FULL TEXT: CRS BRIEF ON REPEAL OF 1993 TAXATION OF FICA BENEFITS.

                           CRS ISSUE BRIEF

SUMMARY

Until 1984, Social Security benefits were exempt from income tax. For years many analysts advocated social security's tax treatment be the same as for other pensions, whose benefits are fully taxable except for the portion attributable to the worker's contributions. To help restore social security's solvency, Congress enacted a provision in 1983 making up to one-half of benefits taxable for upper income recipients. Under the 1983 law, a portion of Social Security benefits was included in taxable income of taxpayers whose adjusted gross income combined with 50% of their benefits exceeds $25,000 for individuals or $32,000 for married couples filing jointly. By design, these thresholds are not indexed to rise with inflation. The proceeds are credited to the Social Security trust funds.

In his FY1994 budget, President Clinton proposed that the taxable proportion of Social Security benefits be increased to 85% (the proportion said to be the least anyone would pay under the rules applying to other pensions), effective in 1994. The House approved the President's proposal as part of the 1993 omnibus budget reconciliation bill. The Senate version limited the proposal to recipients whose threshold incomes exceed $32,000 (single) or $40,000 (couple), with proceeds going to the HI trust fund. Conferees on the bills approved the Senate version but further raised the thresholds to $34,000 (single) and $44,000 (couples), and this became final law (P.L. 103-66).

Repeal of the '93 provision is part of the Republican "Contract with America." H.R. 8, the "Senior Citizens' Equity Act," would phase out the provision over 5 years, at a cost of $14.9 billion. The new Republican House leadership intends to present the measure for a vote in the first 100 days of the 104th Congress.

Proponents of repeal argue that increased taxation of benefits is unfair as it changed the rules in the middle of the game, penalizing and reducing the income of recipients who made decisions based on old law and who cannot change past work and savings decisions. Regardless of abstract arguments about tax principles, many recipients regard increased taxation as simply a reduction in the benefits they had been promised. They see taxation of benefits as an indirect means test, which they oppose because they view Social Security as an "earned right," unlike welfare, where need determines the level of benefits. Finally, they maintain that the increase in taxation of benefits grossly distorts marginal tax rates and provides a strong disincentive for many recipients to work.

Opponents of repeal argue that it would simply be a giveaway for a small minority of well-off recipients that would exacerbate the Government's fiscal problems and weaken the Medicare trust funds. It would enlarge what they perceive as an inequitable tax advantage for Social Security benefits, especially when the after-tax income of recipients is compared to that of struggling working families with the same gross income. Moreover, they say that in the effort to control the Government's fiscal imbalances, including entitlements, the current provision is the most equitable and efficient way to implement de facto benefit reductions. They say that it concentrates more of the burden on higher income households, and thus better aligns benefits with need, than would broader measures that would also affect the poor (e.g., cuts in cost-of-living adjustments).

MOST RECENT DEVELOPMENTS

On Sept. 27, 1994, as part of the "Contract with America," 300 Republican candidates for the House of Representatives pledged to repeal the provision in the 1993 OBRA that increased the maximum proportion of Social Security benefits subject to income taxation from 50 to 85%. The rate would be reduced back to 50% gradually, over a period of 5 years. The measure was introduced Jan. 4, 1995, as part of H.R. 8, the "Senior Citizens' Equity Act." The new Republican House leadership intends to present the measure for a vote in the first 100 days of the 104th Congress. On Jan. 19, 1995, the House Committee on Ways and Means held a hearing on H.R. 8.

BACKGROUND AND ANALYSIS

CURRENT LAW

In general, the Social Security and tier one railroad retirement (analogous to social security) benefits of most recipients are not subject to the income tax. A portion of Social Security and tier one railroad retirement benefits is included in taxable income for recipients whose "provisional income" exceeds certain thresholds.

"Provisional income" is adjusted gross income plus one-half the Social Security benefit and otherwise tax-exempt "interest" income (i.e., interest from tax-exempt bonds). The thresholds below which no Social Security or tier one benefits are taxable are $25,000 (single), $32,000 (couple filing joint return) and zero (couple filing separately).

The tax on benefits when income exceeds these thresholds depends on the level of the income. If it is between the $25,000 or $32,000 threshold and a second level threshold of $34,000 (single) or $44,000 (couple), the amount of benefits subject to tax is the lesser of: (1) 50% of benefits; or (2) 50% of income in excess of the first threshold. If income is above the second threshold, the amount of benefits subject to tax is the lesser of:

(1) 85% of benefits or

(2) 85% of income above the second threshold, plus the smaller of (a) $4,500 (single) or $6,000 (couple) or, (b) 50% of benefits.

For couples filing separately, taxable benefits are the lesser of 85% of benefits or 85% of provisional income.

Neither the first nor second level thresholds are indexed to rise with inflation or wage growth.

This tax treatment differs from that of private pension and civil service benefits, in which all benefits that exceed the amount of the employee's contribution are fully taxable. In 1994, about 23% of Social Security recipients paid tax on their benefits.

The proceeds from taxation of Social Security and tier one benefits at the 50% rate are credited to the Social Security trust funds and the railroad retirement system, respectively. Proceeds from taxation of Social Security benefits and tier one benefits at the 85% rate are credited to the Hospital Insurance trust fund of Medicare.

EXAMPLE 1 to the right illustrates how the provision currently works. The taxable portion of a $10,000 annual benefit for a single taxpayer who has $32,000 in adjusted gross income (AGI) is computed thus: First, provisional income is determined (1/2 x $10,000 = $5,000 [one-half of the Social Security benefit], + $32,000 [adjusted gross income] = $37,000). Because it is over the applicable second tier threshold of $34,000, 85% of the difference between provisional income and the second-tier threshold ($37,000 minus $34,000 = $3,000 x 85% = $2,550) is added to the lesser of (a) $4,500 or (b) $5,000 (50% of benefits). In this case $2,550 + $4,500 = $7,050.

If in this example the recipient's adjusted gross income were, say, $28,000, provisional income would be $33,000 (one-half the Social Security benefit [$5,000] plus $28,000 = $33,000. Because this is less than the applicable second tier threshold of $34,000, the amount of benefits subject to tax is the lesser of (a) 50% of benefits ($5,000) or (b) 50% of the difference between provisional income and the first-tier threshold ($33,000 minus $25,000 = $8,000 divided by 2 = $4,000). Because $4,000 is less than one-half of the Social Security benefit, it would be the amount of benefits subject to the income tax. If the recipient's other income were less than $20,000, he would pay no tax on his Social Security benefits because the combination of one-half of his Social Security ($5,000) and his other income would be less than the threshold of $25,000.

                        Example 1: Current Law

Because of the $25,000 and $32,000 thresholds, recipients with low incomes are largely unaffected by the taxation of benefits. Of those affected, the majority have annual incomes of $50,000 or more. TABLE 1 shows, for varying degrees of income, the number and proportion of recipients who are projected to pay taxes on their benefits in 1995, and the amount of taxes they are projected to pay. These are AVERAGES, and do not necessarily indicate the actual tax liability of persons in these income brackets.

          TABLE 1. Effect of Taxing Social Security Benefits

Until 1984, Social Security benefits were exempt from the Federal income tax. The exclusion was based on rulings made in 1938 and 1941 by the Internal Revenue Service (IRS). The reasoning then appeared to be that: (1) the lack of an explicit provision to tax benefits implied that Congress did not intend for them to be taxed; (2) the benefits were intended to be "gifts" made in aid of the general welfare, not annuities; and (3) taxing benefits would defeat the underlying purposes of the Social Security Act.

Under these rules, the treatment of Social Security was similar to that of other types of Government transfer payments (such as Aid to Families with Dependent Children, Supplemental Security Income, and black lung benefits), but in sharp contrast to that of benefits under the Federal Civil Service Retirement System and private pension plans. Benefits from these other pension plans are fully taxable except for the proportion of total lifetime benefits (using projected life expectancy) attributable to the employee's own contributions to the system (and on which he or she had already paid income tax). Both the value of the lifetime contributions and expected benefits are computed in nominal (i.e., current) dollars.

Under social security, the worker's contribution to the system is his or her share, or one-half, of the payroll tax, officially known as the Federal Insurance Contributions Act (FICA) tax. The amount the worker pays into the Social Security system is taxed when earned. The employer's contributions to the system, however, are not considered part of the employee's gross income and can be deducted from the employer's gross business income as a business expense. In other words, neither the employee nor the employer pays taxes on the employer's contribution. Thus, under the old law the benefits resulting from the payment of payroll taxes were not only tax free, but arose from income partially sheltered from taxation.

For years many analysts questioned the basis for the IRS rulings and advocated that the tax treatment of Social Security be the same as for other pension income. The 1979 quadrennial Advisory Council on Social Security debated whether Social Security benefits should be subject to taxation. A majority concluded that the original IRS ruling was wrong and that the tax treatment of private pensions was a more appropriate model for tax treatment of social security. They estimated that the most anyone who entered the workforce in 1979 would pay in nominal payroll taxes during his or her lifetime would equal 17% of the Social Security benefits he or she would ultimately receive. (This was the most any individual would pay; in the aggregate workers would make payroll tax payments amounting to substantially less than 17% of their ultimate benefits.) Because of administrative difficulties involved in determining the taxable amount of each individual benefit, the Council recommended instead that half of everyone's benefit be taxed. They justified this ratio as a matter of "rough justice" and noted that it coincided with the portion of the tax (the employer's share) on which taxes had not been paid.

However, it was only after the Social Security system was threatened with insolvency in the early 1980s that taxing benefits received serious political attention. The 1982 National Commission on Social Security Reform proposed that, beginning in 1984, one-half of Social Security cash benefits and tier I benefits payable under the Railroad Retirement Act be taxable for individuals whose adjusted gross income, excluding Social Security cash benefits, exceeded certain thresholds, with the proceeds of such taxation credited to the Social Security trust funds. The Commission deliberately did not include any provisions for indexing the threshold amounts. It was understood that as nominal incomes rise, as they nearly always have, increasing proportions of Social Security recipients would be affected by the proposal. The Commission's proposal had an obvious "notch" problem, in that the extra dollar of income that would put one over the threshold would have had the effect of subjecting fully one-half of Social Security benefits to taxation. In enacting the 1983 Social Security Amendments (P.L. 98-21), Congress essentially adopted the Commission's recommendation, but substituted an arrangement for determining the amount of benefits to be taxed that imposed the tax on benefits gradually as a person's income rose above the thresholds. Under this arrangement, the amount of taxable benefits was the lesser of one-half of benefits or one-half of the excess of the taxpayer's provisional income (see above) over thresholds of $25,000 (single) and $32,000 (couple).

In subsequent years pressure to solve the Government's mounting fiscal problems led to calls to subject a greater share of benefits to taxation. Many supporters of doing so maintained that Social Security should be treated like private and civil service pensions. In 1990, the Social Security Administration's Office of the Actuary determined that, if these rules were applied to social security, the ratio of total employee Social Security payroll taxes to expected benefits (all in nominal dollars) for current recipients would be, on average, about 4% or 5%. For workers entering the workforce today and for the next decade, the ratio would be, on average, about 7%. Because Social Security benefits replace a higher proportion of earnings of workers who are lower paid and have dependents, and because women have longer life expectancies, the workers with the highest ratio of taxes to benefits would be single, high-paid males. The ratio for these workers entering the workforce today would be 15%.

Strict application of the rules applicable to private and civil service pensions was seen to present practical administrative problems, however. Determining the proper exclusion would be complex; for example, it is possible that several people may receive benefits based on the same worker's account. It was recognized that a simpler and more practical approach would be to approximate the effect of applying private pension rules by subjecting a set percentage of Social Security benefits to the income tax. Taxing 85% of benefits (the portion of benefits on which tax would not have been paid for single, high-paid males) was suggested because it would assure that no one would have a higher percentage of benefits subject to tax than if the tax policy for private and civil service pensions were actually applied.

President Clinton's Proposal

As part of his plan to cut the Federal budget deficit, President Clinton proposed on Feb. 17, 1993, that the proportion of benefits subject to taxation should be increased from 50% to 85%, effective in 1994. His budget document said this would "move the treatment of Social Security and railroad retirement tier I benefits toward that of private pensions." Just as under the law in 1993, only Social Security recipients whose adjusted gross income plus one-half of their benefits exceeded the thresholds of $25,000 (single) and $32,000 (couples) were to pay tax on their benefits. Also as under 1993 law, the first step was to add one-half (not 85%) of benefits to adjusted gross income. However, 85% of the difference between the resulting figure and the thresholds was to be compared to 85% of the Social Security benefits, and the lesser of the two figures was to be the amount of benefits taxed. Structured this way, the measure was meant not to affect recipients currently exempt from paying taxes on benefits.

The proposal was included in his FY1994 budget submitted Apr. 8, 1993. The Joint Committee on Taxation (JCT) projected that it would generate $32 billion in new revenues over 5 years. The proceeds would not have been credited to the Social Security trust funds, as under then current law, but to the Medicare Hospital Insurance program, which has a less favorable financial outlook than does social security. Doing so also would have avoided procedural obstacles that could have been raised in the budget reconciliation process. (For a complete discussion of these procedures, see CRS Report 93-23 EPW, Social Security: Its Removal From the Budget and Procedures for Considering Changes to the Program.)

H.Con.Res. 64, the FY1994 Concurrent Budget Resolution, passed by the House by a vote of 243 to 183 on Mar. 18, 1993, included the additional revenue from the President's proposal. (The budget resolution estimated the increased revenue to be $32.0 billion over 5 years.) The Senate, by a vote of 54 to 45, agreed to H.Con.Res. 64 on Mar. 25, 1993, after inserting in lieu thereof the text of S.Con.Res. 18, the Senate companion measure. The Senate version included an amendment, approved by a vote of 67-32, by Senators Lautenberg and Exon expressing the sense of the Senate that the revenues set forth in the resolution assume that the Finance Committee would make every effort to find alternative sources of revenue before imposing additional taxes on the Social Security benefits of recipients with threshold incomes of less than $32,000 (single) and $40,000 (couples). In other words, under this provision, the proportion of benefits subject to taxation was to increase from 50% to 85% only after an individual's or couple's adjusted gross income plus one-half of Social Security exceeded new thresholds of $32,000 and $40,000. The thresholds for taxing 50% of benefits were to remain at $25,000 and $32,000. Earlier, the Senate rejected by a vote of 47-52 an amendment by Senator Lott that would have deleted from the resolution the revenue projected from the President's proposal.

On Mar. 31, 1993, and Apr. 1, 1993, respectively, the House and Senate approved the conference report on H.Con.Res. 64. It included the sense of the Senate resolution. The Senate Committee on Finance held a hearing on the President's proposal on May 4, 1993. On May 13, 1993, by a party-line vote of 24-14, the House Committee on Ways and Means approved the President's proposal, but modified it so that the additional proceeds would be credited to the General Fund instead of Medicare. This measure was included in H.R. 2264, the 1993 omnibus budget reconciliation bill, passed by the House on May 27, 1993.

Senate Proposal

On June 18, 1993, the Senate Finance Committee approved its version of the budget reconciliation package by a party line vote of 11-9. It included the Lautenberg-Exon amendment creating second-tier thresholds of $32,000 and $40,000. The proposal was projected by JCT to produce revenues of $26.3 billion over 5 years, which would have been credited to Medicare's HI trust fund. About 5.6 million recipients (15%) would have been affected (about two-thirds of the number affected by the House-passed measure). During the markup of the package, the Committee rejected an amendment by Senator Grassley to strike all tax increases on Social Security benefits.

On June 24, 1993, the Senate approved (50 to 49) the budget reconciliation bill. It included the increase in the taxation of benefits as passed by the Finance Committee. During consideration of the bill, the Senate rejected an amendment by Senator Lott to delete the taxation of benefits provision. It also rejected an amendment by Senator DeConcini to increase the 85% thresholds to $37,000 (single) and $54,000 (couple), and an amendment by Senator McCain to direct that the proceeds of increased taxation of benefits be credited to the Social Security trust funds.

On July 14, 1993, the House voted 415-0 to instruct its conferees on the bill to accept the Senate version of benefit taxation.

Conference Agreement and New Law

When the House and Senate versions of the budget package were negotiated in conference, the conferees modified the Senate taxation of Social Security benefits provision by setting the second tier thresholds at $34,000 (single) and $44,000 (couple). The proposal was projected by JCT to produce revenues of $24.6 billion to the HI trust fund over 5 years and affect 13% (about 5 million) of Social Security recipients. The measure was included in the final version of the reconciliation bill passed by the House on Aug. 5, 1993, by a vote of 218-216. On Aug. 6, 1993, the Senate passed the bill by a vote of 51- 50. President Clinton signed the measure into law (as part of P.L. 103-66) on Aug. 10, 1993. TABLE 2 shows examples of the additional tax liability of recipients in 1994 under P.L. 103-66.

           TABLE 2. Additional Federal Income Tax Liability

   TABLE 3. Distribution of Tax Increases in 1994 Due to P.L. 103-66

TREATMENT OF NONRESIDENT ALIENS United States citizenship is not required for receipt of social security benefits. Aliens may receive benefits provided they have engaged in covered employment and otherwise meet eligibility requirements. However, aliens residing outside the United States are subject to different tax withholding rules. Because the U.S. Government does not know the amount of other income of these individuals on which to base a tax rate, section 871 of the Internal Revenue Code imposes an arbitrary rate of tax withholding (30%) on almost all the U.S. income of nonresident aliens, unless a lower rate is fixed by treaty. Thus, under current law, 30% of 85% of a nonresident alien's social security is subject to income tax withholding (i.e., the thresholds do not apply).

CONTRACT WITH AMERICA PROPOSAL

On Sept. 27, 1994, as part of the "Contract with America," 300 Republican congressional candidates pledged to repeal the OBRA '93 provision gradually, over a period of 5 years. The percentage of Social Security and railroad retirement tier one benefits subject to income tax would drop from 85% to: 75% in 1996; 65% in 1997; 60% in 1998; 55% in 1999, and 50% in 2000. For nonresident aliens, the percentage of benefits subject to income tax withholding would likewise drop gradually to 50 percent. The measure was introduced Jan. 4, 1995, as part of H.R. 8, the "Senior Citizens' Equity Act." The new Republican House leadership intends to present the measure for a vote in the first 100 days of the 104th Congress. On Jan. 19, 1995, the House Committee on Ways and Means held a hearing on H.R. 8. According to the Office of the Actuary at SSA, the effect of this measure would be to reduce revenue to the Medicare HI trust fund by the following amounts:

                Year                     Cost in $bil.

SUPPORT AND OPPOSITION According to the Washington Post, a spokesman for the National Committee to Preserve Social Security and Medicare has stated that the organization favors repeal of the 1993 provision. The American Association of Retired Persons originally opposed enactment of the 1993 law, and has not changed its position. The National Council of Senior Citizens says it would not favor repeal unless a way were found to replace the revenue that would be lost to the Medicare trust fund. The AFL-CIO and the coalition Save Our Security oppose repeal. So do Robert Ball and Robert Myers, former Commissioner and Chief Actuary, respectively, of the SSA.

ARGUMENTS FOR REPEAL

RECTIFYING DELIBERALIZATION

Proponents of repealing the increase in taxation of benefits argue that the provision in the '93 OBRA is unfair and imposes financial hardship because it lowers incomes of those who cannot change past work and savings decisions. They contend that it changes the rules in the middle of the game, with the heaviest impact on older workers and current retirees who made decisions based on old law and who may be living in large part on their social security. Regardless of abstract considerations of tax equity, many recipients regard increased taxation as simply a reduction in the benefits they had been promised. As shown in TABLE 2, the impact can be substantial. For example, a single individual with a $10,000 annual benefit and other income of $35,000 in 1994 pays almost $1,000 more in income taxes than under old law. Also, these increases affect many middle-income people, not just the "rich" such as those who were the target of the marginal income tax rate hikes also included in the '93 OBRA.

SPECIAL NATURE OF SOCIAL SECURITY

Proponents of repeal argue that Social Security should not have been included in deficit reduction measures because it is different from other Government programs. First, Social Security has its own source of funding, the payroll tax. Second, far from contributing to the budget deficit, Social Security is running surpluses and is projected to do so for another two decades. Third, Congress officially has taken Social Security out of the budget, in large part to isolate the program from budgetary pressures, based on widespread agreement that it is wrong to change its revenues or benefits because of concern about a budget deficit that is really caused by the underfinancing of general fund programs. They say that this concern has been validated by the new law crediting revenues not to social security, but to Medicare. It is argued that Medicare's problems should be solved by constraining medical costs or reforming health care, not by taxing Social Security beneficiaries.

Some opponents go further and argue that, even if Social Security were not accumulating surpluses, it would be wrong to make changes to the program based on budgetary concerns. They maintain that Social Security is unique because it is a "social contract" across generations, in which citizens have paid into the system over their working lives in exchange for promised benefits. They say that changes to these benefits should not be made because of problems that lie outside the Social Security system, but only for sound programmatic reasons.

Opponents also object to the argument that taxing benefits is the best way to align benefits with need. They dislike the concept of indirect means testing because it makes Social Security appear more like welfare, where need determines the level of benefits. They dispute that Social Security and private pensions are analogous, saying that they serve different purposes. They assert that, as the country's only national social insurance system, which provides a bedrock level of protection to nearly all workers and their families from loss of income due to the death, retirement, or disability of the worker, Social Security is special and should be so treated.

EFFECT ON MARGINAL TAX RATES AND INCENTIVES TO WORK

While some critics see the '93 provision as a benefit reduction, others see it as merely an increased tax. To them it is not a decrease in Government spending, but a revenue raiser.

As a tax increase, they say it exacerbates a problem that already existed under the law: distortions of marginal income tax rates. For example, the pre-1993 provision has the effect of increasing the marginal tax rate by at least 50% for additional income that falls between the first tier thresholds ($25,000 or $32,000) and the point at which fully one-half of benefits is taxable. The reason is that for each dollar earned above the threshold amount, $1.50 becomes subject to tax. Thus, on that extra dollar of income, the effective marginal tax rate is 50% higher (e.g, 15% becomes 22.5%, and 28% becomes 42%). Once fully one-half of the benefit becomes taxable, however, each extra dollar of income is taxed only at the marginal rate in the bracket into which it falls. This distortion is heightened under the new law because its effect is to subject $1.85 to tax for each dollar earned above the second tier threshold amount (e.g., 15% becomes 27.75%, and 28% becomes 51.8%). This effect on marginal income tax rates is shown by CHART 1. As it illustrates, there is a large bulge in the effective marginal income tax rates between the threshold where Social Security benefits become taxable and the point where they have been taxed to the limit allowable.

CHART 1. MARGINAL TAX RATES ON ADDITIONAL INCOME UNDER NEW LAW

[chart omitted]

Thus, some critics argue that this approach grossly distorts the progressive tax structure, discriminates against those with higher incomes, and is a strong disincentive to work, save, and invest.

Proponents of repeal say the 1993 law particularly discourages work effort when its interaction with the Social Security earnings test is included. Under this test, if a beneficiary under age 70 has earnings from work that exceed an annual exempt amount ($11,280 for recipients age 65 through 69, and $8,160 for those under age 65, in 1995), his or her benefits are reduced. For recipients under age 65, $1 of the Social Security benefit is withheld for every $2 of the "excess" earnings. For those ages 65-69, $1 is withheld for every $3 of excess earnings. Another way of looking at it is that each dollar of income above the exempt amount reduces a dollar of benefits by 50% (33% for those ages 65-69). The earnings test applies only to earned income and not to savings, investments, and the like.

A frequent criticism of the earnings test is that it often creates a strong financial disincentive to work, or to increase work effort beyond minimal levels. There is a strong disincentive to work if earnings would cause a beneficiary not only to lose a portion of his benefits but also to become liable for payment of income taxes for all or part of his remaining Social Security as well.

Actually, the combination of the Social Security earnings test and the taxing of benefits provision has a smaller effect on marginal INCOME tax rates than just the taxing benefit provision alone. The reason is that the earnings test, by reducing benefits for each extra dollar earned, automatically decreases the amount of Social Security benefits that can be taxed. In other words, the two "taxes" are not additive. The interactive effects are complicated (see CRS Report 89- 40 EPW, Social Security: Issues in Taxing Benefits Under Current Law and Under Proposals To Tax a Greater Share of Benefits). Nevertheless, under some scenarios the effect of additional income from work is to increase the effective marginal tax rate (retirement test plus Federal, State, and local income taxes and Social Security taxes) to over 100%, so that the individual loses money from working.

ARGUMENTS AGAINST REPEAL

THE FINANCIAL PERSPECTIVE

Support for the '93 OBRA provision derives to a large degree from the need to manage the Government's fiscal problems and to shore up Medicare's imminent financial problems. Under projections contained in the 1994 report of the Social Security Board of Trustees, the HI trust will become insolvent in 2001. The loss of the revenue generated by repeal of the '93 OBRA provision would make this problem worse. The long-range effects also would be substantial. Over the next 25 years, it would lose revenue equal to between 0.2 and 0.3% of taxable payroll. (Taxable payroll is the amount of earnings in the economy subject to the HI tax; it is used in long-range forecasts because projected wage and price growth renders costs expressed in dollar terms essentially meaningless.) The effect would be larger in subsequent years because over time larger proportions of recipients will have income higher than the non-indexed thresholds.

In the nearer term, the '93 provision helps satisfy the need to solve the Government's overall fiscal problem. The call today is for sacrifice in order to reduce the gap between the Government's income and its outgo. As Social Security constitutes 20% of what the Government spends, many believe that it must share in putting the Government's fiscal house in order. In contrast, at the time the Bureau of Internal Revenue made its rulings on the tax-free status of benefits in 1938 and 1941, it was estimated that the resulting revenue loss was only $3 to $4 million per year, even then a modest sum.

TAX EQUITY

Economic theory generally supports the idea of treating Social Security benefits similarly to other retirement income. Because equal income, regardless of source, theoretically represents equal ability to pay taxes, it is considered unfair to confer an advantage on one source of income over another. From this perspective, income is income and should be equally taxed (thus, many adherents would go further than merely raising the proportion of benefits that are taxable, i.e., they see no logical reason for the $25,000 and $32,000 thresholds). From this point of view, exclusions from the tax base produce inequities. Besides the instance where two individuals have the same total income but pay different taxes because one has more Social Security income than the other, there is the instance where exclusion of Social Security from progressive taxation is worth relatively more to those who, because of other taxable income, are in higher tax brackets. Put another way, many people think it is unacceptable that even millionaires get to exclude part of their Social Security benefits from the income tax.

In the same vein, they say it is unfair that Social Security recipients pay substantially less taxes than do current workers, especially when payroll taxes are included. Chart 2 contains illustrations that compare the total Federal tax burden (income and payroll taxes) of retired versus working couples under current law. It shows, for example, a retired elderly couple with an income of $30,000 ($13,000 of which is social security) pays Federal taxes that are about one-eighth of the Federal taxes paid by a working couple with $30,000 in earnings. Chart 3 portrays the situation of these couples if the '93 provision is repealed. It shows that even at higher income levels (e.g., $60,000) a retired couple could pay about one-half the Federal taxes a working couple pays. Put another way, proponents of the '93 provision point out that most Social Security recipients pay a much lower EFFECTIVE rate of tax (tax as a proportion of total income) than do other taxpayers, especially workers. The fact that recipients can face higher MARGINAL tax rates across certain bands of income is not because benefits are taxable, but because they are not taxable below the thresholds.

CHART 2. TOTAL FEDERAL TAX BURDEN UNDER CURRENT LAW

[chart omitted]

CHART 3. TOTAL FEDERAL TAX BURDEN UNDER PROPOSED REPEAL

[chart omitted]

ALIGNMENT OF BENEFITS WITH NEED

Proponents of the '93 OBRA provision say that if Social Security should be included in efforts to control the costs of "entitlements," taxation of benefits is the most equitable and effective way to do so. They point out that many advocates of reducing Government spending usually try to structure their proposals so that the poor and/or lower middle-income recipients are protected from benefit cuts. When developing the details of how to accomplish this, they often conclude that the income tax system is the easiest and most effective way to protect the less well-off from loss of income.

A variation of this perspective is that benefit cuts should be concentrated on those most able to afford them. By concentrating more of the burden on higher income households, taxing benefits more fully aligns them better with "need" than would broader measures that would also affect the poor (such as cutting the annual cost-of-living- adjustment). Thus, many regard taxation of benefits as an indirect "means test," but without the cumbersome and intrusive administrative process a direct means test would entail. From this point of view, taxing benefits is seen not as a tax increase, but as a de facto reduction in benefits scaled to bear most heavily on better-off recipients.

LEGISLATION

H.R. 8 (THE SENIOR CITIZENS' EQUITY ACT)

Amends the Social Security Act to increase the earnings limit, amends the Internal Revenue Code to repeal the increase in the tax on Social Security benefits and provides incentives for the purchase of long-term care insurance. Introduced Jan. 4, 1995; referred to Committee on Ways and Means.

H.R. 159 (SOLOMON)

Amends the Internal Revenue Code to provide that tax-free interest not be taken into account in determining the amount of social security benefits included in gross income. Introduced Jan. 4, 1995; referred to Committee on Ways and Means.

S.50 (LOTT)

Repeals the increase in the tax on Social Security benefits. Introduced Jan. 4, 1995; referred to Committee on Finance.

CONGRESSIONAL HEARINGS, REPORTS, AND DOCUMENTS

U.S. Congress. House. Committee on Finance. Taxation of Social Security Benefits. Hearing. May 4, 1993. 103rd Congress, 1st session, U.S. Govt. Print. Off., Washington, 1993. 112 p.

"Serial No. 103-316"

U.S. Congress. House. Committee on the Budget. Omnibus Budget Reconciliation Act of 1993, Conference Report No. 103-213. August 4, 1993. 103rd Congress, 1st session, U.S. Govt. Print. Off., Washington, 1993. 976 p.

FOR ADDITIONAL READING

U.S. Library of Congress. Congressional Research Service. Social Security: Issues in taxing benefits under current law and under proposals to tax a greater share of benefits, by Geoffrey Kollmann. [Washington] 1989. 60 p.

CRS Report 89-40 EPW

-- Determination of taxable Social Security benefits under new law, by Geoffrey Kollmann. [Washington] 1993. 2 p.

CRS Report 93-336 EPW

-- Social security: Its removal from the budget and procedures for considering changes to the program, by David Koitz. [Washington] 1993. 10 p.

CRS Report 93-23 EPW