Taxation

The most important federal tax break involves the taxation of Social Security. Benefits are completely excluded from taxable income for lower-income elderly taxpayers. Single taxpayers with $25,000 to $34,000 in income, and couples between $32,000 and $44,000, receive 50 percent or more of their benefits tax-free, while singles with incomes above $34,000 and couples above $44,000 must pay taxes on up to 85 percent of benefits. A complex formula is used to phase in the taxation of benefits, and it has the peculiar result that over certain ranges of income the marginal tax rate on an extra dollar of non-Social Security income is higher than on an extra dollar of benefits. During the phase-in ranges, Social Security recipients are also subjected to very high marginal tax rates on extra earnings or on extra income from investments, because every extra dollar of such income has a double impact on a person’s tax bill. It is subject to taxation itself, and it adds to the portion of Social Security benefits that will be taxed. This could create disincentives to work and to save. The exclusion of Social Security benefits from ordinary taxable income cost the federal government $17.1 billion in lost revenue in fiscal year 1999.

It has been proposed that it would be proper to include 85 percent of Social Security benefits in taxable income for everyone. The other 15 percent reflects the estimated return of principal invested out of after-tax dollars in a typical private pension plan that enjoys no tax advantages. However, the creation of IRAs, Keoghs, 401(k) plans, and the like has made tax law much more favorable to private retirement savings. Contributions to such plans are deducted from taxable income and withdrawals are fully taxed. Only contributions in excess of the limits imposed for such plans are deprived of tax advantages and contributions of this type are uncommon.

If Social Security is seen as a typical tax-advantaged retirement plan and treated like most other retirement saving plans, it would be appropriate to subject 50 percent of benefits to taxation while allowing 50 percent to be tax free. That is because the 50 percent of the payroll tax that is paid by employers is deducted from their taxable income, while the 50 percent that is paid by employees is financed out of after-tax income.

On the other hand, it might not be appropriate to regard Social Security as a typical retirement plan, because the level of benefits is only loosely related to the payment of payroll taxes. People with lower lifetime earnings receive a higher rate of return than those with higher earnings, dependent spouses receive an extra benefit equal to 50 percent of that of the principal earner, and the return on one’s payroll tax contribution can depend on when income was earned. Consequently, it may be more accurate to regard Social Security as a transfer program that distributes money from high to low earners rather than as a pension program. But there is no consistent rule governing the taxation of transfer payments. For example, unemployment insurance benefits are included in taxable income, while welfare payments are not.

The taxation of benefits obviously reduces their net value, particularly for those affluent taxpayers who are in the highest tax brackets. Thus, the taxation of benefits can be seen as an indirect approach to means-testing Social Security since the tax imposes the largest burden on the most affluent beneficiaries. Given the rapidly rising economic burden that will be imposed by Social Security once baby boomers start to retire, there may be a strong argument for subjecting 100 percent of benefits to taxation as a way of strengthening means-testing.

It should be noted that the taxation of Social Security benefits is a relatively recent phenomenon. Before 1983, benefits were not taxed at all. After that time, a maximum of 50 percent of the benefit was brought into taxable income. The proportion brought into taxable income was not raised to 85 percent for more affluent taxpayers until 1993.

A less important federal tax concession provides an extra standard deduction to each individual age sixty-five and older. In 1999, this equaled $1,000 for single taxpayers and $800 each for married taxpayers. The associated revenue loss was $1.8 billion in fiscal 1999. There is also a nonrefundable tax credit for low-income retirees whose retirement income is mostly taxable, but this credit is rarely used.

Because the use of the standard deduction declines as income rises, the extra standard deduction is most valuable, on average, to lower-income elderly taxpayers. Only about 10 percent of elderly couples with incomes between $20,000 and $30,000 itemize deductions while itemized deductions are used by a substantial majority of those with incomes above $80,000. However, only 15 percent of elderly couples had incomes that high in 1998.

The elderly receive Medicare and Medicaid benefits tax-free, as well as an untaxed subsidy for the purchase of insurance for physician services. Although it would be practically possible to tax such items, it would be extremely unpopular politically. It should be noted that employer-provided health insurance is also tax-free, as are Medicaid benefits.

As noted earlier, private saving for retirement is now highly favored by the federal tax system. Employers’ contributions to defined benefit plans are not, for the most part, considered to be taxable income to the employee. Employer and employee contributions to defined contribution plans are deductible up to specified limits that differ from plan to plan. The tax saving associated with the deduction for contributions into a retirement account is sufficient to pay the tax on future withdrawals if the tax saving is invested at the same rate of return as the rest of the account—and if withdrawals are taxed at the same tax rate as was applicable when the contribution was made. Put another way, it is equivalent, under these very special assumptions, to eliminating the entire tax on income saved for retirement. If the retiree is in a lower tax bracket when funds are withdrawn than when funds were contributed, he or she receives a tax subsidy for retirement saving. That is to say, the after-tax return on the retirement account becomes greater than the before-tax rate of return.

The law provides for a confusing array of defined benefit and defined contribution accounts that have different deduction limits and are subjected to different tax rules. The regulation of such accounts, especially defined benefit plans, is also extremely complicated. The system badly needs simplification.

Whether tax-favored, private retirement accounts improve the income of retirees depends on the extent to which the tax incentives actually increased the retirement savings of people while they were working. There is profound disagreement among economists on this point. Some believe that the tax concessions induce a sizeable increase in retirement saving. Others argue that the savings deducted from taxable income largely represents either transfers from other accounts or saving that would have occurred even in the absence of tax concessions. The naysayers believe that the increase in private saving is less than the associated revenue loss to the federal treasury.