Monday, December 29, 2008

Is the Social Security tax regressive once you account for benefits?

It's sometimes argued that, while income taxes are progressive, the progressivity of the total tax code has to be viewed inclusive of payroll taxes, which are either flat (in the case of the 2.9% Medicare tax) or regressive (in the case of the 12.4% Social Security tax, which applies only to the first $106,000 in earnings). It's not always clear from these statements what the net effect is.

A new CBO letter allows for a better view of this, although even this doesn't tell the whole story (as I'll discuss below). The picture below first shows effective income tax rates by income quintile, for people in 2005. As you'd expect, they're pretty progressive, and the poorest 40 percent of Americans pay negative rates through policies like the Earned Income Tax Credit.

The next picture shows effective social insurance – Social Security and Medicare – tax rates, also by income quintile. While rates are somewhat progressive through the fourth quintile, they decline for the top quintile because of the cap on Social Security taxes.

If we add social insurance and income taxes, along with corporate income and excise taxes, the next picture shows total effective federal tax rates. As you can see, even if we add social insurance taxes, the overall tax code is still reasonably progressive (in my view; others may defined reasonable differently).

But below is a chart I've constructed from a different data source, the GEMINI model of Social Security financing. The key issue with Social Security taxes is that while the tax itself is regressive, the benefits are progressive. Since taxes pay for benefits, you want to look at the progressivity of the Social Security program as a whole. The chart below is for individuals retiring in the 2030s, although they would not be much different for people retiring earlier or later (it's just the data I had lying around…). I've calculated effective payroll tax rates by lifetime earnings quintile, which means the payroll tax paid minus the disability and retirement benefits the individual receives. If you received benefits exactly equal to your taxes (plus interest at the government bond rate) then your net tax would be zero. Although net tax rates are always lower than the statutory 12.4% rate, at least for people (as here) who survive to retirement, the distributional picture is very different.

The highest quintile of lifetime earners pays a net tax of around 3 of earnings. This implies that they pay 12.4% of wages while working, but then receive benefits back equal to around 9.4% of wages. While this isn't a great deal – in a fully funded system they'd receive back everything they paid in – it's better than paying 12.4% and getting nothing back.

But notice what happens as lifetime earnings decline. Net tax rates are negative, meaning that (under current law benefits, at least) most folks would get out more in benefits than they pay in taxes. For the lowest earners, net taxes are very negative, around -27 percent. This means that on average these folks receive about three times more in benefits than they pay in taxes. Remember this the next time someone says that the Social Security tax is regressive: sure, it is, but things look very different when benefits are counted into the picture.

As a P.S., why are net tax rates more negative for the middle quintile than for the second quintile? The answer to that is, I don't know – although because this data output mixes both retirement and disability benefits, it should be possible to disaggregate them and get a better feel for things.

1 comment:

William said...

Again someone is trying to justify or complain about taxes paid by individuals by adding a flat tax with a base limit to a progressive tax with no limit. Social Security is a dedicated tax or as the Social Security act refers to as a "contribution." It has statutory authority to use only those funds recieved by the dedicated tax or the income from the trust fund and the trust fund balance to pay benefits. IT may not borrow money to pay benefits and general revenues may not be used to pay Social Security Benefits nor may Social Security Revenues be used to pay for General Budget Expenses.

Social Security by law cannot borrow money. It has statutory authority to spend only those funds received from the dedicated social security tax on wages, tax on benefits and funds in the trust fund. Federal Law prohibits transferring general revenues to any trust fund.[1]

By law the trust fund cannot be drawn down to zero. The trustees must submit a report promptly to congress detailing benefit cuts or tax increases when in any given year the trust fund is projected to fall below 20% of that given years expenses. Social Security's ability to pay future promised benefits is dependent solely on the ability to raise social security taxes.[2]

[1] United States Code Title 42, Chapter7, Subchapter VII, Sec. 911 (a),

[2] United States Code Title 42, Chapter7, Subchapter VII, Sec. 910 (a),

What would be more interesting is to see the effect of FICA taxes on the U.S. Savings Rate, mortgage term and inflation has had over time. How much of our federal income tax dollar goes to pay interest on the debt? At what point will the interest on the debt consume 100% of federal income taxes? How does running a 1% deficit of GDP affect the economy? Can running continued 1% deficits be bad, yes? Why?

Does Medicare have a limit on what it can payout in any given year once the trust fund is reduced to 20% of any given years expenses, yes? That limit is 5.8% of Wages, unless the Medicare tax is increased.