Thursday, September 11, 2008

Illustrating the effect on Social Security of new CBO assumptions regarding income tax policy

In this post discussing the new CBO projections for Social Security financing, I noted that one big change relative to the Trustees approach and to prior CBO practice was to assume a literal "current law" approach to income tax policy. Current law for income taxes implies that the Bush tax cuts expire over the next several years, the AMT remains un-indexed for inflation, and "real bracket creep" pushes more and more taxpayers into higher tax brackets. (See this op-ed for discussion of this topic.) This is a major issue for income tax policy, but also affects Social Security because the program derives part of its revenues from income taxes levied on retirement benefits. These flow back to Social Security to help finance benefits. While the formula is complex, roughly speaking individuals with incomes greater than $25,000 may have to pay income taxes on part of their Social Security benefits. Currently, around one third of retirees pay taxes on their Social Security benefits.

The Social Security Trustees assume that income taxes will remain roughly constant relative to GDP, which is consistent with how Congress has tended to modify taxes in the past. However, revenue from benefit taxation will rise, because the $25,000 income exclusion isn't indexed to inflation. As a result, a larger share of retirees in the future will pay taxes on their benefits. So both CBO and the Trustees correctly project that more retirees will pay taxes on their benefits, but CBO differs in assuming that the tax rates retirees pay will also increase significantly.

One way of illustrating this difference is to treat the taxation of retirement benefits as a de facto reduction or means test of benefits. Today, revenues from benefit taxation equal around 0.35% of taxable payroll while benefit payments equal around 11% of payroll. So the taxation of benefits can be treated as around a 3% reduction in the average retirement benefit.

The chart below shows the size of the effective reduction in average retirement benefits going forward, under 2008 Trustees projections, 2008 CBO projections and 2006 CBO projections (the last full projection done prior to 2008). Under Trustees projections and the 2006 CBO projections, which followed the Trustees practice of assuming that income taxes remain steady relative to GDP, benefit taxation rises from around 3.3% of average benefits to around 5-5.5% of average benefits over 75 years. Under the new CBO projections, which assume that future average income tax rates will be almost double those of today's, benefit taxation amounts to over 8 percent of total benefits. This increase improves the CBO 75-year actuarial balance projections by around 0.24% of taxable payroll, or around 18.5%.

The point of all this is simply that this methodological change is consistent with the literal reading of current law and with CBO practice in other documents, but is also probably not anyone's "best guess" of what will actually happen in the future. When we think qualitatively about the size of the future Social Security shortfall, this methodological choice should be borne in mind.

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