Why and From Where Came the “Donut Hole” in Obama’s Social Security Tax Proposal?
June 15th, 2008 . by economistmom
OK, I’m starting to pay more attention to what the candidates are saying regarding tax and budget policy, now that there are only two candidates to follow. Obama’s announcement on Friday regarding his proposal to raise Social Security’s maximum taxable income level was news (here’s an AP story) because for the first time he explicitly spelled out to what level the taxable max would be raised. And while I give his campaign lots of credit for coming out with the details, I’m disappointed that those details were not as sensible as I had hoped–no plain “eliminate the maximum” (now at $102,000), and no simple “raise the maximum to $___”.
Instead, Obama is proposing that the current Social Security payroll tax of 6.2% apply to wage incomes up to the current maximum of $102,000, not at all to the wage dollars earned between $102,000 and $250,000, but again for wage dollars above $250,000. This is what the “donut hole” term refers to.
(Now brace yourselves for some math… or skip the next paragraph and trust me, if you’d rather…)
In other words, someone with wage income of $150,000 would see no change in payroll taxes from current law (the tax would still be 6.2% of $102,000 (the taxable maximum) or $6,324, for an average or effective tax rate on a $150,000 earner of $6,324/$150,000 = 4.2%. But someone with wage income of $500,000 would see an increase in payroll taxes from what under current law is the same maximum tax paid by anyone with income over $102,000, of $6,324, to what under the Obama proposal would be $6,324 + ($500,000-$250,000)*.062 = $6,324 + $15,500 = $21,824. That’s an increase in the effective tax rate for the half-millionnaire, from $6,324/$500,000 = 1.3% to $21,824/$500,000 = 4.4%.
So what the rather capricious “donut hole” structure buys the Obama campaign is some consistency in their general theme that taxes on the rich (implicitly defined as those with incomes above $250,000) are too low and that the federal tax system overall is not progressive enough. The “donut hole” structure turns a tax that is proportional up to the taxable max and regressive (with effective tax rates declining as income rises) above the taxable max, into a tax that becomes progressive (with effective tax rates rising with income) at very high incomes (beyond $250,000). Yet the “hole” part of the “donut hole” means the payroll tax would still be regressive when one compares the burden of anyone below the current taxable maximum (who can legitimately be considered “middle-income”) with anyone above it–because anyone above $102,000 has at least some income that would be completely exempt from the tax. (Only people with wage income below $102,000 would pay an effective tax rate as high as the statutory marginal rate of 6.2%.)
This strikes me (and Len Burman of the Tax Policy Center) as a very messy and inefficient way to try to introduce more progressivity into the federal tax system. It doesn’t work well because it goes at it through the wrong tax instrument, through a payroll tax that is intended to be mostly proportional in incidence, instead of going at it through the parts of the federal tax system that are actually intended to be progressive–such as, for example, the individual income tax, and in particular (if we care mostly about adding progressivity at the very top) the alternative minimum tax.
Note that you won’t find this “donut hole” way of raising Social Security taxes in revenue option #39 of CBO’s “Budget Options.” (You will find various income-tax ways of making the overall tax system more progressive–or less progressive–though.)
Here’s the radical idea I have: look at the purposes and inherent structures of the taxes we have, and work to improve these taxes so they achieve those purposes more efficiently. Keep Social Security payroll taxes mostly or even entirely proportional, by raising or even eliminating the taxable maximum. If you’re worried about those people who earn between $100,000 and $250,000 that the candidates sometimes refer to as “middle income” (so I’m one of them), then that probably stems from the fact that you know that the alternative minimum tax is sort of unfair on folks in this income range, compared with the really rich people with incomes above $500,000. But if that’s why you feel sorry for these people (i.e., feel sorry for me), then fix the part of the tax system that is responsible for the inequity. Don’t go arbitrarily mucking up one part of the tax system (the payroll tax) to treat the symptoms of disease coming from another part of the tax system (the AMT and its interaction with the rest of the individual income tax).
So today I did a little Tim Russert-style investigating as to how the Obama campaign would have come up with this idea for a payroll tax “donut hole.” I had not heard the “donut hole” concept floated about before, but it turns out that was because I wasn’t really focusing on the candidates’ tax and budget proposals before.
It turns out that back last September, Senator Obama published an op-ed in the Quad-City Times that said, regarding Social Security reform (emphasis added):
I do not want to cut benefits or raise the retirement age. I believe there are a number of ways we can make Social Security solvent that do not involve placing these added burdens on our seniors. One possible option, for example, is to raise the cap on the amount of income subject to the Social Security tax. If we kept the payroll tax rate exactly the same but applied it to all earnings and not just the first $97,500 [the taxable max in 2007], we could virtually eliminate the entire Social Security shortfall.
In other words, in September 2007, Senator Obama seemed to be floating the idea of eliminating the taxable maximum altogether. (But note: Obama was already saying last fall that he did not want to cut Social Security benefits by, for example, raising the retirement age. That’s pretty explicit in the above.)
Meanwhile, also in September, Senator Edwards had a different idea for how to raise Social Security taxes, as reported in this ABC News story (which incidentally also quotes the above Obama op-ed as well as Concord’s Bob Bixby):
Former Sen. John Edwards, D-N.C., has also talked about raising the Social Security tax cap. But he would do so in a more limited way than suggested by Obama.
While Obama has suggested imposing the 12.4 percent tax on all income above $97,000 per year, Edwards would only impose it on those making more than $200,000 per year. Income between $97,000 and $200,000 would continue to be exempt from Social Security taxes under the Edwards proposal.
“I do think we need to have a bubble above $97,000, probably up to about $200,000 so we don’t raise taxes on middle-class families,” Edwards said at Thursday’s AARP forum. “But, above the $200,000, these millionaires on Wall Street ought to be paying their Social Security taxes.”
…Interesting…
And by November 11, in an interview with none-other-than Tim Russert on NBC’s Meet the Press, Obama was floating the idea of the “donut hole”–as reported in this MSNBC article which includes a link to the video:
[D]uring an interview on NBC’s “Meet the Press,” Obama said subjecting more of a person’s income to the payroll tax is the option he would push for if elected president.
He objected to benefit cuts or a higher retirement age.
“I think the best way to approach this is to adjust the cap on the payroll tax so that people like myself are paying a little bit more and people who are in need are protected,” the Illinois senator said.
“That is the option that I will be pushing forward.”
…Obama’s proposal could include a gap or “doughnut hole” to shield middle-income earners from paying more in taxes, he said.
(Also note: he was still objecting to benefit cuts/higher retirement age–and Tim Russert was giving him a hard time for having taken real solutions “off the table” when they had been on the Obama table earlier in 2007.)
I wish Senator Obama had stuck with what seemed to be his first instincts on the Social Security tax–to raise the cap in a simple, sensible way. I think as time went on he started thinking too much and trying to do too many things with it–trying to please too many people. And that’s the discouraging part–that such mucking up of well-intended policies can happen even during the campaign, well before the elected President has to do such mucking up (”compromising” is what it’s called) in order to find agreement with a diverse, bipartisan Congress. It shouldn’t yet be time to bring out the donuts.
I suspect the explanation is very simple: Obama believes that he MUST be able to say — flatly and without qualification — that he will raise taxes ONLY for people with incomes above $250,000 and for NOBODY else, ever, absolutely, in any way. Any deviation from that simple message, no matter what the reason, will play into McCain’s hands — leading voters to mutter, “Well, I’d like to vote for him, but those Democrats just want to raise taxes.”
Why does everyone ignore the idea that if you make more than $1M a year, you’re probably getting it in non-wage compensation (options, stocks, capital gains, dividends and interest) that are exempt from Social Security taxes anyway? According to the IRS (through the Tax Policy Center) the top 400 taxpayers got more than 50% of their income this way.
You can drive the taxable ceiling all the way to infinity and you’re not going to touch non-wage income without applying the tax to unearned income.
Discussed further at http://infosnackhq.blogspot.com/2008/04/interesting-tax-data.html
I often wonder what all the brouhaha is really about. The Regan Administration turned the Social Security System into a true insurance fund by doubling the FICA payments to the system that created a 5-Trillion (and growing) Trust Fund that, depending on the actuarial charts you use, should more than cover the Baby-Boomers.
So, what is the “Problem?” That the T-Bills that the SSI Trust fund is invested in will have to be redeemed over time. Since Congress and the subsequent administrations have used this Trust Fund to “Balance the Federal Budget” (a.k.a., justify massive tax reductions for the top 1% of income earners) the problem is that the We, the US Government are going to have to honor the contract.
What Obama, McCain, et al are trying to do is prevent the redemption of the T-Bills that have been, and are being, used to cover the profligate spending by Congress. And, the upper-income citizens have a deep seated problem with any form of taking money out of any “Trust Fund.”
This “Donut Hole” idea is just another form of pandering that does not address the actual problem — our government has over-spent while handing out tax breaks to the most wealthy on the flimsy beleif that somehow it will all come back to the federal treasury in the form of “trickle down” magic. Yeah-Right!
I agree that the “donut hole” is likely designed so that Obama can truthfully state that he is not raising taxes on anybody making less than $250,000. It reminds me of the “no new taxes” pledge signed by many Republicans. I believe that McCain has not signed this pledge but has verbally stated that he will not increase taxes under any circumstance.
In any case, I also agree that the “donut hole” is very bad policy. Currently, Social Security is chiefly proportional in that benefits are based on taxable earnings. There is some progressivity in that higher income brackets get a lower return (see step 5 here) and there are spousal and survivor benefits. However, the “donut hole” would unnecessarily complicate an already complex formula and could undermine support for for what is perceived to be a universal program.
In addition, Social Security does not have a current shortfall. As can be seen in the table at the bottom of this page, Social Security had a surplus of $187 billion (including Disability Insurance) in 2007. If we increase the current income, it may well lead to increased spending since monies borrowed from Social Security doesn’t affect the unified deficit. However, I believe that the current Social Security formula would entitle those who pay the additional taxes to additional benefits (though at the lower replacement rate). Hence, our financial situation could possibly turn out to be worse.
I think it would be better to hold off on increasing the maximum taxable income until that income is needed and work instead on changing the formula to increase Social Security’s sustainability. Amazingly, the current formula makes no adjustment for the increase in life expectancy. Hence, the current formula is guaranteed to blow up, given enough time. Certainly, there may need to be some protection for low-wage physical laborers who cannot work beyond the current age limits. However, that should not keep us from making any adjustments. One interesting adjustment is put forth by Pete Peterson on page 200 of his book “Running on Empty”. That adjustment is to index new benefits to prices instead of wages. Most people are not even aware of this part of the formula so changing it should not be that difficult. However, even such changes may have to wait for a commission after the election. In any case, we should not be locking ourselves into questionable policies like the “donut hole”.
The reality is the economics policies of both candidates will be steered towards getting votes. Right now we are seeing the different ideologies of the candidates. McCain is for tax cuts (for rich as well) and Obama is for higher taxes on rich but less on the poor. Obama’s strategy will lead to more donut holes and complexity. This is a smart move by both candidates for two reasons:
1- It will get their base behind them.
2- They can target their plans to the middle or independent voters.
I am sure Obama has extensive data on the independent voters and future policies will be directed their way. After he or McCain is elected, the real plans will come out in more detail. For now, they need to get elected by appealing to voters.
I am kind of the designated Soc Sec guy at Angry Bear so let me throw in a couple things:
#3 Reagan did not ‘double’ the payroll tax, he increased it by 2 points to 12.4% total (with employer match). The various TFs all flirted with zero in the 1982-83 time frame but do to some fancy borrowing between them never individually went to default. The 83 Reform did put the Trust Fund back on the path to Short Term Actuarial Balance but did not change the operations or nature of Social Security in any material way.
Nor is the Trust Fund $5 trillion. Total Intragovernmental debt was $4.1 trillion as of Friday (via Treasury’s Debt to the Penny) of which the two Social Security Trust Funds total $2.1 trillion.
And just to be a pedantic twit: in Social Security jargon ‘SSI’ does not stand for ‘Social Security Insurance’ instead it is the official acronym for a separate program run by Social Security called ‘Supplemental Security Income’ which in the event is funded out of the General Fund. And to pile on: the Trust Funds were never the equivalent of a vault whose assets could be raided. By design every surplus dollar from FICA went through Social Security to the General Fund and was replaced by Special Treasuries. There is nothing nefarious about this, that is what happens when you buy a government bond: you give them money, they give you a promise and a piece of paper, they spend the money. Now certainly on a year by year basis this surplus can and has been used to disguise the size of the General Fund deficit, but there is nothing underhanded about the actual financial transaction, the whole thing rises from a misconception of what the Trust Funds actually are, which is a reserve account maintained by the Treasury Dept meant to buffer short term gaps between income and cost. Both the ‘raid’ and the ‘prefunding’ narratives are essentially mythical.
#4 Well it is not particularly true that the current tables make no adjustment for the increase in life expectancy. The Trustees publish explicit models for future mortality in the Reports. See tables V.A3 and V.A4 and these are reflected in the Cost estimates and so implicitly in the Benefit Formula though not as an adjustment per se. If people want to make a principled case why they are understating future mortality then great, but absent that the future assumed changes are fully built into the models already. So it just isn’t true that the system is “guaranteed” to blow up, indeed under the Trustee’s alternate, and in my view plausible, Low Cost model Social Security is seen to be overfunded after about 2055 (see tables VI.F7 and VI.F8 plus Figure II.D6 (copied to my site under The Shape of Low Cost))
Two final points. It doesn’t make sense to call a moderate cut in benefits in 2041 a ‘crisis’ that needs to be addressed by benefit cuts or a change in the index. As it is the projected cut actually ends up with a better real benefit than retirees get today (78% of the scheduled 160% real benefit = 125% compared to what a similarly situated retirees get today). The notion that this represents some existential financial crisis simply doesn’t hold up to the numbers. Moreover the current payroll gap needed to deliver full benefits is small (1.7%) and has been shrinking on average since 1997 (2.23%), there is absolutely no call to do anything on either the tax or benefit side in the near to medium term. Most of the ‘crisis’ narrative is being driven by places like Cato’s Project on Social Security Privatization and the market purist crowd at Club for Growth. Very little of it is driven by real concerns about solvency or retirement security per se, instead the intelligence is being shaped around the pre-conceived policy goal.
Len Burman heard from the Obama campaign today and got some clarification(?) on the donut hole: http://taxvox.taxpolicycenter.org/blog/_archives/2008/6/15/3745902.html. He also was more “Tim Russert-like” than I and looked up the whole transcript of that Nov. 2007 Meet the Press show that I cited. Here it is: http://www.msnbc.msn.com/id/21738432/.
Bruce Webb wrote:
#3 Reagan did not ‘double’ the payroll tax, he increased it by 2 points to 12.4% total (with employer match).
Agreed. I’ve often wondered where that claim came from. If you google for “doubled the Social Security tax”, you get a number of hits but none that I could find that show the calculation. I suspect that the claim is based on the maximum annual tax. Judging from Table VI.A1 in the 2008 Trustees Report, the maximum tax was $3177.90 (10.7% of $29700) in 1981 and $6361.20 (12.4% of $51300) in 1990. That’s about double but it’s over a period of nine years and doesn’t adjust for inflation, much less for wages (on which initial benefits are based). Hence, it’s not really a fair comparison.
#4 Well it is not particularly true that the current tables make no adjustment for the increase in life expectancy. The Trustees publish explicit models for future mortality in the Reports. See tables V.A3 and V.A4 and these are reflected in the Cost estimates and so implicitly in the Benefit Formula though not as an adjustment per se.
I agree that the Trustees Report does include life expectancy in its three projections (Low Cost, Intermediate Cost, and High Cost). In fact, this is likely much of the reason why the Intermediate projection currently estimates that the Social Security trust fund will be exhausted in about 2041. My point is that current law fixes the normal retirement at 67 forever (a gradual increase from 65 was legislated some years back). If life expectancy continues to climb, this will surely have to be increased again at some point. If we could find some reasonable way to factor that into the benefit formulas, the projections would immediately improve.
If people want to make a principled case why they are understating future mortality then great, but absent that the future assumed changes are fully built into the models already. So it just isn’t true that the system is “guaranteed” to blow up, indeed under the Trustee’s alternate, and in my view plausible, Low Cost model Social Security is seen to be overfunded after about 2055 (see tables VI.F7 and VI.F8 plus Figure II.D6 (copied to my site under The Shape of Low Cost))
It seems prudent to me to at least plan for the Intermediate Cost estimate. Perhaps “guaranteed to blow up” was not the best choice of words. But, as I said, if we continue to have the good fortune of living longer, we will have to figure out a way to pay for it at some point. That’s a very good “problem” to have. If a doctor could magically extend my life by ten years, I would be more than happy to work for a few of them or make some other adjustment if I was unable to work.
Most of the ‘crisis’ narrative is being driven by places like Cato’s Project on Social Security Privatization and the market purist crowd at Club for Growth. Very little of it is driven by real concerns about solvency or retirement security per se, instead the intelligence is being shaped around the pre-conceived policy goal.
I agree that many of those pushing a “crisis narrative” have questionable motivations. As I stated, the current problem is the deficit in the general fund, not the surplus in Social Security. In addition, the largest future problems are almost surely in Medicare and Medicaid, not Social Security. Finally, with the disappearance of pension funds in the workplace, I think that it’s critical that we continue the pension-like features of Social Security. For many people, it’s the only remaining program to guarantee some minimal level of income for their entire lives. However, I do think that it’s possible to openly discuss and deal with Social Security’s problems without giving in to the “crisis narrative”.
B. Davis (and for that matter Economist’s Mom) I have a running Social Security series at Angry Bear. Informed pushback is more than welcome.
B. Davis (and for that matter Economist’s Mom) I have a running Social Security series at Angry Bear. Informed pushback is more than welcome.
Thanks, I’ll check it out.
Does anyone else have a fundamental problem with raising the social security tax for a program that already takes in more than it pays out on a year to year basis (projected surplus until roughly 2017)?
I understand raising the tax when the program goes cash flow negative when redeeming treasuries will put further pressure on government spending and taxes.
I understand raising the tax now would help the actuarial gap for the Social Security program itself but I see it having the effect of delaying action on our overall fiscal imbalance when you look at projected spending needs for all government programs.
I think it is disengenious and offensive.
M Gilleland wrote:
Does anyone else have a fundamental problem with raising the social security tax for a program that already takes in more than it pays out on a year to year basis (projected surplus until roughly 2017)?
Yes, I do. As I said in comment number 4 above, raising the social security tax now will make the unified deficit look smaller and will likely lead to more spending and taxcuts as we run it back up to a level that politicians and the public feel comfortable with. As you can see from the graph and the table at the bottom of this page, the unified was already decreased by $293 billion in 2007 via the monies that the general fund borrowed from the trust funds.
The fact that the same FICA tax dollar can be used to fund the Social Security trust fund AND to decrease the unified deficit has long made the FICA tax a favorite among politicians. You notice how the FICA tax is rarely mentioned when they start talking about tax cuts. Of course, the idea that you can spend the same dollar twice is illusionary. Either the Social Security trust fund or the unified deficit are not really what they seem to be. Since I seriously doubt that the government will renege on its Social Security debt, I think that the unified deficit is the largest illusion. In any case, I see no reason to feed this illusion by raising the social security tax now.
The thing Obama’s plan ignores is that one’s salary, for benefits calculation purposes, is also capped at $102,000 currently. That’s why the payroll tax stops at that level. Elminating the cap, wheher on all earned income or after the donut hole, without eliminating the cap on salary for benefits purposes, represents nothing more than turning Social Security into a welfare program, as opposed to one where what people pay in bears some reasonable relation to what they get out.
So what Obama really is proposing is changing Social Security from a retirement savings program based on contributions to a welfare program where the wealthy subsidize the poor, and is disguising this by talking about progressive tax policy.