Means testing and implicit taxes

Often I see proposals for means testing entitlement programs. For instance, Richard Posner writes:

Perhaps some politician will be bold enough to advocate that all entitlements programs, including social security as well as Medicare, be means-tested, as Medicaid is. There is no reason why people who can afford to provide for their retirement should be subsidized by the government, which is to say by the taxpayer. But such a reform does not appear to be politically feasible.

This is a very common sentiment: in an era of impending fiscal crisis, why should the government be paying Social Security benefits to Bill Gates? Economically, however, its logic is questionable.

Means testing is an implicit tax, with all the distortionary effects of ordinary taxes. If $1000 in additional income causes you to lose $100 in government benefits, your effective marginal tax rate is 10% higher than it otherwise would be. It’s strange to see people who would cringe at higher-bracket tax increases suddenly turn around and extol the virtues of means testing Social Security—and it’s hard to attribute this to anything other than a superficial understanding of what “taxes” really are.

But in fairness, the fact that means testing is an implicit tax doesn’t mean that it’s necessarily a bad idea. Two circumstances come to mind.

First, maybe the program in question is highly inefficient. Tyler Cowen, for instance, argues that since Medicare is an in-kind benefit while Social Security is a cash transfer, we should always cut Medicare first. If you believe that Medicare is extremely wasteful, you can make the argument that the benefits from a cutback outweigh the drawbacks of what Greg Mankiw once called “an income tax surchage levied only on old, sick people”. Of course, it’s hard to see how this argument could possibly apply to Social Security, which is as close to a pure transfer program as you can come.

Second, maybe the implicit tax is a relatively efficient one. Under many proposals for Social Security means testing, this is clearly not the case: cutting back benefits on the basis of current ability to pay is a terribly inefficient proposal, wrapping an income tax and a severe capital tax into one. As Scott Sumner once pointed out, this proposal would place the burden of fiscal adjustment entirely on responsible savers like himself, offering continued benefit checks to the former NFL star who blew his savings by his 40th birthday but not to the far lower-income nurse who steadily contributed to her 401(k).

Still, it’s conceivable that we could design a means testing scheme that worked more effectively. For instance, we could means test on the basis of lifetime income. This would mean an effective hike in income taxes—which makes you wonder why we shouldn’t just enact a direct increase instead—but at least there’s a glimmer of an argument as to why it would be efficient. After all, a progressive tax on lifetime income is more distributionally accurate than a progressive tax schedule on year-to-year income: your earnings across several decades are a better indicator of your ability to pay than your earnings in any single year, and there’s no reason to let a millionaire pay at a low rate because he happened to have a bad year.

Moreover, given the current system for calculating benefits, at the margin means testing would be easy to implement. Right now, the Primary Insurance Amount formula for Social Security offers benefits at a rate of 15% for average indexed monthly earnings over $4,517 (and a higher rate for earnings below that). We could easily lower this percentage to 0%, or even a negative rate at sufficiently high levels. Making the PIA formula more progressive is, in fact, one of the recommendations of the much-maligned deficit commission:

The Commission recommends gradually transitioning to a four-bracket formula by breaking the middle bracket in two at the median income level ($38,000 in 2010, $63,000 in 2050), and then gradually changing the replacement rates from 90 percent, 32 percent, and 15 percent to 90 percent, 30 percent, 10 percent, and 5 percent.

But regardless of the specific proposal, there’s one fact we can’t escape: means testing is a marginal tax increase. As such, it ought to be given the same consideration as any other tax increase, and we shouldn’t let a highly distortionary change in incentives slip by just because we’re not officially calling it a “tax”.

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10 Comments

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10 responses to “Means testing and implicit taxes

  1. A major problem with means testing is that either (1) the level is set so that it only effects the rich, which doesn’t save any meaningful amount of money, or (2) the level is set much closer to the median income, in which case it hurts too many people. It’s one thing to say that we shouldn’t pay SS to Bill Gates, it’s another to say we shouldn’t pay those in the middle class.

  2. As far as SS goes, you do not need to means test, as a fist step just equalize the pay out. Currently those who earned more get more. I understand that they also paid in more but the program is not a retirement plan it is social insurance a welfaer program. As currently structured it is a stupid retirement program and very stupid welfare program.

    On medicare and medicaid and all medical care I think that the focus for Government should be on how to cover the poorer less capable people while not covering everyone else and while avoiding a high marginal tax rate. For capable rich and middle class people we should be discouraging prepaid healthcare as much as possible, trying to get them to pay more out of pocket. They are smart enough to do it right, not skipping treatments that will reduce future expenses. Further government cannot be smarter than the median voter which means it cannot be smarter than this group. On the other hand many poor people are poor due to not being good at running their own affairs.

    I like the idea of Gov. providing insurance with very high deductibles (tens to hundreds of thousands dollar deductibles) for the rich and middle class and low deductibles for the poor.

  3. Scott Sumner

    Thanks for the link. BTW, I now regret one aspect of my post. I singled out the Democrats, but I have come to realize that the GOP is in many ways just as likely to favor policies that reduce national saving.

  4. Fmb

    The flip side is that forced savings is not a tax.

  5. Jim Glass

    With CBO saying that on current law income tax collections must increase 50% (by pct of GDP) from 2008-2030 just to keep even with spending increases on SS/Medicare/Medicaid, we can be *sure* that both significant tax hikes and benefit cuts are coming — and they *all* will have serious efficiency and fairness arguments against them. So it will be “pick our poision”.

    Any chance to fix SS both efficiently and fairly has already passed. But some thoughts….

    [] It’s strange to see people who would cringe at higher-bracket tax increases suddenly turn around and extol the virtues of means testing Social Security

    And perhaps even stranger to see people who deride “tax cuts for the rich” defending transfers *to* the rich from the poorer — even to the point of generally greatly increasing taxes on the poorer (see that 50%) to preserve those transfers to the rich.

    Having Warren Buffet’s employees at Dairy Queen pay higher taxes to protect his benefits certainly seems contrary to the progressive notions behind social insurance.

    As to the distortionary effect of tax cost, let’s not forget the deadweight cost of taxes, rising by the square of the increase in the tax rate. Feldstein puts the marginal cost for income tax at 76 cents on the dollar. To the extent benefits aren’t cut by means-testing or otherwise … a 50% increase … you do the math.

    [] cutting back benefits on the basis of current ability to pay is a terribly inefficient proposal, wrapping an income tax and a severe capital tax into one.

    Yet it is the option most consistent with the program’s social insurance purpose — while blindly cutting back benefits for the needy at an equal rate as the well off is contrary to it.

    Economic efficiency often is not the primary purpose of government programs. :-)

    [] Still, it’s conceivable that we could design a means testing scheme that worked more effectively

    I should hope we already have!

    As the father of one child in college and two more on the way there soon (so far) I am means tested in full — income, savings, investments, value of home, the works — repeatedly to determine how much tuition my family must pay.

    Note well: With college costs and expenses *well* over 6-figures per student, many familes have much more at stake in this mean test than they ever would in a SS means test.

    Now nothing personal, but I’ve got to say that when I see academic analysts point out all the ills that would result from means testing entitlements for the mere purpose of saving the national fisc, while being perfectly sanguine (at a minimum) about their own employers imposing gross means testing on the masses to collect the revenues that pay their own salaries, I am less than happily impressed.

    Maybe we should just use the FASFA form to means test Social Security?

    • As to the distortionary effect of tax cost, let’s not forget the deadweight cost of taxes, rising by the square of the increase in the tax rate. Feldstein puts the marginal cost for income tax at 76 cents on the dollar. To the extent benefits aren’t cut by means-testing or otherwise … a 50% increase … you do the math.

      But I’m saying that means-testing is a form of income tax! (Either it’s nearly a pure income tax, as in the better proposal that I highlighted, or a economically destructive mix of income taxes and capital taxes, as in many proposals.) As such, at the margin it will incur deadweight loss in exactly the same way as income taxes. It doesn’t rescue us from the issues you’re highlighting at all.

      It’s certainly possible that people are irrational and do not respond to means-testing in the same way that they respond to explicit income taxes. But I don’t see why they would necessarily be less responsive, at least in the long run: I can definitely imagine people saying “why work? it’s just going to be taken out of your social security when you retire”. This wouldn’t be a perfectly rational, homo economicus response to means-testing, but it would nevertheless be a very dramatic one.

  6. Jim Glass

    But I’m saying that means-testing is a form of income tax!

    It can be viewed as some sort of tax, sure, but…

    1) The behavioral response to a tax on wealth/investment income from age 65+ will be different than one on earnings from work during ages 18 to 65. It would consist much more of wealth and income shifting, as seen currently with the estate and gift tax.

    2) One must ask which is more consistent with the progressive purpose of Social Security: a tax on the richer so they don’t go sailing off on their yachts on the taxpayer’s dime during a period of severe fiscal crunch, or a tax increase on the poorer to enable the richer to keep sailing off on their yachts.

    3) Both taxes are coming anyhow. There is no way on God’s Earth that a 50% income tax hike (or any equivalent) is coming without benefits being cut correspondingly (by delaying retirement age, means testing, whatever) as part of the deal. We have as precedent for this the 1983 bailout of Social Security which was near exactly 50% tax increase and 50% benefit cuts.

    As I said, we’ve reached “pick your poison” time. That means you can’t just be against means-testing, you have to be for a superior alternative to close the same fiscal gap. Which is … a higher tax on workers to keep the subsidies to the rich whole? … a general cut of benefits, such as by delaying retirement age, that will regressively constitute a greater loss of overall income to the poorer than to the richer?

    Back for a moment to Posner’s point:

    “There is no reason why people who can afford to provide for their retirement should be subsidized by the government, which is to say by the taxpayer.”

    Is it really optimal to always consider the reduction of a promised subsidy to be a tax?

  7. AJ Michaels

    Means testing for SS and Medicare will be the final attack on the American Middle Class. Think about it folks. Traditional retirement plans (fixed benefit) are gone. Whats left are 401Ks, IRAs, and Social Security (SS). If you save for your 401k and IRA you will lose your SS with the means testing. Do the math,

    your taxed 6.2% on a salary up to around $106K for a guarrenteed benefit of Social Security. If you do the 401K you risk another 5% or more of income for a potential better gain. In most cases this gain is nominal and you will be penalized by your saving through means testing and loss of SS. If you’re in the middle class and the government starts means testing, stop 401K and IRA. Spend what you saved during your late 50′s and early 60′s before you take SS. Also, hide all liquid assets. Mine will get lost in Vegas. wink. wink.

    This income manipulation is done for more than SS but also protect your Medicare. One serious illness and your middle class estate is wiped out.

    Don’t kid yourself, the target for means testing isn’t the very wealthy like Bill Gates. That is a strawman argument. The target is the upper middle class making $100k to $250K.

    The answer for SS is to raise the salary cap for contributions to SS to $250K and put a top level limit on SS payout at 70 yr old of $55K adjusted for inflation.

  8. Pingback: Avoiding the word “tax” | Matt Rognlie

  9. SirGareth

    First, social security is already means tested in several ways.

    1) Those that pay the most in for the longest number of years received the least share of their contributions back in benefits. Their contributions are redistributed to provide “social welfare” to those who don’t work as hard, as long, or as productively as those who do.

    2) Only wage income below $106,000 is used to support this wealth re-distribution scheme. Millionaires and investment income is not subject of any of the current wealth redistribution schemes of social security.

    3) Social security contributions are fully taxed as income taxes before they are collected to fund benefits, even the large wealth redistribution portions of this funding are taxed as income tax as it their income was to pay for their own benefits. In the case of workers paying the maximum social security contribution, they pay federal income taxes on the large welfare component or this income redistribution as well, effectively they pay double taxation at the federal level and often the state level as well on the funds going into the trust fund.

    4) Social security income is almost fully taxed again at the federal and often the state levels as benefits are paid out. effectively a triple taxation funds used to pay one own benefits at both federal and state levels

    We must decide what social security is, if its a retirement insurance scheme funded by ourselves for ourselves then lets straighten out the actuarial tables and run it as such. The trust fund is really a trust fund and not a government perpetrated fraud.

    If this was only a welfare scheme all along then all income for all sources are obligated to fund it and to refund the “trust fund” portion of our contributions (at interest) that have been fraudulently collected from middle class wage earners over the last 28 years. I can think of no better scheme for doing this than applying a surtax to that income that has traditionally escaped paying for this welfare scheme.

    This is what you always get with government: incompetence: fraud, trickery, waste, theft, and abuse. This is why we need to keep the frauds called “liberals” away from government. This fraud is “their” fraud.

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