above $250,000 would be subject to FICA taxation, while incomes between $102,000 and $250,000 would be spared. Obama claims that the tax would hit only 3% of the wealthiest taxpayers. However, there is one problem with this: he does not indicate whether the $250,000 threshold will be indexed for inflation. If the higher threshold is not indexed, then the donut hole will grow smaller and smaller in the years to come and eventually disappear. This is because the lower figure is subject to indexing and increases each year. In 2006, the FICA taxation threshold was $94,200; in 2007, it grew to $97,500, and this year it is $102,000. If the higher threshold remains static, more and more middle class taxpayers will be subject to FICA. A tax designed to punish the wealthy will end up ensnaring middle income earners.

Moreover, under current rules, Social Security caps both benefits and earnings. Thus, unless Obama also favors paying more Social Security benefits to the wealthier earners -- highly unlikely -- then his plan undermines Social Security’s historic role as a basic social safety net rather than a program that redistributes income. This realization has triggered criticism even from Democrats, including Henry Aaron of the liberal Brookings Institution and former Rep. Charles Stenholm of Texas. “When you say you’re going to begin means-testing the program,” Stenholm noted, “you begin to convert Social Security from an insurance program to a welfare program.”

The revenue boost that Obama seeks, of course, assumes that the most productive sector of the economy will supinely pay this tax. That’s unlikely too. Even before the plan was officially announced, financial planners were urging their clients to take evasive action. Among the options recommended:

• For those with discretionary income, take a bonus or exercise stock options this year before a new administration takes office

• For the self-employed (who have to pay both the employer and employee portions of the tax), consider reducing the amount of salary they pay themselves

• Consider putting more money in a deferred compensation arrangement.


Thus, Obama’s plan isn’t likely to do much to help Social Security, but it’s sure to provide plenty of opportunities for tax lawyers and accountants.
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