Taxation

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TAXATION

Elderly persons are treated very well by the U.S. federal tax system and by the tax systems of many states and localities. They get an extra federal standard deduction, Social Security benefits are taxed lightly or not at all, pensions get special relief, and state and local property tax burdens are often offset by income tax relief. It is not, however, easy to provide a simple, widely accepted philosophical justification for taxing an elderly person at a lower rate than a younger person with the same income.

These tax concessions may simply reflect the political power of elderly voters. People sixty-five and over constituted 16.5 percent of the voting age population in the 1996 election, but provided over 20 percent of the votes. Their political importance will grow considerably when an increasing number of baby boomers reach age sixty-five in the years following 2010.

Despite the political power of older voters, it is hard to believe that significant tax breaks would be possible without the tacit support of the younger population. Older people are popular. Many are peoples’ grandparents, and young people certainly hope to survive to an age at which they too can enjoy the tax concessions granted older adults.

However, it must be noted that the benefits conveyed to older Americans have a considerable cost—a cost that will rise as the population ages. The related revenue loss must be added to the much larger benefits appearing on the spending side of the budget. Social Security is now the largest single federal program and Medicare spending will soon exceed defense spending. Those over sixty-five absorb about 50 percent of the civilian, noninterest expenditures of the federal government. Although the tax preferences given to older Americans are quite small relative to the benefits received on the spending side of the budget, they do add up. They also imply that younger workers are forced to pay higher taxes than they would otherwise. Given American hostility to higher taxes, it is probable that the benefits conveyed to older adults on both the spending and tax side of federal, state, and local budgets tend to crowd out other government activities in areas such as defense, child welfare, and highways.

Federal tax law

The most important federal tax break involves the taxation of Social Security. Benefits are completely excluded from taxable income for lower-income elderly taxpayers. Single taxpayers with $25,000 to $34,000 in income, and couples between $32,000 and $44,000, receive 50 percent or more of their benefits tax-free, while singles with incomes above $34,000 and couples above $44,000 must pay taxes on up to 85 percent of benefits. A complex formula is used to phase in the taxation of benefits, and it has the peculiar result that over certain ranges of income the marginal tax rate on an extra dollar of non-Social Security income is higher than on an extra dollar of benefits. During the phase-in ranges, Social Security recipients are also subjected to very high marginal tax rates on extra earnings or on extra income from investments, because every extra dollar of such income has a double impact on a person’s tax bill. It is subject to taxation itself, and it adds to the portion of Social Security benefits that will be taxed. This could create disincentives to work and to save. The exclusion of Social Security benefits from ordinary taxable income cost the federal government $17.1 billion in lost revenue in fiscal year 1999.

It has been proposed that it would be proper to include 85 percent of Social Security benefits in taxable income for everyone. The other 15 percent reflects the estimated return of principal invested out of after-tax dollars in a typical private pension plan that enjoys no tax advantages. However, the creation of IRAs, Keoghs, 401(k) plans, and the like has made tax law much more favorable to private retirement savings. Contributions to such plans are deducted from taxable income and withdrawals are fully taxed. Only contributions in excess of the limits imposed for such plans are deprived of tax advantages and contributions of this type are uncommon.

If Social Security is seen as a typical tax-advantaged retirement plan and treated like most other retirement saving plans, it would be appropriate to subject 50 percent of benefits to taxation while allowing 50 percent to be tax free. That is because the 50 percent of the payroll tax that is paid by employers is deducted from their taxable income, while the 50 percent that is paid by employees is financed out of after-tax income.

On the other hand, it might not be appropriate to regard Social Security as a typical retirement plan, because the level of benefits is only loosely related to the payment of payroll taxes. People with lower lifetime earnings receive a higher rate of return than those with higher earnings, dependent spouses receive an extra benefit equal to 50 percent of that of the principal earner, and the return on one’s payroll tax contribution can depend on when income was earned. Consequently, it may be more accurate to regard Social Security as a transfer program that distributes money from high to low earners rather than as a pension program. But there is no consistent rule governing the taxation of transfer payments. For example, unemployment insurance benefits are included in taxable income, while welfare payments are not.

The taxation of benefits obviously reduces their net value, particularly for those affluent taxpayers who are in the highest tax brackets. Thus, the taxation of benefits can be seen as an indirect approach to means-testing Social Security since the tax imposes the largest burden on the most affluent beneficiaries. Given the rapidly rising economic burden that will be imposed by Social Security once baby boomers start to retire, there may be a strong argument for subjecting 100 percent of benefits to taxation as a way of strengthening means-testing.

It should be noted that the taxation of Social Security benefits is a relatively recent phenomenon. Before 1983, benefits were not taxed at all. After that time, a maximum of 50 percent of the benefit was brought into taxable income. The proportion brought into taxable income was not raised to 85 percent for more affluent taxpayers until 1993.

A less important federal tax concession provides an extra standard deduction to each individual age sixty-five and older. In 1999, this equaled $1,000 for single taxpayers and $800 each for married taxpayers. The associated revenue loss was $1.8 billion in fiscal 1999. There is also a nonrefundable tax credit for low-income retirees whose retirement income is mostly taxable, but this credit is rarely used.

Because the use of the standard deduction declines as income rises, the extra standard deduction is most valuable, on average, to lower-income elderly taxpayers. Only about 10 percent of elderly couples with incomes between $20,000 and $30,000 itemize deductions while itemized deductions are used by a substantial majority of those with incomes above $80,000. However, only 15 percent of elderly couples had incomes that high in 1998.

The elderly receive Medicare and Medicaid benefits tax-free, as well as an untaxed subsidy for the purchase of insurance for physician services. Although it would be practically possible to tax such items, it would be extremely unpopular politically. It should be noted that employer-provided health insurance is also tax-free, as are Medicaid benefits.

As noted earlier, private saving for retirement is now highly favored by the federal tax system. Employers’ contributions to defined benefit plans are not, for the most part, considered to be taxable income to the employee. Employer and employee contributions to defined contribution plans are deductible up to specified limits that differ from plan to plan. The tax saving associated with the deduction for contributions into a retirement account is sufficient to pay the tax on future withdrawals if the tax saving is invested at the same rate of return as the rest of the account—and if withdrawals are taxed at the same tax rate as was applicable when the contribution was made. Put another way, it is equivalent, under these very special assumptions, to eliminating the entire tax on income saved for retirement. If the retiree is in a lower tax bracket when funds are withdrawn than when funds were contributed, he or she receives a tax subsidy for retirement saving. That is to say, the after-tax return on the retirement account becomes greater than the before-tax rate of return.

The law provides for a confusing array of defined benefit and defined contribution accounts that have different deduction limits and are subjected to different tax rules. The regulation of such accounts, especially defined benefit plans, is also extremely complicated. The system badly needs simplification.

Whether tax-favored, private retirement accounts improve the income of retirees depends on the extent to which the tax incentives actually increased the retirement savings of people while they were working. There is profound disagreement among economists on this point. Some believe that the tax concessions induce a sizeable increase in retirement saving. Others argue that the savings deducted from taxable income largely represents either transfers from other accounts or saving that would have occurred even in the absence of tax concessions. The naysayers believe that the increase in private saving is less than the associated revenue loss to the federal treasury.

State income taxation

Tax burdens on older adults vary greatly from state to state. Many replicate federal law in allowing an extra standard deduction, and some do not tax Social Security benefits at all. Many also exclude a large portion of other types of retirement income. This creates a severe inequity between people whose income flow is in the form of pensions and people who get exactly the same income from interest and dividends that are fully taxed. Table 1 describes selected tax provisions that especially affected elderly taxpayers in different states in 1998. It does not include provisions related to property taxes.

The combination of federal and state income tax burdens

The total income-tax relief given older adults can be very important. The precise amount of the relief, however, depends on how income is received. In Tax Benefits for the Elderly (2000) Rudolph Penner presents a number of examples, loosely based on data from the Statistics of Income (U.S. Treasury, Internal Revenue Service). One example involves a retired couple age sixty-five or older with $67,372 in income (in 1998) who get 24 percent of their income from Social Security, 40 percent from pensions and annuities, 30 percent from interest and dividends, and 5 percent from earnings. In Hawaii, such a couple would pay about $5,500 less in taxes than a younger couple receiving the same total income from wages. The tax liability of the older couple is thus reduced by 36 percent, or by 8.1 percent of income. In South Carolina, the elderly couple would receive a tax cut of about $4,000, or 6.0 percent of income. In Georgia, the benefit is about $2,100, or 3.2 percent of income. None of the above figures count property tax concessions. In all cases, the tax cut for older couples would be much lower if almost all income came from wages and interest and dividends.

For lower incomes, the percentage cut in the tax liability is usually higher, although the absolute value of the cut declines. Assuming $28,323 of income, with 37 percent derived from Social Security, 33 percent from pensions and annuities, 15 percent from interest and dividends, and 15 percent from earnings, the percentage tax cuts in Hawaii, Georgia, and South Carolina are 12.1 percent, 9.8 percent, and 9.2 percent, respectively. Because the percentage cut tends to grow at lower income levels, it can be said that the tax concessions given to elderly persons tend to be progressive. However, it must be reemphasized that they also tend to be erratic. A person who decides to work after the normal retirement age and who does not benefit from a tax-free pension will, in many states, receive much less of a tax break than a retired person with exactly the same income from Social Security and private pensions. Because people tend to retire earlier if they have a more generous pension, the tax concessions provided for retirement income undoubtedly encourage some to retire earlier than they would without the tax concession.

Property tax relief

Many states provide income tax relief related to property taxes paid at the state and local level. Often, the relief is restricted to elderly persons. In some states, such as Washington, people as young as sixty-one can qualify. The disabled often also qualify.

There are two types of relief. The first is often referred to as a circuit breaker and is confined to low-income taxpayers. For example, Connecticut, Nebraska, New Jersey, Ohio, and Washington all have special provisions of this type focused on the elderly, but in all cases, the relief phases out at relatively low income levels. The second type of relief provides a property tax exemption that does not depend on income. Alabama, Kentucky, Mississippi, South Carolina, and West Virginia have provisions of this type targeted at the elderly. For example, an exemption of assessed value up to $20,000 is provided in West Virginia. The average residential property-tax rate in the state is about 1.2 percent, so that the amount of relief for average property owners is $240. Generally, property-tax relief consists of relatively small concessions compared to the income-tax relief described earlier.

Death taxes

Estate and inheritance taxes are imposed at the time of death and are extremely important to affluent elderly persons. The federal estate tax exempts $675,000 of lifetime taxable transfers of wealth, and this amount is now scheduled to rise in steps described in a tax law passed in May of 2001. The first increase is to $1,000,000 in 2002 and 2003, and ultimately the exemption is increased to $3.5 million in 2009. With a modicum of estate planning, couples can double the basic exemption although the new law will impose limits on this privilege in future years. After the exemption is exhausted, a tax rate of 37 percent is currently applied—a rate that gradually rises to 55 percent on taxable estates greater than $3 million, but these rates are to be lowered in the future. The federal estate tax is supposed to disappear altogether in 2010 and then to be reimposed in 2011, but that, as well as scheduled exemptions and rate reductions, could be changed many times before then.

Because of the large exemption, only 2 percent of estates pay the federal estate tax, but that figure greatly understates its effects. Only one member of a couple actually pays the tax, but it is of concern to both. Moreover, many avoid paying only because of judicious planning. Perhaps more important politically, many aspire to be rich enough to be affected, although few will attain the requisite amount of wealth.

For whatever reason, the tax is extremely unpopular and many who have no hope of paying it still regard it as being extremely unfair. Many consider it to be a tax on those who are frugal, hard working, and altruistic toward their descendants. Although special provisions ease the burden of the tax on those wishing to convey farms and small businesses to family members, many do not think that the special provisions are lenient enough and complain that the need to pay the tax forces sales of property. However, such sales are actually extremely rare.

Proponents of the tax praise its progressivity and see it as a tool for extracting taxes from those who have been skilled at avoiding income taxes through their lifetime, either legally or illegally. It is also seen as a device for preventing great concentrations of wealth.

The federal estate tax law now allows a 100 percent credit up to a certain limit against the federal estate tax for estate taxes levied by states. The limit on the credit is related to the taxable value of the estate. Because a state estate tax levied up to the limit does not impose any extra cost on taxpayers, all states impose so-called pick-up taxes that exploit the entire federal limit. The new law gradually reduces these credits and repeals them entirely in 2005.

Thirteen states and Puerto Rico levy inheritance taxes in addition to pick-up taxes, while four states have additional estate taxes. An inheritance tax depends on the size of the bequest left to an individual heir, whereas an estate tax depends on the total value of the estate left by the decedent, regardless of how it is spread among heirs. Estate and inheritance tax rates and basic exemptions vary greatly from state to state and often depend on the relationship between the beneficiary and the decedent, with close relatives being favored.

A strong trend has developed at the state level toward reducing or eliminating estate and inheritance taxes because they are so unpopular politically. In 1989, eighteen states levied inheritance taxes and eight levied estate taxes in addition to pick-up taxes. In January 1999, only fourteen states had inheritance taxes and four still had estate taxes. New York has been reducing its very heavy estate tax by raising exemptions and cutting rates.

Effects of state and local tax policy on location decisions

States have an additional reason to lower their estate and inheritance taxes. They do not want to pressure affluent elderly taxpayers into moving to states that have only pick-up taxes or very-low estate and inheritance taxes.

More generally, states and localities tend to use tax policy to compete for older Americans. They are considered to be attractive residents, especially those who are more affluent, because they are law abiding, often attract other forms of economic activity, and do not impose costs on local school systems.

Duncombe, Robbins, and Wolf (2000) have investigated the effect of state and local fiscal policy on the migration of retirees. They have found that inheritance, income, and property tax policies have more effect on location decisions than expenditures on social services and law enforcement. However, it takes very large tax cuts to provoke even tiny amounts of in-migration. The authors conclude the revenue losses are likely to far outweigh any economic and fiscal benefits derived from attracting older adults. In a much older study, Voss, Gunderson, and Manchin (1988) also concluded that tax factors are significant, but not overwhelmingly important. Both studies suggest that amenities offered by a state, such as climate, are much more important in affecting the migration patterns of older adults. Both studies also do statistical analyses that result in the perverse conclusion that high estate taxes seem to attract certain types of older migrants. This obviously fallacious result would seem to provide a further indication that tax burdens are a relatively unimportant determinant of where older people choose to live.

Conclusions

Federal, state, and local tax systems tend to treat elderly taxpayers very generously. The costs of this generosity will rise rapidly after 2010 when the number of elderly persons will grow at an extremely rapid rate and the number of workers will stagnate because of the continuation of low birth rates that began in the 1960s.

The devices used to provide tax relief to older adults often have erratic and inequitable effects. People with the same income can face quite different tax bills depending on how the income is received. If it is deemed desirable to provide tax relief to older individuals, it would be more equitable to do it with an extra exemption, a tax credit, or lower tax rates for all those over a certain age, say sixty-five, rather than concentrating relief on specific types of income likely to be received by old people, such as Social Security or pensions. Whether one chooses a credit, an extra deduction, or a lower tax rate would depend on how one believes that the tax relief should be shared by different income groups. Superficially, it appears somewhat odd to provide any tax relief at all to very affluent older taxpayers. However, the current tax and transfer system, along with private policies such as means tests for college financial assistance, already contain numerous disincentives for accumulating wealth. It is necessary therefore, to be cautious as to how far we should go in continually making the system more progressive.

Rudolph G. Penner

See also Estate Planning; Pensions; Retirement Planning; Savings; Social Security.

BIBLIOGRAPHY

Duncombe, W.; Robbins, M.; and Wolf, D. ‘‘Chasing the Elderly: Can State and Local Governments Attract Recent Retirees?’’ Aging Studies Program. Paper 22. Syracuse, N.Y.: Center for Policy Research, 2000.

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Nalebuff, B., and Zeckhauser, R. J. ‘‘Pensions and the Retirement Decision.’’ In Pensions, Labor, and Individual Choice. Edited by David A. Wise. Chicago: University of Chicago Press, 1985. Pages 283–316.

National Conference of State Legislatures. Fiscal Affairs: State Death Taxes. Available on the World Wide Web at www.ncsl.org

Penner, R. ‘‘Tax Benefits for the Elderly.’’ The Retirement Project Occasional Paper No. 5. Washington, D.C.: The Urban Institute, 2000.

Poterba, J. M.; Venti, S. F.; and Wise, D. A. ‘‘How Retirement Savings Programs Increase Saving.’’ The Journal of Economic Perspectives 10, no. 4 (1996): 91–112.

U.S. Office of Management and Budget. ‘‘Tax Expenditures.’’ Analytic Perspectives: The Budget of the United States Government, Fiscal Year 2001. Washington, D.C.: U.S. Government Printing Office, 2000.