The Worst Tax of All is Not Even a Tax: The Case of the Social Security Earnings Test

Posted by Jeffrey Brown on Aug 8, 2011

Filed Under (Retirement Policy, U.S. Fiscal Policy)

Most people dislike paying taxes because every dollar sent to the government is one less dollar they have to spend themselves.  Because taxes make people “poorer” (ignoring, for a moment, the fact that many of those tax dollars are returned to citizens in the form of Social Security income, health benefits, or other government services), they have less money to spend on goods and services.  This is what economists call the “income effect” of taxes.  While this is the part that most normal people dislike, it is not what economists typically care about. 

You see, economists recognize that if you need to raise revenue, then it has to come out of somebody’s pocket.  And whoever’s pocket you choose to take it from will cause that person to have less money to spend.  That is just arithmetic. 

We can also have very spirited debates about whose pocket we should take those taxes from.  This is the “distributional” question.  Or to put it in laymen’s terms, this is the issue of “fairness” or “equity.”  While economists have a lot to contribute to these discussions in terms of analytical rigor, at the end of the day, one’s views on this are determined by non-economic factors, such as ideology, religion, one’s sense of justice, and so on.  Economists may get passionate on these issues, but there is really no reason that a randomly drawn economist’s view of the “fair” level of income redistribution should be given any more weight than a randomly-drawn non-economist’s view.

But there is a third factor – one that is at the heart of economics.  It is the issue of the “efficiency” of a tax system.  And by efficiency, we don’t mean something as narrowly conceived of how much it costs the IRS to collect your taxes (although that is a part of it, albeit a tiny one).  Rather, what we really care about are the incentive effects of taxation.  To use economics terms, we care about “substitution effects” of taxes (as opposed to the income effects above).  And we care about the “deadweight losses” that arise when taxes distort incentives. 

Put simply, for a given amount of revenue raised, some taxes destroy more economic activity and/or population well-being than do others.  This is because of the natural human behavioral response to switch away from taxed goods or activities and towards untaxed (or lower taxed) goods or activities.  So, when we tax labor earnings, people work less.  When we tax capital, people invest less.  When we tax wage income more heavily than health insurance, people get paid a higher share of their compensation in the form of health insurance.  When we tax dividends more highly than interest, firms issue more debt and less equity.  When we levy tariffs on foreign-made goods, people buy more American-made and fewer foreign-made goods.

In all of these cases, the taxes distort decisions, leading to a reallocation of economic activity.  And it is this reallocation that is inefficient, because in addition to raising revenue, the reallocation of activity destroys value.  So, for every dollar raised by levying a tax, we might destroy two dollars of economic value.  The amount of value destroyed over and above the revenue raised is what we refer to as a “deadweight loss.”  And this is what economists really dislike.  (As an aside, there are some unusual cases where imposing a tax is actually good for social well-being, such as when we tax something that the private market fails to account for on its own, such as pollution.  This is the basis for my earlier blog in which I called for an Osama bin Laden tax on carbon to reduce our dependence on foreign oil.)

So, if you wanted to design the PERFECT example of the WORST possible tax, what would it look like?  It would be a tax that created a lot of deadweight loss, but raised no revenue.  That is, you would impose a tax that changed the way people behave, making them worse off, while raising no revenue.

Why would anyone ever want to do this?  Well, my hope is that no one ever would want to do it.  But that does not stop politicians from actually doing it. 

My example?  The Social Security Earnings Test.

If you want an explanation of how the Earnings Test works, you can read all about it by clicking here.  But the quick version is this: If you claim Social Security benefits at age 62 but continue to work and earn money over a threshold, then Social Security reduces your monthly benefit by 50 cents for each additional dollar you earn.  This is on top of any income and payroll taxes you may have to pay.

The Earnings Test is actually not a tax in reality.  It raises no revenue whatsoever.  Why?  Because the money that Social Security reduces your benefit by is actually returned to you in the form of higher future Social Security payments!  And the calculation is roughly “actuarially fair” – meaning that for the average person, you get back the same amount with interest that you put in. 

In other words, the government raises NO revenue from this tax.  That is ingredient #1 for the worst possible tax.

Ingredient #2 is that the earnings test distorts behavior, causing people to work less than they otherwise would.  At least that is my working hypothesis.  The issue is this – if people understood that the earnings test is not really a tax, then it should have very little impact on the work versus retirement decision.  But most people do not understand this.  Rather, they view it as a 50% tax on earnings.

As evidence of this, the AARP conducted a survey of Social Security knowledge.  When they asked people what would happen to a hypothetical 63-year old who continues to earn $40,000 per year while collecting benefits, four out of 5 people ages 55 -66 correctly answered that this would reduce his current benefit.  Then, equally importantly, 3 out of 5 respondents believed that this person would never get the money back. 

So there you have it.  The “tax that is not a tax.”  You get all the negatives (i.e., distortion of labor supply decisions) and none of the revenue.

This idea was implemented so poorly that one might just think it was thought up by the U.S. Congress.  And you’d be right.