(revised 6/17/08)

In preparing our analysis of the candidates’ tax plans, we sent descriptions to each campaign for comment/clarification/correction. Senator Obama’s staff asked us not to include his reported support for a Social Security tax on earnings above $200,000 or $250,000, saying that there was no specific proposal. So we left the Social Security proposal out of our core analysis.  We also left out Senator McCain’s proposal for an optional alternative tax system on similar grounds. We did discuss these non-proposals in two sidebars in our analysis.

Senator Obama got specific today. He’d now subject earnings above $250,000 to payroll tax.  Earnings between the OASDI maximum—currently set at $102,000 and indexed to wage growth—and the $250,000 threshold would remain untaxed. The gap has been nicknamed a “donut hole,” which makes the policy sound like a tasty treat. 

Senator Obama has not been clear about what rate would apply, when the tax would take effect, or even what the tax base would be.  (See our follow-up blog post.)  Assuming that the proposal would apply the full 6.2 percent OASDI (old age survivors and disability insurance) tax, paid by both employers and employees, to earnings above the threshold, TPC estimates that the proposal would raise $629 billion, or about 0.4 percent of GDP, over the ten-year budget period. The long-run shortfall in the program is about 1.1 percent of GDP, so, assuming that all of the additional revenue goes into the Social Security trust fund and benefits would not rise for high earners, the proposal would close less than half of the trust fund’s long-run deficit.

Social Security has earned the reputation as the third rail of American politics, so Senator Obama deserves applause for proposing anything tangible during a campaign, but this proposal isn’t exactly a profile in courage. Its entire burden falls on less than one percent of taxpayers, who would also face significantly higher income taxes under Obama’s plan and are presumably either indifferent to taxes or already planning to vote for McCain. And almost everyone agrees that benefit cuts, such as raising the retirement age, should be an important part of the fix. No word from the Senator on that front.

Then there are concerns about the economic incentives under the proposal. Most economists believe that workers pay the employer portion of payroll taxes in the form of lower wages, so extending the tax would raise effective tax rates for high earners by about 12 percent. Combine that with a top income tax rate of 39.6 percent, the phase-out of itemized deductions—which Obama would like to revive and which amounts to an implicit 1.2 percent surtax—and state income taxes, which typically run around 6 percent, and the combined top marginal tax rate on labor would be over 55 percent. In high-tax states like California and New York, the top rate would be even higher. Such high rates would provide an enormous incentive to hide income from the IRS or make earnings look like capital gains (which Obama would continue to tax at far lower rates than other income) or business profits (which are subject to income tax but exempt from payroll tax).

These responses can entail real economic costs. Tax shelters, more tempting than ever under this plan, are invariably wasteful. (To start, the geniuses who put these schemes together might do useful work under other circumstances.) And some high earners may avoid the tax by working less, though evidence suggests is that such responses are modest.

Bottom line: kudos to Senator Obama for kicking off the discussion, but let’s hope that policymakers soon move beyond the simplistic solutions.