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Gingrich’s flawed Social Security and income tax proposals

By Robert Pozen,December 26, 2011

With Newt Gingrich vying for front-runner status in the Republican presidential primaries, his positions on important public policies such as Social Security and income taxes deserve scrutiny. In both cases, Gingrich adopts familiar Republican concepts — but then undermines their key objectives.

Gingrich’s “fix” for Social Security builds on a Bush-era proposal. He would allow younger workers to contribute a portion of their payroll taxes to a private account instead of to the Social Security fund. These accounts could be invested in one or more diversified mutual funds in a plan regulated by the federal government.

But Gingrich takes a radical step further by effectively telling those workers not to worry if their investments of payroll taxes do poorly. According to Gingrich, “The Treasury will send them a check to make up the difference” between their fund returns and their scheduled benefits under Social Security.

By guaranteeing the government’s scheduled benefits as the floor, Gingrich gives workers a tremendous incentive to roll the dice. After all, if their investments do well, the workers will receive higher retirement payments. If their investments crater, the workers still get the guaranteed benefits from the Treasury. Heads you win, tails (we) taxpayers lose.

Gingrich argues that holders of private retirement accounts could not assume much risk because they would be allowed to invest in only a few diversified funds, such as those offered by the 401(k)-type plan for federal employees. Gingrich is right that this plan would prevent workers from buying stocks in individual companies such as Google or from investing in the latest social-networking initial public offering. Under that civil service plan, however, individuals can invest in international stock funds or small company stock funds — diversified funds with considerable downside risk.

Moreover, Gingrich’s plan explicitly allows workers to quickly switch between funds. Such switching would increase the risks of these investments if workers attempted to time the market. Although market timing is usually not a successful strategy for unsophisticated investors, these workers would not worry about guessing wrong. They would, under Gingrich’s proposal, still receive the guaranteed schedule of Social Security benefits from the Treasury.

Similarly on income tax reform, Gingrich picks up the Republican idea of a flat tax for individual income — and perverts its basic principles. Under the core concept of a flat tax, individuals would pay only one tax rate, which could be quite low because there would be few, if any, tax deductions or tax credits.

Gingrich has proposed a flat tax for individuals with a 15 percent rate after an exemption for the initial $12,500 of income. But Gingrich’s plan does not follow through on the elimination of tax deductions and credits. Of the current major deductions, he eliminates only the deduction for state and local taxes. Gingrich also retains many expensive credits, such as the child tax credit and the earned-income tax credit.

Simply put, Gingrich’s proposal is not a flat tax. It dramatically reduces the tax rate for the top half of the income brackets without eliminating the significant economic distortions caused by tax deductions and credits. For example, he leaves intact the mortgage interest deduction, which is costly and overly broad in that it currently applies to home equity loans, mortgages on second homes and mortgages of up to $1 million per couple.

As a result, the Gingrich not-so-flat tax plan would reduce federal tax revenue by at least $850 billion per year, according to an estimate from the Tax Policy Center published last week. In response, Gingrich would argue that this shortfall would be offset by increasing overall economic growth, since he is a strong advocate of a “dynamic” model for estimating tax receipts. Even under a “dynamic” model, however, it would be extremely difficult to generate enough new growth to produce an additional $850 billion per year of tax revenue with a tax rate of only 15 percent. Indeed, to generate that much additional tax revenue at a 15 percent rate would require an increase in taxable income of $5.6 trillion — more than one-third of the total U.S. gross domestic product.

Moreover, Gingrich would allow taxpayers to choose between the taxes due under his plan and the taxes due under current tax rules. This approach would negate another objective of those advocating a flat tax — simplifying the Internal Revenue Code. Indeed, Gingrich’s plan would increase tax complexity by requiring most taxpayers to compute their taxes twice.

In putting forward these extreme proposals, Gingrich has avoided the tough choices that are necessary to restore fiscal discipline in Washington. Whatever your view of private investments of payroll taxes, it would be a terrible moral hazard to guarantee such investments against bad results. Whatever your view of the merits of a flat tax, it would be a travesty of that concept to adopt a low tax rate while retaining most tax deductions and credits. These extreme proposals should raise serious questions for all voters about Gingrich’s financial stewardship if elected president.

The writer is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. He tweets at www.twitter.com/pozen.