Ideas on Social Security and Tax Reform

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Ideas on Social Security and Tax Reform

by Craig Latzke, March 25, 2005 (posted)

I have two comments about a recent article by Ari Armstrong, a crazy idea to possibly increase the chances that Social Security will eventually be replaced by retirement choices that are actually choices and truly voluntary, a comment about tax reform, and some recommended reading.

Political Feasibility

I think you downplay the importance of the "political feasibility" argument (against fighting to totally end Social Security right now).

Here is an New York Times article I do not endorse but think is worth reading (it is fascinating in content, as well as for its level of statist/socialist bias).

There are a few points I think have merit and speak directly to the issue of political feasibility.

On page 6 the writer tells us about an aggressive plan by David Stockholm (Reagan's budget director) to change Social Security that was too aggressive:

"Stockman was politically naive. By proposing cuts for people on the verge of retirement, he triggered vehement protests. Members of the Republican-controlled Senate showed their instinct for self-preservation by voting 96-0 for a resolution intended to distance themselves from Stockman. James Baker, Reagan's chief of staff, urged the White House to do likewise."

Essentially, those whom you've heard the "political feasibility" argument from are trying to avoid this. I they also have a point in saying that mandatory accounts are better than the current form of Social Security, as these smaller reforms open the door toward farther "ownership" reforms...hopefully/eventually to true ownership, freedom, and choice.

On the next page the author all but makes this same argument:

"[Bush's] plan opts for a slow transition, keeping entitlement-type minimums in place. The amount of money to be diverted into personal accounts -- and therefore, the potential gains -- is relatively small. Some free-market purists are unhappy about this. But Bush's economists, whatever else is said of them, are determined not to re-enact the Stockman debacle by moving too quickly and enacting immediate cuts. They have read their history."

On page 5 the writer mentions "adverse selection:"

"In the 70's, Reagan continued to sermonize against Social Security, often suggesting that it be made voluntary or more voluntary. ... Higher-earning workers (who get a lower proportional return on their payroll taxes) would opt out for certain. This problem is known as adverse selection. Wealthier people contributing higher taxes exit the system, leaving less revenue and a higher burden for the poorer people who remain. In effect, it would become an unpopular welfare program."

Bush's partial opt-out into mandatory accounts, while not perfect, could possibly have the effect of making Social Security less popular and less well-funded, possibly spurring further reform.

Like you, I would like complete reform, and I would like it now. I also don't think we should stop pushing for them, but I do think we should take incremental improvements where we can get them. I think it's possible that Bush's plan could be such an incremental improvement, and I think we should take it. Wars generally take more than 2 days, and true reform often also works slowly. Have patience... and don't prevent true reform by not accepting the baby steps that lead to it.

Income Versus Payroll

You make a technically incorrect statement (I imagine you know this, but just mis-spoke):

"...workers pay the Social Security tax -- 12.4% on all income up to $90,000 as of 2005..."

The Social Security tax is not on income, but on payroll -- which are two largely different things. Income would include capital gains, dividends, etc., which are not taxed for Social Security. There are people who make $50,000, $200,000, or $5 million per year who pay ZERO social security tax.

How to get more support for reform?

My father started me thinking in this direction a couple months ago. We both think the current system is unfair, unjust, unsustainable, etc., but there are three things he quickly observed that make Social Security more acceptable than it really should be to certain segments of our society:

1. Half of the social security tax is hidden from most Americans as it does not show up on their paycheck stub (it's the half paid by their employer).

2. Some people (often those with higher incomes) are largely sheltered from the Social Security tax because much or all of their income is not payroll income.

3. People with very large (even payroll) incomes have a maximum out-of-pocket Social Security tax expense of $11,160 (if we're counting the full 12.4% self-employed people make). To someone making a million dollars per year, that's about 1% of their income. To someone making $20 million per year, that's about 0.0558%.

The first fact essentially hides the real cost of Social Security from most people, while facts two and three essentially make Social Security reform a low-priority issue for the rich and for corporations (and the rich generally have a bigger voice in political issues because they can buy ad space, airtime, and the politicians themselves sometimes).

So, here are my suggestions:

* Extend the Social Security tax burden to all types of income (after adjusting the percentage down so that the same revenue is achieved, just from a larger base), including capital gains, dividends, corporate income, etc.

* Stop hiding half of the cost by collecting it from employers and keeping it off paycheck stubs.

* Don't increase the cap, remove it completely.

Between the three of these we would get Wall Street and the rich to care more about it's cost, make Social Security seem more an entitlement system funded by a tax (which it is) -- less like a retirement account, and simplify the collection of the tax.

FDR was quite smart in dividing and conquering to get Social Security implemented, and this division of burden has lead to many successful Social Security tax increases, zero decreases, and nearly zero reform. I think we could unite more of the country against Social Security if we were united in sharing the costs in a matter proportionate to income.

Tax Reform

I was watching Neil Cavuto about a month ago (he has a business news/analysis show at 2pm on FoxNews, and he seems to be a pretty reasonable guy). He had a show which touched on the topics of Social Security and Tax Reform, and did so almost back-to-back. I think there is a lot of overlap between the two issues, but I noticed they were treated as completely separate issues on the show (unless you count Neil's suggestion that tax reform should have been handled before Social Security reform).

Neil interviewed former Sen. Connie Mack (R-Fla), the chairman of Bush's tax reform panel (the partial transcript can be found here). He seemed like an intelligent guy who understands economics and can communicate his ideas clearly, etc. Among other things, I appreciated that he pointed out that a progressive tax system and a flat tax are not mutually exclusive ("I believe that there are ways to address the issue of progressivity even with a single rate.").

Tax reform, in my opinion, would include eliminating the current system of treating different types of income differently. Not only do we have different rates for different levels of income, but we have a different rate for capital gains income, caps on certain types of taxes, taxes that only apply to payroll income, etc.

I like the idea of a flat tax on all types of income, that allows for few/one deduction(s) (charitable contributions), and doesn't place the burden of any program on only one segment of the population. Such tax reform would obviously impact Social Security reform... as it would by default include my three previous suggestions about Social Security.

I'd also like to see a federal constitutional amendment like TABOR, but now I'm really getting off-topic and into the realm of the impossible.

Recommended Reading

I haven't actually read The Two-Income Trap yet (I just borrowed it from my sister), but the topic sounds really interesting:

"In this brilliantly argued book, Harvard Law School bankruptcy expert Elizabeth Warren and business consultant Amelia Tyagi show that today's middle-class parents are suffering from an unprecedented and totally unexpected economic meltdown. Astonishingly, sending mothers to work has made families more vulnerable than ever before. Today's two-income family earns 75% more money than its single-income counterpart of a generation ago, but actually has less discretionary income once their fixed monthly bills are paid."

Among the bigger causes, they argue, is that these families buy houses in nice areas so their kids can go to nice schools, and they go broke trying to stay in that house. One of the pieces of the solution they propose is wider school choice. I'm not sure if they go so far as to propose replacing the public school system with a voucher system Milton-Friedman style, but it certainly sounds like it lays out a good argument for something like that.

"Instead [of overconsumption as cause for financial trouble], they propose that the culprit is in large part the ever escalating cost of housing and education in America's suburbs. As many parents chase the better schools in an attempt to assure their children the best possible education, real estate prices in areas serviced by those schools rise and with it the cost of the homes."

I would think this also prices many people out of good areas with good schools, and leaves them in a situation that is obviously not desirable (given the risks people are taking to make an exodus from them).

Ari Armstrong Replies

I have never argued that we should "totally end Social Security right now." Instead, I have argued that Social Security should be slowly phased out by incrementally raising the pay-out age or otherwise cutting benefits. This plan could easily be implemented such that it does not impact benefits for those nearing retirement or already in retirement.

My criticism of Bush's proposed mandatory, regulated accounts is emphatically not that they might be implemented too slowly: it is that they might be implemented at all. They would not somehow be more compatible with free markets if they were implemented faster; quite the contrary.

The notion that Bush's plan would eventually destabilize the funding for Social Security and weaken its popularity is a novel one to me, but I don't think it makes for a very good argument. People ought not be tricked into supporting more fundament reform; they should be persuaded through rational argument. Unfortunately, this sort of attempted manipulation of public sentiment seems to be a core strategy of the neoconservative right. The same sort of attempted manipulation seems to have been used running up to the war in Iraq. And so we hear Bush praising Social Security on moral and practical grounds even as he says he wants to change it. Well, if Social Security is as morally virtuous as Bush claims, then it should be expanded, not reformed. So I think the neoconservative strategy is counterproductive. It also leads to this false debate with the left between the status quo and Wall-Street control.

I again reject the notion that mandatory accounts controlled by national politicians represent "baby steps that lead to" "real reform." Well, it's reform, all right, but not reform compatible with free markets. The "real reform" to which mandatory, regulated accounts are more likely to lead is the further socialization of the national economy.

I appreciate the correction concerning payroll as opposed to income. However, Social Security also taxes regular personal business income, which isn't handled through an official "payroll," so that term, too, can be confusing. Offhand, I don't know what percent non-taxed income is of total income, but I suspect it is rather small.

I think the analysis offered about the incentives of rich and poor is quite clever. I fully endorse the idea of requiring each worker to pay the full amount of the tax, as opposed to keeping the tax half-hidden by making employers pay it. Furthermore, I endorse the idea of ending withholdings completely. Workers should instead be required to write a check to the national government for their full tax burden. Of course, this will never happen, because it would mean the end of the welfare state, and today's politicians will prevent any such reform. Furthermore, I endorse the idea of making tax day the day before election day.

The idea of spreading out the Social Security tax to all income, and reducing the overall rate, is a mixed bag. One could argue that, because the plan increases the use of political force against some, it is bad. On the other hand, one could argue that the net use of political force stays the same, whereas the incentives are improved.

However, I oppose the idea for a practical reason. Many Democrats and a number of Republicans would jump at the chance to expand the Social Security tax to all income, but they would not also reduce the overall rate to make the change revenue-neutral. Instead, we'd probably see the rate stay at 12.4%, except applied to all income, the net result of which would be a massive tax hike. I believe this danger far outweighs any potential improvement in incentives the ideal reform would generate.

I appreciate the commentary about the flat tax. The "flat" tax is inherently progressive, in that it doesn't tax the first tier of wealth. That is, the flat tax contains at least two tax levels: zero percent on the first amount of wealth and a higher percent on all additional wealth. The virtue of the flat tax is its simplicity, which would inflict fewer compliance costs. I think a flat-tax reform is reasonable, provided it is revenue neutral or, preferably, revenue reducing.

A warning here about a consumption tax. Alan Greenspan, who has clearly gone over to the dark side, recommended the adoption of a consumption tax along with an income tax. Even consumption taxes advocated by alleged conservatives include the continued taxation of income via Social Security. So we would end up with the worst of both worlds. Once both taxes were in place, the incentive of politicians and interest groups would be to max out both taxes, for an eventual net increase in taxes, and probably a large one. There's nothing inherently more vile about a consumption tax than an income tax, but now that we're stuck with the income tax we should seek to reform that, not impose the other as well.

Likewise, I think at the state and local level we should seek to reduce the total number of taxes. We're taxed on income, sales, and property (and there are many smaller taxes). Not only does this multiplicity of taxes create a maze that obscures the real tax burden from the average tax payer, it skews economic incentives more than would a simple, single tax.

I've not heard of the book described, but offhand it's obvious that, if local, state, and national governments didn't take around half of every family's income, families would have a much easier time financially. Furthermore, the economy would grow much faster, resulting in real wages that increased more quickly. Also, it would be interesting to see a study that estimated how much the cost of the average home is increased because of a whole myriad of construction controls. Obviously today's statist system of education has resulted in de facto segregation in which small regional pockets dramatically outperform poorer areas.

Recently I have written a couple articles about the "ratchet effect" of wasteful state spending. I fear we are nearing the point when technological progress will no longer outpace the expansion of the state, at which point the economy will stagnate and decline. If that happens, I fear the problem could spiral out of control. People who adopt statism rarely blame statism for their economic problems; they usually demand more statism. And there will be plenty of politicians willing to make false promises.

For additional analysis, please see Social Security: Collected links.

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