Taxes on Seniors--How Low Can We Go? (Updated)

Vol. IV, No. 4 (Updated)

It's election season and tax cuts are in the air. So who stands to get a break? What about America's most likely-to-vote group-affluent seniors? Last week, the Senate voted in favor of repealing the 85-percent tier of the Social Security benefit tax. The measure is now due to come up in the House, where it enjoys widespread support. The call for repeal first surfaced in the 1994 GOP Contract with America. It was a bad idea then, and it's a bad idea now. As fiscal policy, repeal is irresponsible. The Medicare trust fund, which is credited with the tax receipts, would lose a source of dedicated revenue totaling $2.4 trillion in today's dollars over the next seventy-five years, the Trustees' official time horizon. Proponents say that this won't hurt Medicare because the shortfall will be made up out of general revenue. But if that's so, then other priorities must be hurt instead. Beyond fiscal irresponsibility, there's a more fundamental problem with repeal: its gross inequity. Proponents say they would remove an unfair tax penalty on seniors. The truth is precisely the opposite: They would undo one of the few efforts in recent years to get seniors to pay a fairer share of the cost of government.

An Historical Accident

Let's start with some background. Until 1983, all Social Security benefits were exempt from federal income taxes. Since 1983, up to 50 percent of benefits have been included in taxable income, but only for single beneficiaries with incomes over $25,000 and couples with incomes over $32,000. Since 1993, up to 85 percent have been taxable for beneficiaries with incomes over higher thresholds, $34,000 and $44,000. The benefit-tax cutters claim that the second 85-percent tier unfairly penalizes affluent seniors. But what's really unfair is not that some seniors pay taxes on most of their Social Security benefits, but that most seniors don't pay taxes on more of them. This is lost on the benefit-tax cutters, who view the 85-percent tier as a recent aberration. It is recent, but no aberration. Rather, it corrects decades of bad policy born of an historical accident. The original exemption for Social Security benefits was not created by Congress, but by off-hand IRS rulings late in the New Deal. Back then, no one paid it much notice because Social Security benefits were small, income tax rates were low, and most seniors had modest incomes. Circumstances soon changed, but the senior lobby long blocked any reform. In 1983, Congress finally subjected one-half of Social Security benefits to income taxes above certain thresholds. Why one-half? The rationale was that the other half was a payback of personal FICA contributions on which income taxes had already been paid. Most experts endorsed the reform, which was modeled on the tax treatment of private pensions. But they noted that it didn't go far enough, since already-taxed FICA contributions in fact represent not 50 percent, but (at the most) 15 percent of benefits. So in 1993 Congress took the next step and made 85 percent of benefits taxable over higher thresholds. Yet all of this still begs the question: Why shouldn't 85 percent of all benefits be taxable? That is, why shouldn't seniors be subject to the same progressive income tax as everyone else? As it is, just one in three Social Security recipients now pays any taxes on his or her benefits-even at the 50-percent tier. And just one in six pays taxes at the 85-percent tier. Meanwhile, working families pay taxes on 100 percent of earnings.

A Tale of Two Couples

The injustice of rolling back the Social Security benefit tax is best appreciated by comparing the total tax burden on the old and the young. The favorable treatment of Social Security, after all, is not the only tax favor most seniors enjoy. Besides paying no payroll taxes, they get a larger standard deduction in the federal income tax code. They also benefit from a variety of deductions and exemptions at the state and local level, such as "empty-nester" breaks on property taxes. All this adds up to a colossal imbalance. Consider a (not atypical) illustration. It's a tale of two married couples residing in Fairfax County, Virginia. One is a 35 year-old working couple with one small child, $30,000 in self-employment income, and a condo worth $100,000. Their bill for the "big four" taxes-federal and state income taxes, federal payroll taxes, and local real estate taxes-will come to $7,709 this year. Now consider their neighbors down the hall-a 70 year-old retired couple with the same $30,000 in income, split evenly between Social Security benefits and taxable investment returns, and the same $100,000 condo. How much does the second couple pay in the big four taxes? Just $53. They owe no FICA tax. With their larger standard deduction and total exclusion for Social Security benefits, they owe virtually no federal income tax. And they owe no state and local taxes. Like many states, Virginia not only entirely exempts Social Security, it gives seniors huge extra deductions. Like many counties, Fairfax waives property taxes for seniors (but not the young) beneath certain income levels. Now imagine that the same couples have $75,000 incomes and $200,000 condos. (For the working couple, we again assume that all income is self-employment income; for the retired couple, we assume $30,000 in Social Security benefits and $45,000 in taxable investment returns.) Here's what you get: The working couple pays $25,290 in the big four taxes, while the retired couple pays just $11,258. Of that, the extra 85-percent Social Security tax tier accounts for exactly $1,569. Such vast discrepancies are impossible to defend. Some try to justify them on the theory that all people are taxed heavily when young and lightly when old, so that over the life cycle it evens out. But this doesn't wash. In fact, today's seniors were much more lightly taxed when young by all levels of government than young people are today. In 1965, for example, the maximum any working couple could contribute to Social Security was $696 dollars a year-versus $18,898 today. And what about today's young when they grow old? On the benefit side, they will have to bear the brunt of cost-cutting reform when the age wave rolls in. And on the tax side, here's the killer: Because the Social Security benefit-tax thresholds are not indexed to inflation, nearly all benefits will eventually become taxable. In other words, what we don't dare to ask of today's retired couple is already written into law for tomorrow's.

A Level Playing Field

The reality is that seniors are much more active in politics than the young-and that legislators take this into account. Unfortunately, a vicious cycle may be at work, with legislated favors leading seniors to greater involvement in politics and legislated burdens leading the young to greater apathy. It cannot bode well for America's future when the rising generation thinks there's no such thing as a level playing field. Let's be clear: The Concord Coalition does not believe that Americans ought to pay heavy taxes. What we do believe is that in a democracy, once the total cost has been determined, the burden should be fairly shared. Right now, the burden is not-and rolling back the Social Security benefit tax will only make matters worse.

Total Taxes of Equal-INCOME Couples in Fairfax County, Virginia, in 2000


Age 35

Age 70

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$30,000 Family Income    
Federal Income Tax

$   1,320

$         53

Federal Payroll Tax $   4,239 $           0
State Income Tax $      919 $           0
Local Real Estate Tax $   1,231 $           0
Total Taxes

$   7,709

$        53

$75,000 Family Income    
Federal Income Tax $   8,906 $     8,286
Federal Payroll Tax $ 10,597 $            0
State Income Tax $   3,325 $        510
Local Real Estate Tax $   2,462 $   2,462
Total Taxes $ 25,290 $  11,258
Notes: All couples take standard deduction; young couples have one child.  For young couples, all income is self-employment income; federal income tax reflects $500 child credit available in 1999.  For lower-income senior couple, income is $15,000 in Social Security benefits and $15,000 in taxable investment returns; for higher-income senior couple, it is $30,000 and $45,000, respectively