The House GOP Tax Plan’s Disparate Treatment of Income Sources

09 Thursday Nov 2017

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Bernie Sanders, Bubble Tax, corporate income tax, Double Taxation, FICA Tax, House GOP Tax Plan, Investment Incentives, Obamacare Surtax, Pass-Through Income, Scott Sumner, Tax Burden, Tax Incentives

Update: In writing the following post, I neglected to devote sufficient attention to the rules that would govern taxation of pass-through income under the House GOP tax plan. Those rules significantly alter some of the conclusions below. Those rules are discussed in a later post: Stumbling Through Pass-Through Tax Reform.

Double taxation of corporate income is a feature of the U.S. income tax code that is partially addressed in the tax reform bill proposed by the House GOP. Corporate income is taxed to the firm and again to owners on their receipt of dividends or when a company’s growth results in capital gains. Ultimately, the total rate of taxation matters more than whether it is implemented as single or double taxation of income flows. However, there is an unfortunate tendency to view corporate taxes as if they are levied on entitites wholly separate from their owners, so double taxation carries a stench of politically sneakiness. It also creates multiple distortions in the decisions of investors and the separately managed firms they own.

Non-corporate income taxation is reduced by the House plan even more substantially than the cut in taxes on corporate-derived income. However, the plan does not reduce taxes on high-earning professionals, many of whom are situated similarly to successful business owners and investors from an economic perspective.

Tax Burdens and Distortions

The federal corporate tax is not borne 100% by shareholders, as discussed in the previous post on Sacred Cow Chips. Some part of the burden is borne by labor via reduced wages. It is difficult to correct for this distortion in terms of calculating an effective marginal tax rate on corporate income. For example, suppose a new 35% tax would reduce corporate income from $100 to $65. The firm finds, however, that it can reduce wage payments by half of the expected tax payment, or $17.50. The firm would now earn $117.50 before tax and $76.38 after tax. Relative to the new level of pre-tax income, the tax rate is still 35%. It is no less than that by way of the reduction in wages, though the impact on the firm’s pre-tax income is mitigated.

The discussion here of tax rates, and even double taxation, is not intended as commentary on tax fairness. It might or might not be fair that the burden of the tax is shared with labor. Instead, the issue is the magnitude of the economic distortions caused by taxes. Tax rates themselves are a reasonable starting point for such a discussion, and they are easy to measure. Lower tax rates beget fewer distortions in economic outcomes than high tax rates. Low rates provide greater incentives to save and invest in productive assets, which enhances labor productivity, wages, and economic growth. Indeed, businesses go to great lengths to avoid taxes altogether, if possible, but typically those are non-productive uses of resources, which demonstrates the very distortions at issue.

Current and Proposed Marginal Tax Rates

Under current law, the top personal income tax rate on dividends is 20%. It is 23.8% if we include the Obamacare surtax. Adding that to the corporate rate yields the effective top tax rate paid by shareholders: 23.8% + 35% = 58.8%. The GOP bill does not alter the 23.8% top rate on dividends or capitals gains. By virtue of the corporate tax reduction, however, the plan would reduce the overall top rate on shareholders to 23.8% + 20% = 43.8%.

The income earned by investors in pass-through entities like proprietorships, partnerships and S-corporations is taxed as personal income under current law at rates ranging from 15% to 39.6% (43.4% at the top, including the surtax). Thus, under present law, the owner of a pass-through company is taxed less heavily at the top rate than the owner of a public company (43.4% vs. 58.8%). (I am ignoring the 15.3% FICA payroll tax owed by self-emloyed individuals in proprietorships or partnerships on incomes up to $127,200, and 2.9% above that level. The combined tax rates would be almost equal even if we include the FICA tax.)

The tax on pass-through business income would be reduced under the GOP bill via a cap of 25% on federal business income taxes. Presumably, this cap would nullify the House plan’s “bubble tax” of 6% on personal income between $1.2 million and $1.6 million of income, as well as the Obamacare surtax. Thus, the tax advantage for pass-through entities over corporations would be somewhat wider under the House plan than under current law (25% vs. 43.4%). (The FICA tax on owners of proprietorships and partnerships would not quite equalize the overall marginal tax rates over a certain income range.)

In addition, the House plan rewards the owners of pass-through businesses relative to individuals earning high levels of wage and salary income. If anything, the bill would penalize these individuals. For example, while the owner of a high-earning pass-through would face a 25% tax rate, a high-earning professional or corporate employee would pay the top marginal rate (39.6%) plus the surtax (3.8%) and possibly the bubble tax (6%). This is one reason why Scott Sumner says it looks as if the House plan was designed by Bernie Sanders!

The Upshot

The tax system should be neutral across different sources of income. Divergent effective tax rates on owners of corporations, pass-throughs, and high wage-earning individuals is undesirable and introduces arbitrary elements into private decision-making. If anything, the House GOP tax plan exacerbates those differences. By cutting marginal tax rates, it would reduce the magnitude of business tax distortions both for corporate and pass-through organizations and their owners, but the relative advantage of pass-throughs would increase relative to corporations, and owners of corporations and pass-throughs benefit relative to high-earning individuals. Let’s hope this is fixed as the bill evolves, but more balanced reductions in rates would require higher rates on business owners than contemplated in the current plan.

Saving Social Security

14 Friday Oct 2016

Posted by pnuetz in Privatization, Social Security

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Disablity, FICA Tax, Redistribution, Self-Directed Investments, Social Insurance, Social Security, Social Security Privatization, Social Security Returns, Social Security Trust Fund, Survivors' Benefits

Social Security benefit levels are anything but sure for current workers, given the likelihood of benefit cuts to preserve the long-term solvency of the system. In fact, even without those cuts, Social Security provides very poor yields for retirees on their lifetime contributions. Instead of a tradeoff between risk and return, the system offers bad outcomes along both dimensions: lousy benefit levels that are not at all “safe”.

To get a clear sense of just how bad the returns on Social Security contributions (i.e., FICA tax deductions) truly are, take a look at this Sacred Cow Chips post from late 2015: “Stock Crash At Retirement? Still Better Than Social Security“. According to the Social Security Administration’s own calculations, without any future changes in the program, a retiree can expect to get back 1 to 4 times their lifetime contributions (obviously, this is not discounted). If you think that’s acceptable, consider a real alternative:

“Suppose you are given an option to invest your FICA taxes (and your employer’s [FICA] contributions) over your working life in a stock market index fund. After 40 years or so, based on historical returns, you’ll have stashed away about 12 – 18 times your total contributions (that range is conservative — 40 years through 2014 would have yielded 19x contributions). A horrible preretirement crash might leave you with half that much.“

Allowing workers to self-direct their contributions over a lengthy working life, whether they invest in equities, government bonds, or other assets, holds much more promise as a way to provide for their retirement needs.

As for risk, projected benefit levels are worse when possible program changes are considered. It’s widely accepted that changes must be made to the way contributions by current workers are handled and how future benefits are determined, or else the system’s value to them will be a greatly diminished. The Social Security Trust Fund, which once funded government deficits via FICA surpluses over benefit disbursements (while the demographics of the labor force allowed), has dwindled, and it has never been invested to earn the returns necessary for long-term solvency. Shall today’s workers face later eligibility? Reduced benefit levels? Or both? Or can we face up to the reality that workers will do better by choosing the way their funds are invested?

The contributions of today’s workers are paid out directly to current retirees. This practice must be modified, but the nation still faces a large and immediate liability to current retirees. How will it be paid if the system is overhauled to allow self-directed investment alternatives? Current workers must pay for some portion of that liability, but that portion could be phased out over several decades. The transition, however, would initially require additional taxes, borrowing, or voluntary conversion by some retirees to a discounted cash-balance equivalent, much as most private sector defined-benefit pensions have been converted to cash-balance equivalents.

Ultimately, workers should benefit from their own individual contributions. One objection is that self-directied investments and “privatization” of one’s own contributions would cause the system to lose its function as social insurance. Recall, however, that eligibility for benefits requires contributions, so it is not a general program of assistance. Nevertheless, there are several ways in which Social Security fulfills an insurance function. In a strong sense, it provides insurance against the risk of failure to save for retirement. More fundamentally, disabled workers can qualify for benefits, and the dependents of a deceased contributor are also eligible (survivors’ benefits). In addition, the current system provides greater returns to individuals with relatively low contributions. Under self-direction, these features could be retained via minor redistributional elements applied to investment returns, particularly given the superior returns available to equities over periods of sufficient length.

When U.S. politicians discuss the future of Social Security, they usually say they’ll fight against the dark intent of those who wish to take away hard-earned benefits from seniors. This despite the fact that few (if any) observers have suggested cutting benefits for current retirees, or even for those now approaching eligibility. The self-righteous proclamations about protecting retirees are a dodge that avoids the need to take a position on dealing with the system’s insolvency. But an easy answer is available: reform the system by allowing workers to self-direct their contributions into more promising investment vehicles.

Social Security: Saving or Tax? Proceeds or Aid?

17 Monday Aug 2015

Posted by pnuetz in Big Government

≈ 2 Comments

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CATO Institute, Federal entitlements, FICA Tax, George W. Bush, Lump Sum vs. Annuity, Michael Tanner, Michigan Retirement Research Center, National Bureau of Economic Research, NBER, payroll taxes, Privatization, retirement, Social Safety Net, Social Security Privatization, Social Security Trust Fund, Treasury Special Purpose Bonds, Welfare Payments

In general parlance, an entitlement is a thing to which one is entitled. If you have paid into Social Security (FICA payroll “contributions”), you should feel entitled to receive benefits one day. Why do I so often hear indignant complaints about the use of the term “entitlement” when applied to Social Security and Medicare? I’ve heard it from both ends of the political spectrum, but more often from the Left. It is usually accompanied by a statement about having “paid for those benefits!”. Exactly, you should feel entitled to them. You are not asking society to pay you alms!

Yet there seems to be resentment of an imagined implication that such “entitlements” are equivalent to “welfare” of some kind. That might be because the definition of an entitlement is somewhat different in the federal budget: it is a payment or benefit for which Congress sets eligibility rules with mandatory funding, as contrasted with discretionary budget items with explicit approval of funding. Because payments are based solely on eligibility, Social Security, Medicare and many forms of welfare benefits are all classified as entitlements in the federal budget. Obviously, those complaining about the use of the term in connection with Social Security believe there is a difference between their entitlement and welfare. But as long as they are willing to leave their “contributions” and future eligibility in the hands of politicians, their claim on future benefits is tenuous. Yes, you will pay FICA TAXES, and then you might be paid benefits (alms?) if you are eligible at that time. Certainly, the government has behaved as if the funds are fair game for use in the general budget.

Having made that minor rant, I can get to another point of this post: the Social Security retirement system offers terrible returns for its “beneficiaries”. Furthermore, it is insolvent, meaning that its long-term promises are, and will remain, unfunded under the current program design. However, there is a fairly easy fix for both problems from an economic perspective, if not from a political perspective.

The chart at the top of this post shows that Social Security benefits paid to eligible retirees are less than the payroll taxes those same individuals paid into the system. The chart is a couple of years old, but the facts haven’t changed. It’s boggling to realize that you’ll receive a negative return on the funds after a lifetime of “contributions”. That kind of investment performance should be condemned as unacceptable. However, you should know that the program is not “invested” in your retirement at all! Social Security’s so-called “trust fund” is almost a complete fiction. Most FICA tax revenue is not held “in trust”. Instead, it is paid out as an intergenerational transfer to current retirees. In the past, any surplus FICA tax revenue was invested in U.S. Treasury special purpose bonds, which funded part of the federal deficit. Here is a fairly good description of the process. The article quotes the Clinton Office of Management and Budget in the year 2000:

“These balances are available to finance future benefit payments … only in a bookkeeping sense. They do not consist of real economic assets that can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury that, when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits, or other expenditures.“

Unfortunately, for the past few years, instead of annual surpluses for the trust fund, deficits have been the rule and they are growing. Retiring baby boomers, longer life expectancies, slow income growth and declining labor force participation are taking a toll and will continue to do so. Something will have to change, but reform of any kind has been elusive. An important qualification is that almost any reform would have to be phased in as a matter of political necessity and fairness to current retirees. Unfortunately, just about every reform proposal I’ve heard has been greeted by distorted claims that it would harm either current retirees or those nearing retirement. In fact, leaving the program unaltered is likely to be a greater threat to everyone down the road.

There are three general categories of reform: higher payroll taxes, lower benefits, and at least partial privatization. Tax increases have obvious economic drawbacks, while straight benefit reductions would be harmful to future recipients even if that entailed means testing: the return on contributions is already negative, especially at the upper end of the income spectrum. Michael Tanner discusses specific options within each of these categories, including raising the normal and early retirement ages. None of the options close the funding gap, but at least higher retirement ages reflect the reality of longer life expectancies.

Early in his presidency, the George W. Bush administration offered a reform plan involving no tax increases or benefit cuts. Instead, the plan would have offered voluntary personal accounts for younger individuals. Needless to say, it was not adopted, but it would have kept the system in better shape than it is today. The key to success of any privatization is that unlike the Social Security Trust Fund, workers with private accounts can earn market returns on their contributions, which are in turn reinvested, allowing the accounts to grow faster over time. Tanner notes that 20 other countries have moved to private accounts including Chile, Australia, Mexico, Sweden, Poland, Latvia, Peru, and Uruguay. This sort of change does not preclude a separate social safety net for those who have been unable to accumulate a minimum threshold of assets, as Chile has done. Tanner’s article lays out details of a tiered plan that would allow participants a wider range of investments as their accumulated assets grow.

Economic research suggests that participants do not place a high value on their future benefits. From a 2007 National Bureau of Economic Research (NBER) paper by John Geanakoplos and Stephen Zeldes entitled “The Market Value of Social Security“:

“We find that the difference between market valuation and ‘actuarial’ valuation is large, especially when valuing the benefits of younger cohorts. … The market value of accrued benefits is only 2/3 of that implied by the actuarial approach.“

An implication is that younger workers who have already made contributions could be offered the choice of a future lump sum that is less than the actuarial present value of their benefits when they become eligible. Such a program could cut the long-term funding gap significantly, if the results found by Geanakoplos and Zeldes can be taken at face value, though it could create additional short-term funding pressure at the time of payment.

Qualified support for such a program seems apparent from another 2007 NBER paper by Jeffrey R. Brown, Marcus D. Casey and Olivia S. Mitchell entitled “Who Values the Social Security Annuity? New Evidence on the Annuity Puzzle“. They find that:

“Our first finding is that nearly three out of five respondents favor the lump-sum payment if it were approximately actuarially fair, a finding that casts doubt on several leading explanations for why more people do not annuitize. Second, there is some modest price sensitivity and evidence consistent with adverse selection; in particular, people in better health and having more optimistic longevity expectations are more likely to choose the annuity. Third, after controlling on education, more financially literate individuals prefer the annuity. Fourth, people anticipating future Social Security benefit reductions are more likely to choose the lump-sum, suggesting that political risk matters.“

Moreover, lump sums may offer an additional advantage from a funding perspective: a 2012 paper from the Michigan Retirement Research Center at the University of Michigan by Jingjing Chai, Raimond Maurer, Olivia S. Mitchell and Ralph Rogalla called “Exchanging Delayed Social Security Benefits for Lump Sums: Could This Incentivize Longer Work Careers?” found that “... workers given the chance to receive their delayed retirement credit as a lump sum payment would boost their average retirement age by l.5-2 years.”

Certainly, it would be difficult for private accounts to fare as badly in terms of returns on contributions than the system has managed to date. The future appears even less promising without reform. There are several advantages to privatization of Social Security accounts beyond the likelihood of higher returns mentioned above: it would avoid some of the labor market distortions that payroll taxes entail, and it would increase the pool of national savings. Perhaps most importantly, over time, it would release the assets (and future benefits) accumulated by workers from the clutches of the state and self-interested politicians. They are not entitled to pursue their political ends with those assets; they are yours!