Tax Policy and the Economy, Volume 31

Contents

Copyright

NBER Board of Directors

Relation of the Directors to the Work and Publications of the NBER

Introduction

Robert A. Moffitt

Is Uncle Sam Inducing the Elderly to Retire?

Alan J. Auerbach, Laurence J. Kotlikoff, Darryl Koehler, and Manni Yu

Trends in Cumulative Marginal Tax Rates Facing Low-Income Families, 1997–2007

Gizem Kosar and Robert A. Moffitt

Taxing the Rich More: Preliminary Evidence from the 2013 Tax Increase

Emmanuel Saez

Business Income and Business Taxation in the United States since the 1950s

Conor Clarke and Wojciech Kopczuk

A Distribution-Neutral Perspective on Tax Expenditure Limitations

Louis Kaplow

Copyright

© 2017 by the National Bureau of Economic Research. All rights reserved.

NBER Board of Directors

© 2017 by the National Bureau of Economic Research. All rights reserved.

Relation of the Directors to the Work and Publications of the NBER

© 2017 by the National Bureau of Economic Research. All rights reserved.

Introduction

Robert A. Moffitt

Johns Hopkins University and NBER

The five papers in this issue of Tax Policy and the Economy are all directly related to important and often long-standing issues involving current taxes and tax policy, often including how transfer programs affect tax rates and behavior as well.

Auerbach, Kotlikoff, Koehler, and Yu take a lifetime perspective on the marginal tax rates facing older individuals and families arising from a comprehensive set of roughly 30 different sources, including the federal income tax and state income taxes, the payroll tax, the federal corporate income tax, and a long list of transfer programs including the Social Security retirement program, Medicare, food stamps, Supplemental Security Income, and Disability Insurance benefits. The transfer programs impose tax rates when their benefits are phased in or out as work and earnings rise. Using a sophisticated calculator that assumes consumption smoothing over the lifetime for any present discounted value of income and that incorporates mortality rates as well as projected lifetime earnings profiles and borrowing constraints, the authors apply it to households in the Survey of Consumer Finances to derive a marginal tax rate equal to change in the net present value of lifetime spending per dollar of lifetime wealth (human capital and financial) resulting from increases in work, retirement ages, earnings, and other measures of labor market activity. Their results show an enormous dispersion of marginal tax rates within the older population—even among those with the same or similar level of resources—but many very high rates as well, higher than in the past literature, which imply a lower net gain in sustainable living standards from working longer. The authors ascribe these high rates primarily to Disability Insurance, Medicaid, and the Social Security earnings test.

In the second paper, Gizem Kosar and I provide new estimates of the cumulative marginal tax rates facing low-income families over the period 1997–2007, which arise from federal and state income taxes, payroll taxes, and four major mean-stested transfer programs: the food stamp program, Medicaid, the Temporary Assistance for Needy Families (TANF) program, and subsidized housing programs. In addition to considering more transfer programs than most past work, they calculate rates for all family types, both those with and without children and for those married and unmarried. They find strong variation in tax rates facing families of different types and participating in different combinations of programs, but especially strong variation by level of earnings. For most families, marginal rates are low or negative at low-earnings levels, particularly at levels below the poverty line, and are somewhat higher for earnings just above the poverty line. But for the minority of families participating in multiple programs, earnings just above the poverty line often result in very high marginal tax rates, often exceeding 100%.

Saez adds to the large literature on the effect of federal income taxes on behavior, focusing on the now-traditional effect of taxes, as measured by the net-of-tax rate, on pre-tax-reported income. He provides new evidence from the increases in the top rates on labor income and capital income that took effect in 2013. Using only published IRS statistics and hence using transparent and easily understood methods, he finds a large difference between the short-term and medium-term elasticity of reported income with respect to the net-of-tax rate. From 2012 to 2013, Saez finds a large elasticity, in excess of one, driven primarily by an uptick in dividends and capital gains realizations in the top 1% of the income distribution. He argues that this was largely a result of timing changes, as the tax rate increases were largely expected sufficiently before they took effect to allow taxpayers to alter the timing of income receipt. But over the period 2011 to 2015, the elasticity was much smaller. Over that period, behavioral responses were modest and only a small reduction in reported income occurred. The incomes of top earners resumed their upward course thereafter.

Clarke and Kopczuk survey the treatment of business income taxation in the United States since the 1950s. Business income is taxed in very different ways depending on the form in which it is generated and received, and its treatment has changed over time with the passage of legislation and administrative rulings. The authors review the history of business income taxation in the United States, drawing on the large body of existing literature on the subject, but go on to provide new data on how business income and its taxation have evolved over time, in many cases going back to 1958. They find that there have been major changes in whether business income is taxed on an accrual rather than realization basis, the extent to which taxation is deferred, and the share of income that is taxed. They also find that business income is increasingly taxed through personal income taxes instead of a combination of corporate and personal taxes and that income is increasingly taxed on an accrual rather than realization basis. They suggest that research that uses time trends in business income could be affected by the changes over time in the composition of that income arising from these tax-related factors. They also point out that international comparisons are affected by these factors as well, for the share of business income subject to tax, for example, has changed in quite different ways in different countries.

Economists of late have devoted much attention to tax reforms that broaden the base to enable lower tax rates—so-called tax expenditure limitation policies. These policies are often viewed as efficiency enhancing because of the resulting reduction in statutory marginal tax rates. Moreover, by tilting the rate reductions to favor lower-income taxpayers, it is thought possible to enhance progressivity as well, without requiring higher marginal tax rates. The typical approach in the literature is to consider alternative tax structures that improve efficiency and/or distribution while holding revenue constant. In the final paper in the issue, Kaplow provides a complementary, distribution-neutral perspective: in the first pass, policies are examined that hold distribution constant as well. Using this framework, Kaplow shows that the resulting reduction in statutory tax rates from base broadening entails no change whatsoever in effective marginal tax rates, so the efficiency gains from apparently lower rates are illusory. Moreover, deviation from distribution neutrality to enhance progressivity in fact requires higher effective marginal rates. Tax expenditure limitation proposals, therefore, do not escape the familiar distribution-distortion trade-off. Kaplow shows that there are true efficiency gains from tax expenditure limitations, but they arise only from the reduction in distortions that tax preferences create between different forms of expenditures, the traditional microeconomic objection to differential taxation.

Endnote

Financial support from the Lynde and Harry Bradley Foundation is gratefully acknowledged. For acknowledgments, sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c13865.ack.

© 2017 by the National Bureau of Economic Research. All rights reserved.

978-0-226-44113-9/2017/2017-0001$10.00

Is Uncle Sam Inducing the Elderly to Retire?

Alan J. Auerbach

University of California, Berkeley, and NBER

Laurence J. Kotlikoff

Boston University, The Fiscal Analysis Center, and NBER

Darryl Koehler

Economic Security Planning, Inc. and The Fiscal Analysis Center

Manni Yu

Boston University

Executive Summary

Many, if not most, baby boomers appear at risk of suffering a major decline in their living standard in retirement. With federal and state government finances far too encumbered to significantly raise Social Security, Medicare, and Medicaid benefits, boomers must look to their own devices to rescue their retirements, namely, working harder and longer. However, the incentive of boomers to earn more is significantly limited by a plethora of explicit federal and state taxes and implicit taxes arising from the loss of federal and state benefits as one earns more. Of particular concern is Medicaid and Social Security’s complex earnings test and clawback of disability benefits. This study measures the work disincentives confronting those age 50 to 79 from the entire array of explicit and implicit fiscal work disincentives. Specifically, the paper runs older respondents in the Federal Reserve’s 2013 Survey of Consumer Finances through The Fiscal Analyzer—a software tool designed, in part, to calculate remaining lifetime marginal net tax rates.

We find that working longer, say an extra five years, can raise older workers’ sustainable living standards. But the impact is far smaller than suggested in the literature, in large part because of high net taxation of labor earnings. We also find that many baby boomers now face or will face high and, in very many cases, extremely high work disincentives arising from the hodgepodge design of our fiscal system. A third finding is that the marginal net tax rate associated with a significant increase in earnings, say $20,000 per year, arising from taking a full-time or part-time job (which could be a second job) can, for many elderly, be dramatically higher than that associated with earning a relatively small, say $1,000 per year, extra amount of money. This is due to the various income thresholds in our fiscal system. We also examine the elimination of all transfer program asset and income testing. This dramatically lowers marginal net tax rates facing the poor. Another key finding is the enormous dispersion in effective marginal remaining lifetime net tax rates facing seemingly identical households, that is, households with the same age and resource level. Finally, we find that traditional, current-year (i.e., static) marginal tax calculations relating this year’s extra taxes to this year’s extra income are woefully off target when it comes to properly measuring the elderly’s disincentives to work.

Our findings suggest that Uncle Sam is, indeed, inducing the elderly to retire.

I. Introduction

Ten thousand baby boomers are retiring each day. Many, if not most, are either poorly or very poorly prepared to finance retirements that may last longer than they worked. One marker of this problem is the financial reliance of retirees on Social Security. Social Security was designed to provide a basic floor to a retiree’s living standard. But it provides at least 90% of financial support to over one-third of elderly households, and almost two-thirds of older households receive at least half of their income from Social Security.¹

This heavy reliance on Social Security is not due to particularly generous levels of Social Security benefits. Instead, it reflects the widespread failure of retirees to save for their retirements. One recent survey reports that 40% of baby boomers have no retirement savings whatsoever.² Data from the 2013 Survey of Consumer Finances show that median assets, including retirement accounts, of households age 55 to 64 equal just $537,225. Thirty-five percent of these households hold less than half of this amount, and 21% hold less than one-fifth of this amount. These and other dismal statistics hold dire implications for the economic well-being of baby boomers through time. According to Munnell, Orlova, and Webb (2013), over half of today’s workers, including boomers who are now retiring, will be unable to maintain their living standards in retirement.

In fact, the baby boomers’ retirements could well prove financially more stressful than those of current retirees. This is a particularly dire possibility as the financial condition of today’s fully retired generations is, itself, quite dire. In 2015, over one-fifth of married or partnered retirees and almost half of single retirees received 90% or more of their income from Social Security.³ In that year, half of married or partnered retirees and three-quarters of single retirees received half or more of their income from Social Security.⁴ Even those who initially have retirement savings are hardly set. Poterba, Venti, and Wise (2012) report that over half of the elderly outlive their financial assets.

The absolute level of income is another means to assess retirement finances. Roughly half of those now over 65 have less than $25,000 in annual income.⁵ This is remarkably low given that the current poverty threshold for a single person is $11,800.⁶ The Supplemental Poverty Measure (SPM) adjusts the official poverty measure for taxes, the value of food stamps and other in-kind benefits, the costs of out-of-pocket medical spending, geographic differences in housing expenses, and other factors. Based on this measure, one in seven people age 65 and older (15%) are poor compared to one in ten under the official measure. The SPM poverty rate among the elderly is far higher for minorities— 28% for Hispanics and 22% for African Americans.

Why might baby boomers have a harder time financing their retirements than today’s retirees? First, many baby boomers, particularly those with higher incomes, can expect to live longer. Indeed, one study predicts a 10% increase in their length of retirement.⁷ Second, boomers are likely, on a risk-adjusted basis, to earn lower real returns on their savings given the prevailing real interest rates. Today’s 30-year TIPS (Treasury Inflation Protected Securities) yield is less than 100 basis points. In 1998, when 30-year TIPS were first introduced, they yielded above 300 basis points.⁸

Third, thanks to the legislated increase in the full retirement age, many will experience lower Social Security replacement rates. Fourth, the failure to index the thresholds at which the first 50% and then 85% of Social Security benefits are subject to federal income taxation means that a growing number of boomers will experience an ever higher rate of Social Security benefit taxation. Indeed, these third and fourth factors imply significantly lower long-run Social Security replacement rates over the next 15 years. Ellis, Munnell, and Eschtruth (2014) foresee an almost 15% decline in the replacement rate between now and 2030.⁹

Fifth, there are now extra Medicare premiums facing those with higher incomes. Moreover, the thresholds at which these premiums take effect are also not inflation indexed. Sixth, the Affordable Care Act included two new high-income Medicare taxes. One levies an additional .9% tax on wage earnings above specified thresholds. The other applies a 3.8% rate to asset income above the same thresholds. Again, these thresholds are, by law, explicitly and intentionally not indexed to inflation.

Seventh, out-of-pocket health care costs as well as the cost of supplemental health insurance (major medical) policies will likely continue to rise. These out-of-pocket costs include increases in out-of-pocket Medicare Part B costs due to three factors—higher Medicare premiums, higher Medicare Part B copayments, and health care costs of outpatient care not covered by Medicare Part B.¹⁰ Indeed, rising out-of-pocket Medicare costs are projected to absorb roughly 2% more of baby boomers’ Social Security benefit checks by 2030.¹¹ Eighth, out-of-pocket copays and deductibles for Medicare Part D, which covers prescription drug expenses, are also projected to rise in real terms.¹²

Ninth, current retirees can rely to a far greater extent on defined-benefit pensions than is the case for baby boomers. According to Form 5500 fillings, the US Department of Labor indicates that since 1975, the number of participants in defined-benefit pensions has been constant at around 40 million. This is true despite a near doubling of total US employment. ¹³ Meanwhile, participation in defined-contribution plans has increased from 11.5 million in 1975 to 92 million in 2013.¹⁴ Instead, apart from Social Security, baby boomers will be relying primarily on their 401(k) and other defined-contribution retirement accounts. But participation in such retirement accounts has been very disappointing. Only 67% of boomers have retirement accounts of any kind and, as stated, many of those with retirement accounts have very low balances.¹⁵

Raising Social Security’s benefit levels significantly could alleviate the boomers’ financial plight, as well as that of many current poor and low-income elderly. But Social Security is 32.2% underfunded, that is, it is in extremely difficult financial straits.¹⁶ What about the rest of the government’s fiscal enterprise? Does it have the financial wherewithal to subsidize far higher Social Security benefits? The answer is clearly no, according to estimates by Auerbach and Gale (2016), based on recent Congressional Budget Office (2014) projections.¹⁷

If the boomers are short on regular assets, short on retirement-account assets, short on defined-benefit pensions, short on Social Security benefits, long on explicit and implicit taxes, and the government can’t help, boomers have but one option to maintain their living standards—earn more by working more at their current jobs, delaying their retirements, or returning to work if they have already retired.

This is far easier said than done. Hour constraints at their current jobs, age discrimination, increasing preference for leisure, and health limitations are four major factors that limit older workers’ abilities and desire to raise their earnings through time. Older workers also experience age-related declines in productivity (Gokhale and Kotlikoff 1992) and, where applicable, negative private-pension accrual associated with ongoing work (Kotlikoff and Wise 1989).

Another major roadblock to higher earnings of older workers is government-imposed work disincentives operating through the tax and transfer system, which can limit the willingness of the elderly to work harder and longer. These work disincentives entail both explicit marginal taxation, such as FICA payroll taxes, implicit taxation associated with the loss of government benefits, such as food stamps, and increased premiums for such benefits as a result of increased earnings— for example, the income-based premiums for Medicare Part B.

This paper studies labor-supply work disincentives facing the elderly. Specifically, it measures the remaining lifetime marginal net tax rates of household heads and spouses/partners ages 50 through 79 included in the 2013 Federal Reserve Survey of Consumer Finances (SCF). The analysis is comprehensive, incorporating all major federal and state explicit and implicit taxes that were in place in 2013.¹⁸ Of particular concern is the potentially huge perceived work disincentive facing those in their early sixties associated with Social Security’s complex earnings test. We say perceived because Social Security’s Adjustment of the Reduction Factor (ARF), which occurs at full retirement age, largely undoes the earnings test’s work disincentive. But perception of the ARF seems so limited that we assume here that it is ignored completely.

A. Summarizing Our Methodology

Our methodology, at its core, is very simple. We run all SCF households through The Fiscal Analyzer (TFA)—a detailed life-cycle consumption-smoothing program, developed in Auerbach, Kotlikoff, and Koehler (2016), which incorporates both borrowing constraints and life span uncertainty. In the course of doing its consumption smoothing, TFA determines how much each household can spend in present expected value, where the term expected references averaging over different