The Wrong Tax
A Moral Economy #8. Part II: What do we have? (continued)
This continues a three part series of excerpts from Social Security Basic Income: A Safety Net for All Americans, which I published in March 2020. Part I: What would it look like? concluded with #2. Part III is How do we get from here to there? This essay includes text from Chapter 5 Slaying the Payroll Tax Dragon. Refer to #1 in the series for a brief introduction of my purpose and perspective on this subject.
Bankrupt in more ways than one
Social Security was conceived as a forced savings program designed to help workers invest in their own retirement. But there is no fund and certainly no asset individuals control and pass along to survivors. Workers do not build any wealth and their financial security is entirely under state control. It is actually a redistribution program because workers pay taxes that the government uses to pay obligations to others. Regardless of how we characterize Social Security, it is paternalistic; it deprives workers of the right to act on their own preferences regarding the timing and methods of savings and consumption. For those living on the edge, taxing every dollar they earn makes them more dependent on income support in the future because they find it more difficult to save.
Social Security benefits are determined by contributions, which are tied to earnings. This means those who are least in need of the pension receive the largest benefit payments — a practice that reflects a very strange idea of income security. As the program approaches a full century of operation, benefits as a percentage of contributions are falling, and unless it is radically reformed, we may soon be paying retirees less than they paid into the program. Unless payments are means-tested, we will be punishing those most dependent on the system.
The payroll tax is a suffocating burden on the working poor and small businesses that a real citizens’ legislature would recognize as a worthy target for reform. But somehow, Social Security is still considered the third rail of politics long after benefits have been delayed for all, taxed for some, and became widely regarded as a pipe dream for young workers. The regressive nature of the tax is its worst feature, but there are other reasons why we need to fund benefit payments from general revenues, starting now. The income tax reform campaign that led to the Tax Cut and Jobs Act (TCJA) targeted marginal tax rates on US corporations. Evidently, in the rush to provide relief to corporations, authors of the legislation did not consider reducing implicit marginal tax rates on the supply of labor — the poverty trap.
Thanks to the lockbox myth (treating payroll taxes as savings), analysis of federal taxes on individuals is overwhelmingly focused on the income tax, which is considered fair to low- and middle-income taxpayers because they pay a small percentage of the total. But what really matters is the total tax picture, in which the payroll tax dominates for all lower income workers. That picture is difficult to assemble under the current structure. Our social safety net is in trouble, and we need to have all cards face up on the table if we want to have honest and productive conversations about policy options.
“Social Security” refers to the Old-Age, Survivors, and Disability Insurance (OASDI) program established by Congress in 1935. Federal payroll taxes of 6.2 percent and 1.45 percent of wages are paid by employers and employees (total 15.3 percent) to fund OASDI and Medicare’s Hospital Insurance (HI) program, respectively.
From the mid-1980s until the mid-2000s, OASDI tax revenues exceeded benefits by increasing amounts; since then, costs have risen faster than revenues because retiring baby boomers outnumber younger people entering the workforce. Trust fund reserves are projected to reach zero in 2034 for the Old-Age and Survivors Insurance (OASI) component associated with Social Security benefit payments. Over the 75-year projection period, combined (OASDI) unfunded obligations would grow to $20.4 trillion in today’s dollars. Eliminating this deficit would require hiking payroll taxes by 3.24 percentage points — from 12.40 percent to 15.64 percent. Alternatively, benefits would have to be reduced by 20.3 percent for all beneficiaries or 24.1 percent for those initially eligible in 2022 or later. Delayed action on these solutions would be even more painful.
These are very big numbers that illustrate just how far we have kicked this can down the road. I object to the payroll tax altogether, so obviously I would not recommend raising the rates, and I have a hard time imagining significant support for any increase by those paying the tax, whether or not they believe the program is fundamentally flawed. They do not need to read the Trustees’ report, nor should they have to. All they need to know is that they’re already forking over more for these IOUs than they pay in federal income taxes. Reducing benefits for all of those eligible by double digit percentages is completely out of the question. Once upon a time, these programs may have been made whole without drastic changes. At this point, all options entail radical reforms.
Several think tanks have tackled the solvency issue. For example, an AEI report on reforming entitlement programs includes a section on Social Security that focuses on providing a safety net for the elderly in the form of a flat benefit at the poverty level. During the very long transition period, no one would lose accrued benefits. Payroll tax funding would continue at a lower rate. The early retirement age would move from 62 to 65, but those still working at 62 would be exempt from the payroll tax.
A Heritage Foundation report rejects ideas that preserve the current system by raising taxes. Payroll tax rates are already high, and they harm those the program is intended to benefit. The report suggests we raise the age of eligibility, provide a flat benefit above the poverty line (like the AEI proposal), and phase out payroll taxes. Benefits would be paid from the general fund:
Since the Trust Fund is merely an accounting mechanism with no real savings to pay Social Security benefits coming due, there would be little harm in eliminating the Trust Fund altogether. US taxpayers are effectively financing Social Security benefits on a pay-as-you-go basis already, as general tax revenues cover the shortfalls between incoming Social Security revenues and outgoing benefits. The absence of this illusory Trust Fund would more likely clear the path for reasonable Social Security reforms. It would enable the nation to recognize the very real and increasing burden on younger generations from unfunded Social Security benefits.
Not easy, but more easily solved
Medicare has two trust funds — Hospital Insurance (HI) and Supplementary Medical Insurance (SMI). HI, also known as Medicare Part A, helps pay for hospital, home health services following hospital stays, skilled nursing facility, and hospice care for the aged and disabled. SMI funds voluntary enrollment in Medicare Part B (physician, outpatient hospital, and home health services) and Part D (drug insurance coverage).[1] Depletion of the HI trust fund is projected to occur in 2028. The Board of Trustees’ long term (75 year) projection based on current law and intermediate assumptions of workers’ earnings is that Medicare expenditures will increase from 3.9 percent of GDP in 2021 ($839.3 billion) to 6.5 percent of GDP in 2096. A 2/3 increase in real (percent of GDP) terms over 75 years may not seem to be cause for alarm, except that Medicare expenditures have already doubled in the last 30 years and as shown in the chart below, almost all of the projected growth is expected in the next 20 years.
While it is clear that Medicare is in need of attention, thanks to the Affordable Care Act (ACA) debates it already has plenty and promises to get even more, with many proposals to expand rather than shrink the program. My only concern with Medicare is the regressive payroll tax. The HI tax collected $303 billion in calendar year (CY) 2021, which is a very large amount of money, but far less than OASDI’s $984 billion collected in the same period. If we manage to replace the larger tax, replacing the smaller one becomes much easier. Besides, as the chart above illustrates, Medicare is already heavily funded by general revenue.
Also, Medicare does not pose nearly the threat to intergenerational inequality. It provides health care services, not cash benefits, that are naturally more in demand by older Americans. They only get what they need. By way of contrast, Social Security payments could help the young as well as the old, and they are not based on need. Medicare, like Social Security, is designed for people over 65, but people who are disabled before reaching retirement age can qualify for Social Security Disability Income (SSDI) and/or Medicare. Younger people who cannot afford insurance have access to Medicaid — a state administered, means-tested health care program jointly funded by state and federal governments.
[1] Medicare Part C is an alternative to coverage under Parts A and B that includes Medicare Advantage and other more comprehensive health insurance plans. Some of its costs are paid for out of the HI and SMI trust funds.
Day of reckoning
Eliminating the taxes that are supposed to fund these programs does not eliminate the obligations. It does, however, open up a couple of debates that are long overdue. The first is how the tax code should be amended to replace the revenue stream and the second is how retirement plan benefits will be determined without payroll tax contributions. The revenue question is daunting. Cutting the payroll tax will benefit 177 million American taxpayers and their families. However, that is very costly and cannot be paid for by taxing others. We have to look at general revenues such as the income tax and how to raise it equitably.
Social Security is a uniquely structured entitlement program. Most income support programs determine eligibility by applicants’ circumstances. With Social Security, benefits are “earned” by payment of taxes and we receive statements each year that quantify what the state owes us. I would call that an obligation. Anyone rejected or cut off from entitlement assistance would be disappointed or upset. But nothing quite compares to the wrath of seniors whose Social Security payments are in jeopardy. Whether or not there is a legal obligation, as a practical matter, there is no question about payment of promised benefits. Shedding existing obligations is off the table for reform, but future obligations are fair game.
Nevertheless, any campaign to repeal and replace this symbolic institution will make the ACA debates look like child’s play. At a time when voters and politicians have never been more polarized, proposals from either side of the political spectrum to do much of anything with Social Security will be met with ridicule, vitriol, and more.
Yet, given our highly related income inequality problem, I see no choice but to firmly grasp the so-called third rail of Social Security. We will survive the shock if we address the core concerns of its defenders. Now might be the perfect time to consider reforms. Young people do not trust the system, and they’re abandoning party politics in droves. If we can finally admit that it’s not a savings plan but a redistribution system, we can objectively examine alternative policies to determine who should pay whom, how and how much.
The next essay in this series will be the first on Part III: How do we get from here to there? It will include text from Chapter 3 Nothing to Lose but Shackles.
