Saturday, May 14, 2005

Social Security Saga - part IV

In addition to reducing future benefits by cutting benefit formulas, there is another alternative to address benefits that is less direct: Tax them. This, of course, already happens, but it could get worse. Section 86 of the Code includes up to 85 percent of social security benefits in taxable income. Thus, assuming a taxpayer gets $100 in social security benefits, $85 could be included in taxable income. Assuming a marginal federal tax rate of 35%, that means you don’t get to keep $100 in benefits: you get to keep only $70.25 after paying $29.75 in federal income taxes. Of course, this amount could be even less if your state taxes such benefits. That, my friends, is a benefit cut of approximately 30% (oops, I’m using that “C” word, even though I’m not part of one of those groups who like to use it the most. Note, however, that I’m not going apoplectic when I use it.)

So, where does that leave us? Taxpayers earning wages are already paying more taxes and will continue to do so, regardless of whether Congress ultimately increases the cap on wages from the current rate of $90,000. That cap will raise automatically by wage indexing, and this means it will reach six figures shortly.

One solution for changing social security could involve raising taxes on all wage earners, but this will probably not be palatable to most politicians. It hits everyone, and the voting public might not like it if you raise their taxes.

A second solution, raising the earnings cap, will be politically easier for the politicians to swallow. It will only hit persons earning more than the current cap, though it will hit them (and their employers) hard. There are not many voters in this group, however, and that makes this group vulnerable to the class-warfare mentality. Make the rich guys pay, they say, even though this means a hit on a particular group that could potentially offset any tax savings from the rate cuts enacted under the Bush Administration.

A third solution, cutting benefit growth (and limiting the reduction to middle and upper income taxpayers) may be more politically palatable, as the hurt comes in the future. Voters would feel the pain of the loss of the income cap in the current year, but they would not feel this pain for some years to come due to the phase-in effects. However, they should make a current-year adjustment in personal retirement saving that could significantly affect current-year consumption, assuming they are really rational planners. (But there probably aren’t near enough of those.)

Both the second and third solutions outlined above, however, have a significant political cost to them: they force us to recognize that what we may like to view as a retirement savings program is really a form of intergenerational wealth redistribution that will look more and more like a welfare program. Blowing the cap (or raising it) will enhance the disparities between contributions and benefits. Ratcheting down benefit growth will add fuel to that fire. As noted in a previous post, the ultimate effect of reduced benefit growth on middle and upper income folk will someday (maybe in 100 years) mean that everyone gets the same benefit. That may suit you, comrade, but I’m not so comfortable with such a system.
Of course, other solutions could also be discussed, and these might include using general tax revenues to support the program. Some of the proponents of national sales or consumption taxes support this, though it, too, smacks of a general welfare program. If we recognize the significant redistributive element, and choose to enhance it, then it seems to me that there is no reason to limit the pain to wage earners – other forms of income could also be included so that those with investment income could share the burden.

Have a good weekend.

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