The Heritage Foundation

Backgrounder Update #193

June 4, 1993

June 4, 1993 | Backgrounder Update on

How Clinton's Budget Plan Taxes the Elderly

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payer were just below the 28 percent Example 1 tax bracket, the government's income Take the example of a retired store manager whose retirement income calculation would push the elderly is $35,500. His lifetime earnings from wages and salary were near, but American into the next highest not above, the maximum wage base for Social Security tax. He bracket and the higher marginal tax receives a modest pension from his former employer, and managed to rate would apply. accumulate savings in a tax-sheltered 40 1 (k) account during his working life (which is now held as an IRA). In addition he has The surtax is targeted on middle-in- invested in some tax-exempt municipal bonds and taxable certificates come retirees because it applies only of deposit. over a range of income that falls be- Actual Provisional tween a fixed threshold and a vari - Income Income able cap. The threshold is $25,000 Amount ($32,000 for joint returns, and not in- Tax Exempt Income dexed for inflation). The cap is in- Untaxable Social Security $9,000 $4,500 dexed for inflation and will go up Municipal Bond Income 2,000 2,000 every year; it is currently equal to 50 1 $11,000 percent of one's Social Security pen- Taxable Income sion. The Clinton Administration pro- Pension from Employer $17,500 $17,500 poses to increase the cap drarnati- Taxable Interest from CDs 2,000 2,000 cally this year, from 50 percent to 85 IRA withdrawals during year 5,000 5,000 percent of the Social Security - amount, which will elevate the cap Total $24,500 $31,000 even more in future years. Only "mid- Threshold (25,000) dle income" elderly Americans are Taxable Amount 6,000 subject to this surtax-those with in- ELDERLY SURTAX @ 15% $900 comes above the cap are not liable for the surtax. Example 2 A married, retired plant manager with an engineering firm, whose A Stealth Tax, Growing with retirement income is $59,400, would pay the ma 'ximum. surtax. His Inflation lifetime earnings from wages and salary were always above the maximum wage base for Social Security tax. He receives a generous The surtax on "provisional in- pension from his former firm, and managed to accumulate savings in a come" is designed to start off at a tax-sheltered 401(k) account during his working life (which is now modest level, taking money from held as an IRA). In addition he has invested in tax-exempt municipal only a few retirees. But gradually it bonds and taxable certificates of deposit. will grow to encompass more and Actual Provisional more less-well-off Americans over Income Income age 65. The silent effects of inflation I Amount will cause an insidious deepening of Tax Exempt Income the surtax threshold. Since the thresh- Untaxable Social Security $20,300 $10,150 old amount of $25,000 is not indexed Municipal Bond Income 2,000 2,000 for inflation, it will drop in real terms $22,300 each year, encompassing millions of Taxable Income additional elderly Americans. Today Pension from Firm $30,100 $30,100 most Social Security pensions are Taxable Interest from CDs 2,000 2,000 under $12,000 per year. But at IRA withdrawals during year 5,000 5,000 today's inflation rate, most Social Se- Total $37,100 $49,250 curity pensions by the year 2015- Threshold (32,000) when the baby boom generation be- Taxable Amount 17,250 gins to pass age 65-will be greater ELDERLY SURTAX @ 28% $4,830 than the threshold and everything a if this individual had a one-time capital gain from the sale of his home, which-put retiree has saved may be subject to him into the top 36 percent tax bracket, his surtax that year would be $6,210, or the surtax. $1,380 hig!ler.

In addition, the cap on the surtax rises with inflation because the amount of an American's cost-of-living (COLA)-adjusted Social Security pension determines how much other income is subject to this surtax. The retiree's annual cost of living increase for inflation in future years will raise the surtax cap by 85 cents for every dollar of inflation.

How Congress Will Discourage Retirement Planning Because Americans take responsibility for their lives with different degrees of prudence, a government policy that punishes hard work and saving, and rewards shortsightedness, will have long-run social consequences un- dermining independence for senior citizens and the national savings rate. Stiff new taxes on those elderly Ameri- cans who look to the future and prepare for their own retirement make it harder for senior citizens to be self-suf- ficient, to live without imposing a burden on their neighbors or their children, and to leave a legacy of achieve- ment behind.

When Social Security was established, it was described explicitly as a supplement to private savings and a family's own financial planning for retirement. It has never been seen as a replacement for someone's own pru- dence and responsibility to plan ahead. The Clinton Administration's proposal will reverse this long-standing policy. It will discourage private savings and preparation for retirement by imposing a discriminatory tax on anyone who takes life-long responsibility seriously. To be sure, there is a constant debate as to whether older Americans are, on average-, net beneficiaries (mean- ing they "take out" more than they have "put in") from Social Security, and whether they generally have a greater net worth-and are thus "richee, than younger Americans. This debate becomes very confused when ideas of "fairness" are based on questions of "rich versus poor." Although most Americans who currently re- ceive Social Security pensions are net beneficiaries, due to low tax rates in earlier years and generous COLA provisions, this windfall does not exist for anyone under age 45 today. Indeed, except for the very poorest wage earners, Social Security benefits will not return them even a fair yield on their investment after age 65 (for women the bias is even more severe). I

The Confused Philosophy of "Tax Fairness" The tax increases advocated by the Clinton Administration are proposed in the name of "tax faimess"-some people are better off than others. Americans understand the concept of fairness in sports, in "equality before the law," and as members of a school or club where everyone has equal rights in the sense that everyone obeys the same rules. A progressive income tax, however, imposes unequal rules: Some people must pay higher tax rates. These unequal tax rates are justified on the basis of "ability to pay." This is sometimes known as the Willie Sut- ton principle, after the famous 1930s bank robber. Asked why he held up banks, Sutton responded, "That's where the money is." The apparent reason for increasing the surtax on "provisional income" is because some people have accumulated savings during their lifetimes and others have not. But placing an additional tax on some older Americans because they have accumulated savings and invest- ments during a lifetime of work, and therefore might be considered "rich" in comparison with a young worker just out of school, newly married, and heavily in debt, confuses all of the issues of wealth and poverty with the normal behavior of both rich and poor throughout a lifetime. An elderly "pooe' person might well have more fi- nancial resources than a young "rich' ' person. Fairness and ability to pay are very different concepts. Tax fair- ness could more properly support a proportional income tax, which would follow an equal rule and take the same "faie, percentage from everyone who receives income.

1 See Michael J. Boskin, "Concepts and Measures of Earnings Replacement During Retirement," in J. Shoven and D. Wise, eds., Issues in Pension Economics (Chicago: University of Chicago Press, 1987). Cbnclu'sion- -

Whether Social Security should remaint tax-exempt pensio'n,,-or,wh&ther it -should be taxed like any private pension can be debated.'But the method-hdopted in -the House budget reconciliation bill to calculate the tax on "provisional income' means- a higher tax rate on savings and investment-thus a tax on each American's prepa- ration for retirement and self-sufficiency in old age, and a penalty on savings.

Joe Cobb John M. Olin Fellow

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