The Really Unfair Tax

REX RYSTEDT FOR TIME
If the double tax on Social Security were eliminated, Michael Kasprzak and Betty Williams would save $1600

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Other members of the Forbes 400 would also do quite nicely, based solely on their stockholdings in their companies. Philip Knight, Nike's billionaire founder and chief executive, who turned a sneaker into a household name, could save $14 million or more in taxes. Michael Eisner, ceo of the Walt Disney Co., could shave off $1 million. Still others belong to an elite tax-savings fraternity. Most notably: the five members of the Walton clan of Arkansas, the first family of Wal-Mart Stores, who could pocket $187 million.

Then there's the man credited with persuading President Bush to dump the dividend tax Charles Schwab. Founder of the discount brokerage firm, Schwab took part in the President's Economic Forum in Waco, Texas, in August 2002. As the President listened to speakers lay out proposals for getting the economy moving, Schwab ticked off several ideas, including a recommendation "to reduce the double taxation of dividends."

The President seized on it. "I love your ideas about...double taxation of dividends," he said. "That makes a lot of sense." Five months later the proposal was incorporated into the Bush tax plan. As for Schwab, he could trim $4 million from his tax bill.

If a picture is beginning to emerge of the Bush plan as a windfall for the upper crust, it's the correct one. Fewer than 600,000 individuals and families with incomes of more than half a million dollars less than one-half of 1% of all tax-return filers collect 29% of the dividends that would become tax free.

Why kill the tax on dividends rather than offer double-tax relief to a broader swath of Americans? The Bush Administration makes the argument that tax relief for investment income is better for the economy than relief for paycheck income. A White House spokeswoman told TIME, "Taxes on capital are very inefficient. So your bang for your buck in terms of lost revenue compared to the amount of jobs and growth that would be created by removing the tax on capital is very high."

However, one could argue that the double tax on Social Security and Medicare, which affects every working person, has grown inequitably large. For much of Social Security's existence, it mattered little because the tax rate was low and the amount of earnings subject to tax was low as well. In 1950 the rate was 1.5%, and it applied to only the first $3,000 of earnings. No one paid more than $45 in Social Security tax. Even by 1970, after the rate had gone up to 4.2%, taxable earnings were $7,800, some $2,000 below the median family income. By 1980 the rate had climbed to 5.08%, and it was levied on the first $25,900 of income, well above the median family income of $21,023. Over the past 25 years, Social Security and Medicare taxes paid by a median-income family have spiraled 333%, from $937 to $4,055. That pace was 11/2 times as fast as the growth in median family income and three times as fast as the increase in the minimum wage.

Middle-income and lower-income taxpayers are hit hardest by Social Security's double tax for yet another reason. The amount of income subject to tax rises annually with inflation, making it the most regressive of all levies. This year workers pay the 6.2% tax on all wage income up to $87,000. Above that, wages are not subject to the tax. As a result, the true Social Security tax rate declines as income rises. A working family that earns $50,000 pays $3,100 in Social Security taxes the full 6.2%. A corporate executive or Hollywood entertainer with wage income of $3 million pays $5,394--the tax on the maximum earnings of $87,000. The Social Security tax rate works out to less than two-tenths of 1%, meaning that middle-income folks pay the tax at a rate 34 times as large.

There is one final inequity. In the case of stock dividends, the double tax is paid by two different parties. Corporations pay the corporate income tax on earnings that are distributed in dividends. Shareholders pay the individual income tax on those dividends. But Social Security's double and triple taxes are all paid on the same income of the same working person.

To be sure, repealing either the double tax on dividends or Social Security and Medicare would add to the federal deficit. The Administration calculates that tax-free dividends would cost the Treasury about $20 billion in the first year. In the case of Social Security and Medicare, the cost would be substantially higher.