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Rescuing Social Security: Taxes and Finance

Copyright © 2004 by David E. Ross

While most people are more interested in taxes and find the other aspects of financing a government program to be boring, the latter must be addressed first. After all, it is the overall financial situation of Social Security that has motivated Presidents and Congress to avoid serious reform of the program.


For a long time now and continuing today, Social Security has operated with a surplus — if you consider it a pay-as-you-go program and not as a true pension plan. More money flows into the program from payroll taxes than flows out as benefits. This has had two serious results.

The first step to reform the finances of Social Security must be removing the program entirely from the general federal budget. Social Security taxes should not be paid to the U.S. Treasury. They should instead be paid to a separate Social Security Administration (SSA) treasury with a permanent Congressional appropriation to fund benefits.

Further, to isolate the SSA from political pressure — to remove the influence over the SSA resulting from control of its operating budget — that permanent appropriation should include the use of Social Security taxes to pay for operations and administration. A limit of 2% of gross revenues should be sufficient, with the Board of Trustees having control over the actual budget for operations and administration, which might be even smaller (leaving the balance for benefits).

Ending the use of Social Security revenues to hide the federal deficit also means that the reserves for future benefits must be invested in federal bonds that count as part of the national debt. The SSA should be barred from buying government bonds except through the same bidding process used by banks and brokers. That is, the SSA should only be allowed to invest in fully marketable securities that pay competitive interest rates.

Since the overall reform should result in a very sizeable reserve, the scope of SSA investments should be expanded to include all federal agency bonds, not merely Treasury bonds.

Finally, the investment decisions of the SSA must be made by professional investment managers employed by the SSA and not by those in the President's administration who want to conceal the magnitude of the federal deficit or promote other political agendas.

Without these changes in financial affairs of the SSA, no reform will work.


The current Social Security tax structure not only is regressive — falling more heavily on those with lower incomes — but also has a negative impact on the economy — discouraging the creation of new jobs.

An apprentice plumber working for a plumbing company making $50,000 per year in wages paid 6.2% of that in Social Security taxes in 2003. In that same year, the professional athlete making $2,000,000 per year paid only 0.3% while the corporate CEO making $10,000,000 paid 0.05%. Yes, the athlete and CEO made much more than would be considered when computing future benefits. However, providing for the elderly in our society should be a shared responsibility — especially under our current pay-as-you-go system where what you pay in Social Security taxes is not building a fund for your own retirement.

Then there is the self-employment tax. When that apprentice plumber qualifies as a master plumber and starts his own plumbing service, if he still earns $50,000 per year after expenses, he will now pay 12.4% of that income. Yes, the plumber will be allowed to reduce his taxable income by half his Social Security tax; but that will not reduce his final income tax by that amount.

Someone whose income consists of dividends, interest, and capital gains pays no Social Security tax at all.

Finally, the employer share of the tax means that a company with highly skilled salaried employees who were already making near $87,000 per year in 2003 saved 6.2% of their payroll expense by making them work overtime rather than hiring more employees and paying more Social Security taxes. Thus, the current Social Security tax discourages the creation of new jobs.

With this reform, benefits would be based on total income, not merely wages and salaries. Thus, the tax should be also based total income. Since the benefits are computed according to the adjusted gross income (AGI) reported on a federal income tax return, the tax should be a percentage levied on the AGI at a rate that covers the cost of future benefits as they are accumulated (not current benefits as in the current pay-as-you-go program).

Only taxpayers accumulating Social Security benefits would pay the tax. That means taxpayers under 18 would be exempt from the tax; if you become 18 any time during the year, you are not exempt. Retired taxpayers already receiving benefits would be exempt from the tax except in the year when benefits begin, because their AGI in that year is used for the final incremental accumulation of benefits. A married couple with one spouse exempt would pay half the tax. No one else — not even members of religious orders — would be exempt from the tax.

The tax rate would be uniform over all taxpayers. There would be no exemption for low-income persons and no ceiling for high-income persons. Yes, those with AGI above the 85th percentile — above the maximum benefit accumulation amount — would still pay the tax on their total AGI. They would be subsidizing those with AGI below the 15th percentile — below the minimum accumulation amount — reflecting the concept that providing some level of retirement security for the elderly is a necessary commitment for all citizens.

Since only individuals would pay this tax, the self-employed would pay the same rate as those working for an employer. Those whose only income is from interest, dividends, and capital gains would also pay this tax since their AGI would result an accumulation of future benefits.

Those who fail to vest in any benefit would receive no refund of taxes paid. If someone dies before collecting any benefit, that person's estate receives neither a refund nor a benefit.

Businesses that are proprietorships or partnerships pass all their taxable profits to their owners, who (as individuals) would pay the tax on their own behalf but would not pay an employer's payroll tax. However, corporate employers would not escape paying a tax for Social Security. This would be levied (at a rate different from the rate on individual AGI) as a surtax on corporate income taxes — not a payroll tax — and only used to cover the costs of inflation adjustments for both benefit accumulations and current benefit payments but not to build the reserves for uninflated benefits.

I cannot estimate what the tax rate would be on individual AGI or the surtax rate on corporate income taxes. While I am confident that the rate on AGI would not exceed 5% (less than half the current combined employee and employer rate), the professional services of actuaries would be required to determine the actual rates.

Thus, an actuarial analysis is required to determine the actual cost (in terms of taxes) of this reform. It would have to take into account the average starting year of earning a taxable income, changes in a person's income over his or her lifetime, the average retirement age, and the actual long-term rates earned on government bonds. Once the initial cost is determined, the cost would need to be repeatedly determined as the input parameters change in an evolving economy.

According to the Constitution, only Congress can levy taxes. The law reforming Social Security should authorize a tax on personal AGI and a surtax on corporate income taxes one-third higher than initially estimated as necessary. It should also authorize the SSA Board of Trustees to reduce the tax rates to the amounts actually deemed necessary by the actuaries and investment managers. That is, the Board could lower the taxes so that only the amounts really needed to fund future benefits are collected; but only Congress has the authority to raise the taxes beyond their initial ceilings. Thus, setting them one-third higher than initially necessary provides leeway in case interest rates remain lower than expected or lifespans become longer than expected. Because the setting of the actual tax rates must be made on sound financial and actuarial bases and not in response to political pressure, the Board of Trustees needs to be independent.

Obviously, if Congress reduces the effective rate of corporate income taxes, it must also raise the surtax ceiling. Conversely, if corporate income taxes are increased, the ceilings might be reduced.

Income Taxes

A separate withholding tax on gross income would be required, with the rate equal to the AGI tax rate. Also, estimated tax computations would have to include an estimate of the AGI tax. These would be transferred to the SSA immediately upon receipt by the U.S. Treasury.

The tax on AGI would not result in a reduction of individual income taxes. Thus, Social Security benefits would be "bought" with after-tax money. However, more than half of the benefits would be paid from the interest earned on government bonds. Thus, half of a person's benefits should be taxable income, even if the AGI is no longer taxed.

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