Separate Accounts

Filed Under (Finance, U.S. Fiscal Policy) by Charles Kahn on Mar 8, 2013

That a large percentage of individuals in the US do not paying income tax is a matter of concern, and not just to conservatives.  There is an underlying  sense that the paying of taxes is a duty, an act of solidarity with the collective goals of a democratically constituted nation.  While fairness requires that those best able to do so provide more of the financial support for those collective goals, fairness also requires everyone provide a share, even if that share is small.

In fact, this decline in tax-paying is partly connected with one of the programs often argued to be the most effective at reduction of poverty–the earned income credit.  Under this program, recipients’ credits are often greater than the total taxes they would have paid.

Many of the features of the earned income credit are desirable from the point of view of economic theory. The program entails virtually no overhead costs for its running. Its relatively low marginal rates distort decisions less than many alternatives (such as a minimum wage or food stamps). It can be targeted fairly accurately to those it is intended for (the working poor with children).

From the point of view of the economist, there is no difference between having a program in which an individual receives $5,000 from the government and pays $500 in taxes, or a program which just nets it all out and pays the individual $4,500.  From the point of view of the voters, and possibly from the point of view of the recipient, there is a big difference between the two. 

Beside the moral, even quasi-religious, sense to this–that paying taxes imparts a dignity to the payer (like the “widow’s mite”; also compare the rabinnic teaching that the poor are also required to give charity), there is of course also an astute political sense to this: if government coffers are filled by “others,” there is no limit to what we demand of government; if they are filled by “us” then we weigh the costs versus the benefits.

We probably need a name for the psychological quirk that causes us to regard such two-way passage of moneys as different from a one-way passage of a net amount. I recommend the term “budgeting illusion” — the sense that when sums are arbitrarily divided into different accounts, the separate pots take on a reality of their own.

Budgeting illusion also lies behind some of the difficulties we have in dealing sensibly with social security. Ultimately the money goes into the government in whatever form–payroll tax, income tax, gasoline tax–and the money comes out in national defense, social security, highways.  There is no economic sense in which the dollars collected “for” one purpose are separable from the dollars collected “for” another. For social security recipients the fungibility is fortunate, since, in particular, the present value of most people’s social security contributions is not sufficient to pay for their benefits.  Nonetheless,  most taxpayers feel that the social security payments are “their” money and the benefits are “their” compensation for it.

Even if there is no economic distinction between different dollars, there is a political distinction: Having the social security’s trust fund in a separate pot allows the social security administration some political autonomy.  It enables SSA to pay benefits without resort to the Congress even in years when they are not bringing in enough revenue to cover their costs.  The system was intentionally set up this way, of course, to ensure that changes would be close to politically impossible.  But the problem that arises is just the flip side of the earned income credit problem: in each case our awareness of the magnitudes of the payments are altered when we separate or combine the different pots of funding.