Note to Tax Reformers: Consider Fixing the Formula for Taxing Social Security Benefits

While public attention is focused on big issues like corporate and inheritance taxes, many smaller but sensible opportunities to improve tax fairness and efficiency are being overlooked. A new Economic Brief from the Richmond Fed discusses one such example—taxation of social security benefits.

Currently, seniors pay income tax on a portion of their social security benefits that rises with increases in their total income, including earned income and other pension income. The formula is complex, but, as the brief explains, its effect is to expose seniors with even modest incomes to surprisingly high effective marginal tax rates—higher than younger workers who earn similar incomes from their jobs alone. For example, a senior with $16,000 in yearly Social Security benefits and $32,000 of income from other sources pays an effective marginal tax rate of 27.5 percent–much higher than the 15 percent marginal rate for a younger worker with wage income of $32,000.

According to the research on which the brief is based, the higher marginal rate discourages seniors from continuing to work. A part-time job that might look attractive at a 15 percent tax rate looks less attractive at 27.5 percent. If the seniors in question worked more, they would contribute more to the Social Security system in payroll taxes.

The brief discusses two possible reforms that would lower marginal tax rates and increase labor force participation of seniors while maintaining revenue neutrality. One would be to tax all Social Security benefits as ordinary income, rather than a portion that rises with income. Doing so would lower effective marginal tax rates and induce more work, thereby generating more revenue both through payroll taxes and taxes on benefits. Payroll tax rates could then be decreased to maintain revenue neutrality. Alternatively, all benefits could be made nontaxable, as they were before 1983.

Surprisingly, this change would result in no lost revenue, since greater payroll tax revenue would roughly equal the loss of revenue from benefit taxes.

Why not give it a try?

Reposted from Niskanen Notes