Taxes and Social Security Progressivity
Social Security’s old-age pensions were designed to replace more of the earnings of retired low-wage workers than of higher-wage workers.
But how is this progressivity affected by the federal income taxes paid by all workers and retirees? A study by economists at the Center for Retirement Research, which sponsors this blog, analyzed this complex issue and found that income taxes have not had any real impact on the overall progressivity of the Social Security program.
To reach this conclusion, the researchers used the actual experiences of older American households contained in survey data linked to their lifetime earnings. There were several different tax effects to consider.
First, the payroll tax that funds Social Security is shared by workers and employers, with differing effects. Although the workers’ payroll tax is deducted from their paychecks, workers must still pay income taxes on that amount.
The payroll tax paid by employers, on the other hand, is transferred directly to the federal government, and no income tax is paid. Although the amount transferred is effectively part of workers’ compensation, they do not have to pay income tax on this portion of their compensation. This reduces the taxable income of all workers, but it is more valuable to higher income workers who pay higher tax rates: a one dollar employer contribution costs a taxpayer in the 35-percent bracket just 65 cents, compared with 90 cents for a lower-paid worker in the 10-percent bracket.
Many low-wage workers pay no income taxes or even receive an Earned Income Tax Credit. But a negative tax rate – in the form of a credit for the lowest-wage workers – means they can’t benefit from the tax exemption implicit in employers’ contributions to Social Security on their behalf.
Another effect is taxation of retirees’ Social Security benefits, which began in 1984. The dollar amount of benefits subject to income taxes is based on income benchmarks that have never been adjusted for inflation. More retirees are continually being pulled into the tax system, which increases progressivity. Today, more than one-third of retirees pay taxes on their Social Security pensions.
When these myriad income tax effects are all taken into account, has Social Security become more or less progressive since its passage?
To determine this net tax effect, the researchers compared the share of all Social Security benefits received by lower-wage households – defined as households with lifetime earnings in the bottom 60 percent of all workers – to their share of all payroll taxes paid into the system. In a progressive program, this group would claim a larger share of the benefits than they paid in taxes. This relationship was estimated for households in three cohorts: people born during the Depression, people born during World War II, and baby boomers born after the war.
For the Depression cohort, the researchers found that adding in the income tax effects made the program slightly less progressive. That’s because the progressive effect of subjecting Social Security benefits to income taxation is more than offset by the gains the well-heeled receive when their employers’ contributions are excluded from their taxable income, which decreases progressivity.
But Social Security’s progressivity increased modestly for War Babies and increased again for early baby boomers – meaning the bottom 60 percent of each cohort gained a larger share of total benefits relative to the tax share they paid. Their net gains equal nearly one-quarter of 1 percent of total benefits. This slight increase in progressivity is largely due to the rising share of retirees subject to taxes on their Social Security benefits.
The intricacies of the federal tax code have enormous effects on the lives of average Americans. But it hasn’t altered a central element of Social Security’s pension program – its progressivity.
The research reported herein was performed pursuant to a grant from the U.S. Social Security Administration (SSA) funded as part of the Retirement Research Consortium. The opinions and conclusions expressed are solely those of the author(s) and do not represent the opinions or policy of SSA or any agency of the federal government. Neither the United States Government nor any agency thereof, nor any of their employees, makes any warranty, express or implied, or assumes any legal liability or responsibility for the accuracy, completeness, or usefulness of the contents of this report. Reference herein to any specific commercial product, process or service by trade name, trademark, manufacturer, or otherwise does not necessarily constitute or imply endorsement, recommendation or favoring by the United States Government or any agency thereof.
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One might analogize Social Security to the major tax-favored retirement systems, regular and Roth. Regular retirement saving is deductible when contributed and taxable when received. Roth retirement saving is not deductible when contributed, but it is not taxable when received. The employer portion of Social Security taxes is not taxed to the employee when contributed, which might suggest -- by analogy -- it should be taxable when received. The employee's portion, because it is taxed when contributed, by analogy to the Roth should not be taxed when received.