Think Social Security is Unaffordable Now? Just You Wait

Millennials who have an interest in the debt and the burden the government can place on the economy should pay attention to a trend among older Americans.  Today, an estimated 10,000 people leave the workforce for a pension from Social Security — every day.

People tend to see this trend as a problem for Social Security, and it is. The trend presents, however, a larger problem for the people who are expected to pay for the general debt of the government. The problem is that retirees in general are leaving income-tax-producing jobs for a pension that is exempt from taxation.

Many people mistakenly believe that Social Security benefits are subject to income taxes.  While the income is reported to the IRS and revenue is collected, the monies paid to the IRS on Social Security benefits are returned to Social Security. Not one penny of the revenue collected on Social Security benefits goes to the general fund to help control the deficit. The penalty collected by the IRS is really a means-tested clawback of benefits.

Not only are people leaving the work force, but as Andrew Biggs reports, the trend is for Americans to retire early over time. In the 1950s, the typical American claimed Social Security benefits at age 68 and lived to around age 76. Today, the typical American retires at age 63 and can expect to survive until age 83. Today only about 30% of first-time checks go to retirees who have reached full retirement age.

It is difficult not to to reach the conclusion that Social Security induces people to retire earlier than they normally would. In fact, Social Security penalizes those who work part-time during early retirement. It is impossible the reach the conclusion that Social Security will not foster lower income tax revenues in the long run.

Let's look at a simple example of consequences. If I were to retire next year, my wife would continue to work, making around $15,000. My accountant tells me that we can manage our income to avoid Social Security's penalties on outside income. Our income tax will drop from $6,700 to zero. Our payroll taxes will drop from roughly $10,500 to $2,250.  Our total tax bill will drop from more than $17,000 to about $2,000.

The situation is worse because of the way that the penalty on Social Security benefits is imposed. My wife's wages might make getting below the penalty threshold more difficult. If we miss the threshold, even by a penny, 50% of my Social Security benefit will be subject to penalty at our marginal rate. As it works out, my wife may quit her job late in the year because the tax and penalty liability would exceed her paycheck.

This picture becomes more troubling once my wife actually retires because we will not fully replace her wages with outside income. We will compensate for lower disposable income by spending less. That lower spending will feed into the economy as a whole. I am not a problem by myself, but 10,000 people retiring every day does present a problem in terms of tax revenue and domestic spending.

There is no doubt that we will spend less. Even with less spending, we will transition from a net buyer of investments to a net seller in order to provide the lower standard of living. As the focus of Americans shifts from equity investments to fixed income, it will affect the capital gains created for all Americans. There are no winners in my spending less money.

Americans need to pay attention to a tax system that is grounded on income when many people are transitioning from an income-based lifestyle to one based on wealth. In my case, we'll get less income and lower spending. More broadly, my decisions are apt to hurt capital-gains taxes paid by others. If it were just me, the change wouldn't be a problem, but there are 10,000 people who are joining me every day. 

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Brenton Smith

Professionally, I manage credit risk in bank deriviatives. Politically I write commentary for www.FixSSNow.Org on the issue of Social Security reform.

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