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Rescuing Social Security: Estimating the Tax
Copyright © 2004 by David E. Ross
The cost of Social Security reform — in terms of the tax rate on adjusted gross income (AGI) — is not easy to compute. A few examples here show how merely varying the number of years worked can affect the amount of tax necessary to fund the proposed reform.
General Assumptions
The following assumptions apply to all of the examples, in part to facilitate comparisons between the examples.
- Inflation
- None. These examples deal only with the tax rate on adjusted gross income (AGI). Funding adjustments to accumulated benefits falls on the surtax on corporate profits.
- Earnings rate on government bonds
- 5.5%
- Retirement age
- All examples assume that retirement — and benefits — begins at age 65, which occurs on 1 January. Thus, the year leading up to retirement has a full AGI.
- Longevity
- Age 78
- Income
- Unless otherwise indicated, all examples use an AGI of $35,000 per year.
Example #1
- Assumption
- Years worked: 40, from age 25 through age 64
- Accumulated annual benefit
- $13,300
- Cost of benefit
- $910 per year, 2.6% of AGI
Example #2
- Assumption
- Years worked: 40, from age 18 through age 57
- Accumulated annual benefit
- $13,300
- Cost of benefit
- $630 per year, 1.8% of AGI
- Comment
- With the same number of years worked and the same AGI, the same benefit is earned as in Example #1. However, because the work started earlier, the invested taxes accumulated earnings longer. Thus a lower tax rate could be used.
Example #3
- Assumption
- Years worked: 40, from age 18 to age 30 and then from age 37 to age 64 (e.g., taking six years off work to care for young children)
- Accumulated annual benefit
- $13,300
- Cost of benefit
- $735 per year, 2.1% of AGI
- Comment
- With the same number of years worked and the same AGI, the same benefit is earned as in Examples #1 and #2. The break in work results in a tax rate between those two examples.
Example #4
- Assumption
- Years worked: 40, from age 25 through age 64
AGI starts at $35,000 but increases 1% per year, reflecting increased job skills
- Accumulated annual benefit
- $16,255
- Cost of benefit
- Starts at $910 and end at $1,341 per year, 2.6% of AGI
- Comment
- The larger benefit from increasing AGI requires a greater tax. This results from the fact that the greatest AGI occurs just before retirement, when the greatest tax paid has no time to earn interest on the investment in bonds.
Example #4
- Assumption
- Years worked: 40, from age 25 through age 64
AGI starts at $35,000 but increases 3% per year
- Accumulated annual benefit
- $16,255
- Cost of benefit
- Starts at $1,120 and end at $3,547per year, 3.2% of AGI
- Comment
- The effect seen in Example #4 is magnified by the greater rate by which AGI increases.
Conclusion
The actual tax must take into account such diverse factors as average AGI and how it varies with age, age at which significant earnings begin (e.g., discounting temporary or part-time work immediately after high school), interruptions in work years, and the extent to which the overall population deviates from the average with regard to those factors.
Nevertheless, it appears that a tax rate of 5% on AGI might be more than sufficient if government bonds continue their long-term average return of 5.5% and the average person has significant AGI for 40 years.
