This column first appeared on TaxVox.
Most capital income earned never is taxed at the individual level, in part because assets are often not sold and their gains never subject to income tax, in part because capital income benefits from a long list of tax preferences, and in part because of outright evasion.
In a recently-published study, Jenny Bourne, Brian Raub, Joseph Newcomb, Ellen Steele, and I used estate tax data linked to individual income tax return data. In the study, we found that most wealthy individuals report an effective taxable return on their wealth of less than 2 percent on their individual income tax returns, with the richest filers reporting the lowest returns. That is, for each $1 million of wealth, the annual amount of taxable dividends, interest, capital gains, and other returns is less than $20,000. Among those with more than $100 million in net worth in 2007, close to 40 percent reported annual taxable returns of less than 1 percent of their wealth. More than two-thirds reported taxable returns of less than 2 percent.
These results are similar to what I found in a study covering the more inflationary 1970s. In yet another study, I found that a select group of owners of businesses and farms subject to estate tax reported even lower taxable returns. And in a book published in the early 1980s, I showed how net income from capital reported on all individual tax returns was less than one-third of total capital income in the economy.
Keep in mind, regardless of what they report on tax returns, top wealthholders often achieve very high actual returns on their assets. The merely wealthy commonly earn stock market returns of 7 to 10 percent per year, while truly rich investors often attained that status by earning even more. Warren Buffett revealed in one income tax return that he recognized only about 1/50th of 1 percent of his wealth as taxable income even though his primary asset, Berkshire-Hathaway stock, had been earning about 10 percent annually.
How do those with capital income achieve such low taxable earnings?
- Capital gains are not taxed until the assets are sold and the gains realized, providing an incentive to hold onto assets as they appreciate. As long as they are unsold, there is no taxable income to report.
- They take advantage of tax preferences. Real estate investors, for example, can defer taxable gains by swapping one piece of property for another through a “like-kind” exchange. The preferential tax rate on long-term capital gains acts as an effective reduction in taxable income, as it has been in most years when the preference was provided as an exclusion.
- Asset holders may avoid capital gains taxes by arbitraging tax laws. For example, they may offset gains with losses. Or they may establish tax shelters that produce current deductions in exchange for lightly taxed or untaxed capital gains.
- The returns from homeownership—the rent saving that comes from equity ownership—are not taxed.
- Retirement saving is heavily favored by the tax system, meaning that asset appreciation and capital income may not be taxed as they occur.
Homeownership and retirement saving provide the primary opportunities for middle-income and moderately-wealthy households to avoid or defer tax on capital income. As a result, they, too, pay limited tax on their returns from capital.
But for very wealthy individuals, the most common tax-avoidance strategy is simply to not sell assets at all and never realize the taxable gains. For example, a shareholder in a publicly traded company may accrue capital gains over time that remain untaxed until she sells her shares. If she holds the asset until death, those accrued but unrealized capital gains are excluded altogether from tax. The assets passed along as a bequest will have basis equal to the value at the date of former asset holder’s death.
Because so little capital income is taxed through the federal individual income tax, corporate and estate taxes have been important tools for taxing those with significant wealth. However, Congress has cut both those taxes over recent decades, most recently in the 2017 Tax Cuts and Jobs Act. Those reductions may have a far larger impact on the effective tax rate on capital income than changes in the statutory individual income tax rate since that levy only applies to income that is realized.
Unfortunately, the fight over capital income taxation usually focuses on how much is collected rather than on the most equitable or efficient way to tax it. Advocates on each side often will accept capital tax increases or decreases any way they can get them. Nor do the debates result in consistent treatment of people at different levels of wealth.
The Trump Administration reportedly is considering reducing taxes on capital income by indexing capital gains taxation for inflation. But at this point, the better question may be how best to distribute the taxes borne by capital owners, not simply how to tax some of them less.
This column first appeared on TaxVox.
The idea of indexing capital gains for inflation is getting a lot of attention these days. Larry Kudlow, who heads the White House National Economic Council, has long suggested Treasury should do this by regulation, while several members of Congress have introduced bills to make the change by modifying the tax code. Exempting purely inflationary gains from tax can be a good idea in principle, but easily flawed in practice. To understand the consequences of such a shift, it is helpful to think about it in terms of a revenue-neutral tax change, not merely another budget-busting tax cut.
In a revenue-neutral context, indexing the basis of assets in computing capital gains could create significant winners and losers among investors. Ordinary shareholders could come out ahead, while private equity firms could be big losers. The effects would largely be dependent on rates of inflation and market returns.
First, though, some background: The argument for indexing rests on the principle that the income tax is meant to tax real, not nominal, income. If my investment returns 8 percent and inflation is 8 percent, then my real income gains are zero. Why should I pay tax on zero income?
To make matters worse, if we taxed all returns to saving with no offset for inflation, we could enormously overtax nominal returns to capital. If returns averaged 8 percent and but inflation was 4 percent, subjecting the full 8 percent nominal return to tax would essentially double the statutory tax rate on capital income.
In the 1984 Treasury study that led to the Tax Reform Act of 1986, these considerations led us to propose indexing the basis of assets that generate capital gains for inflation. But we attempted to apply the principle consistently. We would have indexed capital gains but also indexed other elements related to investment returns. We would have indexed depreciation allowances for inflation but also would have repealed the investment tax credit and set depreciation allowances to approximate economic depreciation. We also would have indexed interest receipts and interest payments for inflation.
Building on the old Treasury plan, imagine Congress indexes the taxation of capital income in a way that would neither gain nor lose revenues over time. Such a change would have many effects on the taxation of investment, but here are two significant ones:
First, such a reform could redistribute the tax break to investors who tended to get lower returns over time from those who through luck or skill were big winners. Consider a reform proposal that substitutes indexing of capital assets for the preferential tax rate on long-term capital gains. The following table shows how this might work for a specific example.
For example, suppose you and I invested $100 ten years ago. Inflation was 2 percent annually over the period, and assume that we’re both in a 35 percent income tax bracket with a current maximum tax rate on long-term capital gains of 20 percent. Suppose that I earned a 3 percent nominal annual return per year and you made 10 percent. With indexing, we’d both reduce our gains by $22 (the amount of inflationary gain on the $100 investment). That would leave me with taxable income of about $12 out of my $34 profit. But you’d have taxable income of $137 out of your $159 gain (10 percent compounded over 10 years). With indexing and no preferential tax rate on capital gains income, we’d both pay the 35 percent rate but only on the real income amounts. Under current law, we’d each pay the 20 percent tax rate on our nominal capital gains ($6.80 tax for me and $31.80 tax for you). This translates in an effective tax rate on my real income of 55 percent and 23 percent for you. So, this proposal would treat all inflation adjusted returns the same, compared to current law, which favors investors with large inflation-adjusted gains.
Second, in a period of high inflation and moderate appreciation of assets, indexing gains for inflation while ending other preferential tax treatment for capital income might lower the amount of such income subject to tax. To illustrate this point, note that if inflation were 8 percent per year and the value of an asset increased at 8 percent per year, there would be no tax due under an inflation-indexing regime, but a positive tax liability under current law (even with the preferential tax rate on long-term gains). In contrast, in a period of low inflation and unusually high appreciation of asset values, such as in recent years, the indexing proposal likely would increase effective tax rates.
To see whether advocates really believe in the principle of excluding inflation from taxable gains, ask them if they would be willing to accept those consequences. In effect, would private equity and hedge fund managers be willing to transfer some of their existing tax breaks to help average investors?
I could make a solid case that such an exchange would be fairer and more efficient since it would provide less reward for get-rich-quick efforts and shift business incentives toward long-run success over short-run profits. This is a concept President Trump endorsed just last week.
But if one wants to lower the taxes on return to saving, would adding indexing of capital gains to existing tax breaks be the best way to do it? Would it be superior, for instance, to a corporate income tax rate cut or a simple tax break for the investors living off their bonds?
Simply adding another capital gains tax cut would create new incentives to game the tax system. For example, if I can borrow at 5 percent and invest the money in an asset increasing in value by 5 percent per year, I have done no real saving and earned no real income. Yet, under current law, I can deduct the full 5 percent in interest costs in computing taxable income while paying tax at a reduced rate on my future realized capital gains. Exempting the effects of inflation only from capital gains that are subject to a preferential tax rate, but not adjusting interest deductions also, would increase the incentive to engage in these types of arbitrage games.
Taxing inflation is a problem that tax reformers might want to address. But offering revenue neutral options provides a litmus test for whether that is really the problem advocates for capital gains indexing want to address.
This column first appeared on TaxVox.
The brilliant Tax Notes columnist Marty Sullivan once summarized one of the great dilemmas in taxation: “It’s simply impossible to put a precise geographical subscript around ‘where’ taxes should be collected.” He mainly had in mind locating the source of capital income, but geography again reared its head recently when the Supreme Court’s South Dakota v. Wayfair, Inc. decision tackled the question of when states can require online retailers to collect sales taxes.
In both cases, it is difficult, if not impossible, for taxing jurisdictions to resolve these issues on their own. But they create important opportunities for these authorities to work together to develop solutions that are fair to taxpayers while assuring that government collects tax that is legitimately owed.
The issues are not easy to resolve. Countries struggle to sort out where a firm’s income is earned when its headquarters, production, marketing, research, and patents can be located anywhere in the world, when its sales routinely cross borders, and when some goods and services can be transferred or sold multiple times as intermediate products along the way toward a final sale.
This environment even affects charities, many of which routinely violate state and national laws simply by maintaining websites that can receive donations from anywhere but have not registered in every jurisdiction that might require it.
The Supreme Court’s Wayfair decision added to these boundary disputes. The Court ruled that states can obligate an on-line retailer to collect and remit sales taxes even if that firm’s website and physical facilities (such as manufacturing and headquarters sites) reside outside their jurisdiction.
Senator Heidi Heitkamp (D-ND) at a recent Tax Policy Center (TPC) event, as well as my colleague, Howard Gleckman, have noted how, for decades, Congress has failed to enact federal legislation to smooth out the administrative nightmares that online and catalog sales can create. But neither have the 50 states been able to agree on a coherent collections model.
However, there are examples of progress both internationally and among the US states.
My TPC colleagues Richard Auxier and Kim Rueben have detailed the various state efforts to use a streamlined sales tax agreement to address common measurement and registration issues caused by the evolution of on-line sales taxes.
Internationally, the OECD and G20 Base Erosion and Profit Shifting (BEPS) project laid out fifteen actions that nations can employ to increase transparency and adopt common standards for treating issues such as interest income, transfer pricing, and controlled foreign corporations.
So far, most of these multilateral efforts have been voluntary. Governments could be more aggressive in developing common practices if legislation or treaties made them mandatory. That big step is often opposed by those who benefit from the status quo, either through existing legislative favoritism or their ability to evade/avoid the laws. Yet pressure to resolve these issues continues to grow.
For example, the federal government could pre-empt some state actions by adopting a nationwide retail tax that it shares with the states according to a fixed formula. For many years, the federal government granted a credit against federal estate tax of up to 100 percent for payments of a state estate tax that included certain features. That gave states a significant incentive to adopt a common estate tax base since failing to do so effectively meant turning revenue over to the federal government.
Similarly, the European Union aims for a standardized tax base for the value-added tax, though its member countries may still set their own rates and are allowed some flexibility in defining their tax base.
In the face of growing complexity, even businesses are embracing common standards, at least up to a point. For instance, brick-and mortar retail firms have complained about their competitive disadvantage when on-line sellers do not collect tax for selling the same goods and services. In a sense, these firms are arguing for a common tax base to apply to both physical and on-line or mail-order sales.
Many firms’ finance and accounting officers complain about having to comply with a wide range of rules for defining income or sales tax bases among multiple jurisdictions. A multinational firm, for instance, may have to file income, sales, and value-added tax reports in thousands of jurisdictions. Even without foreign sales, a US firm may file hundreds of tax returns in the 50 states and numerous cities and counties. To address these concerns, third-party providers and software firms have jumped into this market by selling products to ease the burden on taxpayers and governments alike.
The evolution of the modern economy is only increasing pressure on taxing jurisdictions to cooperate and for federal systems to adopt laws or treaties that encourage or even require such cooperation among sub-national governments. Such efforts extend to registration, filing requirements, reporting, transparency, and definition of tax bases, and, sometimes, minimum tax rates.
These efforts always will be incomplete and ongoing, given legitimate pressures for tax competition and jurisdictional independence. But South Dakota v Wayfair, Inc. is an important step along this meandering path toward sometimes-workable conformity.
This column first appeared on TaxVox.
Government budget and tax analysts who estimate future federal revenues and spending are among the most talented people I know. They probably are a lot more accurate at what they do than typical academics or business consultants. However, their estimates frequently understate the true long-term costs of tax cuts or spending.
When estimators miss on the low side, it is often because they are trying to project costs of those government programs and tax subsidies that are both permanent or “mandated,” absent new legislation, and essentially open-ended.
Unlike programs where the government appropriates a fixed amount of money each year, the costs of mandated programs don’t need to be appropriated to be spent. Meanwhile, open-ended programs leave important determinants of cost, such as demand or price or definitions about who or what qualifies for the program, to decisions made by beneficiaries or service providers. When the two elements are combined, Congress effectively cedes long-term control of the costs to private individuals acting in their own, not necessarily the public’s, interest.
Estimation is simpler for mandatory programs or permanent tax benefits that are not open-ended. For example, estimators know that the cost of the child tax credit will equal the amount of the credit times the number of eligible children. Similarly, Social Security retirement benefits might grow rapidly but can be estimated with fair accuracy because they are set by formulas based on lifetime earnings that provide only limited discretion to recipients.
That is not so for Medicare, where beneficiaries and providers have often been allowed to appropriate resources to themselves. Consumers demand more access to healthcare treatment even as providers—who mostly are compensated based on volume—happily increase the supply of those treatments. Because there is little effective market discipline, health care provided by government creates a perfect fiscal storm. For example, suppose a drug company markets a new drug under government patent protection; it then sets a price; consumers demand the drug to address the ailment it treats; and—often—Medicare pays.
A similar phenomenon occurs with the open-ended tax subsidy for capital income, which is taxed at lower rates than ordinary income. Since ordinary income is taxed at a top rate of 37 percent while long-term capital gains are taxed at a top rate of 23.8 percent, taxpayers have an enormous incentive to recharacterize their income to benefit from the lower rate. The classic recent example: Hedge funds that have converted a share of their managers’ labor compensation income into lower-taxed long term capital gains income (carried interest).
Over the years, Congress and the IRS have played a game of whack-a-shelter with respect to preferential tax rates for capital income. Smart lawyers find a new way to turn ordinary income into lower-taxed capital gains, government (through either legislation or regulation) shuts it down, and then taxpayers and their advisors find another approach. That process makes it impossible to estimate government revenues for the long-run since estimators are supposed to assume the permanence of what is an inherently unstable law.
Forecasting capital gains revenue is even more difficult because investors can choose when to realize gains and, thus, pay the tax. As a result, gains can be earned over decades but are not taxed (and this generate no revenue) unless “realized” through an asset sale.
In a classic article, Nobel prize winning economist Joseph Stiglitz explained how individuals could take advantage of these arbitrage opportunities to reduce the taxes they pay. Given their voluntary nature, a large share of gains is never taxed because they are held until death—when their assumed cost in the hands of the heir is “stepped-up” to the market price at the time the person making the bequest passes away.
The newest example of an open-ended tax shelter is the Tax Cuts and Jobs Act’s 20 percent individual income tax deduction for income from pass-through businesses such as partnerships and sole proprietorships. It blows a hole in the government fisc so large than a Mack truck could be driven through it—as long as the operator is a sole proprietor. Congress attempted to limit the benefit to some types of earners and some types of businesses, but tax lawyers are busily finding ways to convert excluded businesses into qualified ones, and wage earners into independent business owners.
The structure of these types of laws makes estimating difficult enough. But two other factors make forecasting even more challenging.
The first is that the compounding of cost growth may take place years in the future and congressional scorekeeping conventions generally limit projections to the first 10 years, the so-called “budget window.” Underestimating a growth rate by a couple percent per year, for instance, compounds to a very large number over time.
The second is that estimators may be reluctant to project very large costs in the absence of empirical evidence. For example, the 20 percent tax deduction for pass-through income is new, and there is little information upon which to predict the magnitude of gaming that will occur. The revenue estimator doubtlessly will assume some gaming, but may not be imaginative and daring enough to forecast without much data a large multiplier for what lawyers or providers, in absence of further whack-a-shelter legislation, will invent for their clients.
Much is wrong with a system that allows enactment of open-ended mandatory spending programs and tax preferences. Until we repair that system, it is worth remembering there is a built-in bias towards underestimating their long-term costs.
On February 15, 2018, Senators Chuck Grassley (R-Iowa) and Orrin Hatch (R-Utah) requested specific information from the Internal Revenue Service (IRS) on its oversight activities of nonprofit hospitals. Skeptical about whether some or many nonprofit hospitals actually operate as charities, they sought evidence that they provide “community benefits.”
To provide evidence well beyond what the IRS considers, I suggest that they and the hospitals themselves adopt a tool I developed to help assess whether a charity fully utilizes the charitable resources available to it. It turns out that a hospital can qualify for tax exemption and provide community benefits while operating more as a partnership serving its doctors, staff, and managers than as a charity. The main value of this tool, however, is not for a top-down assessment by an understaffed IRS wading through a measurement swamp, but for self-assessment of charitable operations by truly mission-driven hospitals.
This measurement tool is simply a variation on the accountant’s most powerful tools: the income statement and the balance sheet. Using this tool goes beyond the traditional balancing of cash flows in and cash flows out, or of assets with liabilities, to what I call the uses and sources of those “resources” gathered to pursue the charitable activities of the hospital. Of course, it can be used by almost all charities, not just hospitals.
Eugene Steuerle, Richard Fisher Chair at the Urban Institute and co-founder of the Urban-Brookings Tax Policy Center gave this presentation at the ABA Tax Meetings Exempt Organizations Committee luncheon in May 2018. A full transcript is available at taxpolicycenter.org.
“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”
I’d like to refine this idea, probably incorrectly attributed to Winston Churchill, with the wisdom of my teachers, by distinguishing among luck, serendipity, and misfortune. To me, luck—good or bad— results from random factors beyond our control. Serendipity reflects the good things more likely to happen when we put ourselves along a path with a higher-than-average probability of success, while misfortune happens, often unnecessarily, when we bet against a house that has stacked the odds in its favor.
I realize that the lexicographers may not fully agree with my definitions.
Chauncey M. Depew told the story that Noah’s wife one day was caught kissing the cook.
“‘Noah,’ she exclaimed, ‘I’m surprised!’
“‘Madam,’ he replied, ‘you have not studied carefully our glorious language. It is I who am surprised. You are astounded.’”
Are charities on a serendipitous path, where a virtuous cycle of improvement is more likely, or a path with greater odds of a vicious cycle of misfortune? I suggest that the treatment of charities in last year’s tax reform may reflect a path if not misfortunate at least less serendipitous than possible.
In any case, I want to spend most of this talk discussing why the current tax law is unsustainable and sets in motion forces for further reform. I then set out a bold but difficult agenda worth pursuing as we venture down that still-to-be-determined path.
This column first appeared on TaxVox.
By roughly doubling the standard deduction and limiting the deduction from federal taxable income of state and local taxes (SALT), the Tax Cut and Jobs Act of 2017 (TCJA) significantly reduced the tax benefits of homeownership, especially for middle-income households. Not only does it cap the deductibility of state and local taxes, including local property taxes, it also substantially reduces the number of taxpayers who will itemize deductions at all, including those who pay mortgage interest.
As a result, it raises important questions about the future viability of tax subsidies that primarily benefit higher-income taxpayers who own expensive, highly-leveraged homes. These changes made homeownership tax subsidies even more upside-down than pre-TCJA tax law and provide a tax incentive to further concentrate the distribution of private wealth.
The Congressional Joint Committee on Taxation (JCT) recently released projections on the future distribution of some of the tax benefits of homeownership. Out of 77 million projected homeowners in 2024, only about one-fifth will make $50,000 or less. Yet, they’ll comprise about half of all households, homeowners and nonhomeowners alike. These taxpayers with annual incomes under $50,000 will get only about 1 percent (or less than $400 million out of $40 billion) of the overall tax subsidy for home mortgage interest deductions. Meanwhile, households with more than $100,000 of income will garner almost 90 percent of the subsidy.
These estimates for the mortgage interest deductions understate the total value of tax benefits from homeownership. Property tax deductions are also skewed to the rich and the upper-middle class. At the same time, it is more beneficial to build up home equity largely tax-free than to pay income tax on the returns from money kept in a savings account. This additional incentive also benefits the haves more than the have-nots because it is proportional to the amount of equity a homeowner possesses. So those with a large amount of home equity are far better off than new, usually younger, homeowners who rely heavily on borrowing to purchase a home.
There is something of a paradox to the new tax law, however. The increase in the standard deduction, and the caps on deductions for home mortgage interest and state and local tax payments are all steps that make the overall tax system more progressive. And the reduction in tax incentives probably put a small brake on inflation in the value of housing, making it a bit more affordable for both renters and homeowners.
Still, as a matter of homeownership policy, the result is that only a little over one tenth of taxpayers—those who will still itemize after the TCJA—will have the opportunity to benefit from most tax subsidies for homeownership. And that will require advocates for extending ownership incentives to more low- and middle-income groups to make the case not simply for better distributing existing tax subsidies but for maintaining any at all. As the increase in the standard deduction shows, there are a lot of ways of promoting progressivity that do not entail subsidizing homeownership.
The case for homeownership subsidies in the tax code and elsewhere rests mainly on the following two grounds: (1) homeownership is a way of promoting better citizenship and more stable communities; and (2) homeownership helps improve wealth accumulation by nudging many who might not otherwise save to do so by paying off mortgages and making capital improvements on their houses.
The saving argument is one that does apply mainly to low- and moderate income households. Homeownership is the primary source of saving for these households, even more important than private retirement saving. If one cares about the uneven distribution of wealth, and related issues of financing retirement for moderate-income households, then encouraging wealth accumulation through housing may be an appealing strategy.
The bottom line: When it comes to homeownership, the TCJA has left the nation with an upside-down tax incentive that applies to only about one-tenth of all households—nearly all of them with high incomes.
Such a design doesn’t pass the laugh test for political sustainability. The new tax law’s crazy remnant of a homeownership tax subsidy should encourage policymakers to rethink housing policy, including tax benefits and direct spending programs for both renters and owners. Given the structure of the TCJA’s tax subsidies, the bar is relatively low for policymakers to find an improvement.
Would you believe that President Donald Trump is eligible for an extra Social Security benefit of around $15,000 a year because of his 11-year-old son, Barron Trump? Well, you should believe it, because it’s true.
How can this be? Because under Social Security’s rules, anyone like Trump who is old enough to get retirement benefits and still has a child under 18 can get this supplement — without having paid an extra dime in Social Security taxes for it.
The White House declined to tell us whether Trump is taking Social Security benefits, which by our estimate would range from about $47,100 a year (including the Barron bucks) if he began taking them at age 66, to $58,300 if he began at 70, the age at which benefits reach their maximum.
Of course, if Trump, 71, had released his income tax returns the way his predecessors since Richard Nixon did, we would know if he’s taking Social Security and how much he’s getting. There’s no reason, however, to think that he isn’t taking the benefits to which he’s entitled.
Meanwhile, Trump’s new budget proposes to reduce items like food stamps and housing vouchers for low-income people. It doesn’t ask either the rich or the middle class to make sacrifices on the tax or spending side. And it doesn’t touch the extra Social Security benefit for which Trump and about 680,000 other people are eligible.
The average Social Security retiree receives about $16,900 in annual benefits. Does it strike you as bizarre that someone in Trump’s position gets a bonus benefit nearly equal to that?
Does it seem unfair that by contrast to Trump, most male workers — and for biological reasons, an even greater portion of female workers — can’t get child benefits because their kids are at least 18 and out of high school when the workers begin drawing Social Security retirement benefits in their 60s and 70s?
Trump is eligible for the Late-in-Life-Baby Bonus, as we’ve named it, because the people who designed Social Security decided in 1939, about five years into the program, that dependents and spouses needed extra support. They didn’t think much (if at all) about future expansion in the number of retirees, primarily male, who would have young kids.
The Late-in-Life-Baby Bonus goes to about 1.1 percent of Social Security retirees and costs about $5.5 billion a year. That’s a mere speck in Social Security’s $960 billion annual outlay.
Yet the Late-in-Life-Baby Bonus is a dramatic — and symbolic — example of hidden problems that plague Social Security, problems that few non-wonks recognize and that reform proposals have largely ignored.
Those problems are why the two of us — Allan Sloan, a journalist who has written about Social Security for years; and C. Eugene Steuerle, an economist who has written extensively about Social Security, co-founded the non-partisan Urban-Brookings Tax Policy Center and is the author of “Dead Men Ruling: How to Restore Fiscal Freedom and Rescue Our Future” — combined forces to write this article.
We want to show you how we can help Social Security start heading in the right direction before its trust fund is tapped out, at which point a crisis atmosphere will prevail and rational conversation will disappear.
Calling for Social Security fixes isn’t new, of course, but the calls usually focus primarily on fixing the increasing gap between the taxes Social Security collects and the benefits it pays.
For us, however, the Late-in-Life-Baby Bonus is an example of why reform should not only restore fiscal balance but should also make the system more equitable and efficient, more geared to modern needs and conditions, and more attuned to how providing ever-more years of benefits to future retirees puts at risk government programs that help them and their children during their working years.
If all that mattered were numbers, we could easily provide better protections against poverty with no loss in benefits for today’s retirees, while providing higher average benefits for future retirees. But that works only if the political will is there to update Social Security’s operations and benefit structure. After all, a system designed in the 1930s isn’t necessarily what we’ll need in the 2030s.
And make no mistake about how important Social Security is. Millions of retirees depend heavily on it. According to a recent Census working paper, about half of Social Security retirees receive at least half their income from Social Security — and about 18 percent get at least 90 percent of their income from it. Add in Medicare benefits, and retirees’ reliance on programs funded by the Social Security tax are even higher.
Given the virtual elimination of pension benefits for new private-sector employees and the increasing erosion in pensions for new public-sector employees, Social Security will likely be needed even more in the future than it is today.
Simply throwing more money at Social Security isn’t the way to solve its imbalances, much less deal with the Late-in-Life-Baby Bonus and some of the other bizarre things we’ll show you.
Money-tossing would just continue the pattern of recent decades that provides an ever increasing proportion of national income and government revenue to us when we’re old (largely through Social Security and Medicare), and an ever smaller proportion when we’re younger (anything from educational assistance to transportation spending). This shortchanges the workers of today and tomorrow who will be called upon to fork over taxes to cover the costs of Social Security and other government programs for their elders.
We began with the Late-in-Life-Baby Bonus because giving people like Trump — a wealthy man with a young child from a third marriage — an extra benefit unavailable to 99 percent of retirees is a dramatic example of how problems embedded in Social Security cause inequities and problems that few people other than Social Security experts know about.
Think that we’re overreacting to a minor quirk? We aren’t. Here are some additional aspects of Social Security that we think violate standards of equal justice and common sense:
There’s the Single Parent Shortchange, whereby many single parents — largely mothers with below-average earnings — pay Social Security taxes to cover spousal and survivor benefits for other people even though the solo parents can’t receive them. Sure, many people contribute toward benefits they will never see, especially if they die before retirement age. But the Single Shortchange strikes us as horribly unfair. Single parents are among the lowest income payers of Social Security taxes. Why should they subsidize other folks’ never-working spouses in a way that gives the biggest benefits to the best-off people?
Then there’s the Agatha Christie Benefit: Some divorced people get a bonus from Social Security only if their former spouse dies. And the Serial Spouse Bonus: If someone has had, say, three spouses, each might get the same full spousal and survivor benefits available to the one lifetime spouse of another worker — provided that each marriage lasted at least 10 years. If a marriage lasts nine years and 364 days, the spouse gets zippo.
The Equal Earner Penalty means that a couple with two people each earning $40,000 gets about $100,000 less in lifetime benefits than a couple with one spouse earning $80,000 and the other earning nothing. This happens even though both couples and their employers pay identical Social Security taxes.
Many if not most of these inequities would be illegal in private retirement plans.
Fixing the Late-in-Life-Baby Bonus and the other inequities we mentioned (as well as plenty that we omitted) is more about remedying injustice than cutting costs; giving some people more benefits and others less would pretty much offset each other.
The system needs to be overhauled not simply to become more fair by giving less to the Trumps of the world and more to the less fortunate among us, but because Social Security, created in the 1930s, was largely constructed around a world in which married women were expected to stay at home. People also had shorter lifespans then and retired later, so that today retirees receive benefits for 12 more years on average than retirees in the system’s earlier days.
Back in 1965, there were about four workers for every person drawing benefits. Currently the ratio is in the low threes. Now, the decline in birth rates is hitting with a bang as baby boomers retire en masse, with the ratio expected to fall to about 2.2 in 2035. Each baby boomer retirement leads to an increase in takers and a decrease in makers.
Not dealing with this decline in workers-to-beneficiaries — a good chunk of which is caused by Social Security treating people as young as 62 as “old” — has broad implications for the revenues available for all government services, not just Social Security, as well as for the growth rate of our economy.
Even as fewer workers support more retirees, the average value of Social Security retirement benefits continues to rise. Look at the increasing “present value” of Social Security benefits for a two-income 65-year-old couple earning the average wage each year and expecting to live for an average lifespan.
In 1960, such a couple needed to have on hand $269,000 (in 2015 dollars) in an interest-bearing account to cover the cost of their lifetime benefits. Today, it’s about $625,000. In 2030, it will be about $731,000. And in 2055, when a Millennial age 30 this year turns 67, the full retirement age under current law, the present value of scheduled benefits hits seven digits: $1,029,000. Include Medicare, and benefits are about $1 million for today’s couple, rising to $2 million for the millennial couple.
These benefit-value increases are caused by a combination of longer lives for retirees and Social Security formulas that increase benefits as wages rise.
These numbers matter because Social Security isn’t like an Individual Retirement Account or a pension plan that sets money aside for you today for use when you retire. It’s mainly an intergenerational transfer system: Today’s workers pay Social Security taxes to cover their parents, who previously paid to cover their parents, who paid to cover their parents. That’s the way the system has worked since its founding in 1935. Social Security taxes paid by current workers and their employers get sent to beneficiaries, not stashed somewhere awaiting current workers reaching retirement age.
The system does have a trust fund that in the early 1980s was about to run out of money. A crisis loomed. As a result, after a report by the Greenspan Commission, Congress in 1983 enacted reforms that included gradually raising the normal retirement age (but not the early retirement age) and subjecting some Social Security retirement benefits to federal income tax.
This led to temporary surpluses while baby boomers were in their peak earning years. But now that boomers are retiring rapidly, Social Security’s tax revenues are falling farther and farther behind benefits being paid out.
The trust fund is projected to run dry in about 15 years. Meanwhile, every year without reform adds to the share of the burden required of the young, who already are scheduled to have lower returns on their Social Security contributions than older workers.
Do you think that if someone offered millennials a choice, they would want to face huge student debt, declining government investment in their children and higher future taxes (which are inevitable as deficits mount) — in exchange for a more generous retirement than today’s retirees get? Or would they prefer a system that treats them and their children better when they’re younger?
We’re both way past millennial age — but we know which we would prefer.
Now, we’ll show you how we can tweak Social Security to address the problems we’ve discussed without cutting benefits for current retirees or denying future retirees average benefits higher than current retirees get.
It’s about math. Social Security pays out far more than would be required to provide well-above-poverty-level benefits to all elderly recipients. Future growth in the economy will help tax revenues and benefits rise, which would give us room to modify the payout formulas and deal with problems that this iconic program isn’t addressing.
Those problems include poverty and near-poverty for millions of retirees, particularly the very old. That problem is greater for people who retired at 62 rather than waiting for their full retirement age, a move that locks them into lower payments for the rest of their lifetimes.
How can we orient the system more progressively to the needs of modern society, provide a stronger base of protection for all workers, and slow the growth rate of benefits to bring the system into better balance? To shore up Social Security permanently, it’ll be necessary to slow down the overall growth in benefits, encourage more years of work and end the pattern of people having ever-longer retirements as lifespans increase and Social Security doesn’t adapt its rules. At some point, it will also require a revenue (i.e., tax) increase, too.
Here, in simplified form, are some suggestions for making Social Security more modern and more fair.
- Change the benefit structure. Reduce the level of benefits that retirees get in their 60s and early 70s but give them higher-than-now benefits in their mid-to-late 70s and beyond. That would shift resources to retirees’ elder years when they have greater needs, including a higher probability of having to pay for long-term care.
- Raise the minimum benefit. Have a strong minimum benefit for most elderly that’s indexed to wage growth, which typically exceeds inflation. This would raise benefits for one-third to one-half of the elderly in a way that will essentially remove them from poverty.
- Trim benefit growth for those at the top. Offset at least part of the cost of higher minimum benefits by paying the highest-paid recipients less in the future than they would get under the current formula. Slow the rise in benefits for future retirees with way-above-average lifetime earnings by indexing their benefits to inflation rather than to wage growth.
- Index the retirement age. Having people work for additional years helps pay for higher levels of both lifetime and annual benefits. So if people on average are living a year longer, they should have to work a year longer. Those additional income and Social Security taxes would help support both Social Security and national needs that are higher priority than paying additional retirement years. Gradually phase out the early-retirement age that leads many healthy couples to retire on Social Security for close to three decades for the spouse who lives longer.
- Make spousal and survivor benefits more fair. Modify these benefits so that they provide higher benefits for those with greater needs rather than giving the richest bonuses to the richest spouses even when they contributed less in taxes than lower-income spouses. Otherwise, use rules similar to what private pensions use, so that benefits are shared fairly for the time of marriage together.
And one final thing: Bye-bye Late-in-Life-Baby Bonus. Stop paying retirees extra for children under 18. Continue the young-child bonus for widows or widowers below retirement age, and for people on disability.
Eliminating that bonanza for older parents would be a symbolic first step. And who can say? Perhaps now that lots more people (including possibly Trump himself) know that the Late-in-Life-Baby Bonus exists, our leaders might just be embarrassed enough to realize that the sooner Social Security is adapted to modern needs and circumstances, the better.
If this results in starting to fix Social Security the right way, the Late-in-Life-Baby Bonus will have delivered a big-time bonus of its own. The beneficiaries would be our future retirees, our workers and our country as a whole.