Social Security: Taxation of Benefits

Order Code RL30581

CRS Report for Congress

Received through the CRS Web

Social Security: Taxation of Benefits

Updated September 9, 2003

Geoffrey Kollmann

Specialist in Social Legislation

Domestic Social Policy Division

Congressional Research Service ˜ The Library of Congress

Social Security: Taxation of Benefits

Summary

Until 1984, Social Security was exempt from the federal income tax. For years

many analysts advocated that it be treated like other pensions, whose benefits are

fully taxable except for the portion attributable to the worker’s contributions. To

help restore the program’s solvency, in 1983 Congress made up to 50% of benefits

taxable for taxpayers whose income plus 50% of their benefit exceeds $25,000 for

individuals or $32,000 for couples. The proceeds are credited to the Social Security

trust funds. In 1993, President Clinton proposed that up to 85% of Social Security

benefits be taxable (the proportion said to be the least anyone would pay under the

rules applying to other pensions). The 1993 omnibus budget reconciliation bill (P.L.

103-66) limited the measure to recipients whose threshold incomes exceed $34,000

(single) or $44,000 (couples), with proceeds from this measure going to Medicare.

Repeal of the 1993 provision was part of the Republican “Contract with

America,” and was approved by the House of Representatives as part of the omnibus

budget reconciliation bill (H.R. 2491) but was not included in the final law.

Subsequently, with Social Security again facing long-range financing problems,

proposals have been made to increase taxation of benefits further. The 1994-1996

Advisory Council on Social Security recommended that taxation of benefits should

be increased, as did two bills in the 105th and 106th Congresses. There also continues

to be pressure to repeal or mitigate the effects of the taxation of Social Security

benefits. In the 106th Congress, 15 bills were introduced that would reduce taxes on

benefits. In 2000, the House approved H.R. 4865, which would have repealed the

1993 provision, thus lowering the maximum amount of benefits subject to taxation

from 85% to 50%, and would have replaced the resulting reduction in revenue to

Medicare with general fund transfers. In the 107th and 108th Congresses, 12 and 14

bills, respectively, have been introduced that would liberalize the taxation provision.

Proponents of repeal argue that taxation of benefits is unfair, as it changed the

rules in the middle of the game, penalizing recipients who relied 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 it grossly distorts marginal tax rates and provides a strong disincentive

for many recipients to work.

Opponents of repeal argue that it would be a giveaway for well-off recipients

that would weaken the Social Security and Medicare trust funds. It would enlarge

an inequitable tax advantage for Social Security benefits, especially when the aftertax income of recipients is compared to that of working families with the same gross

income. Moreover, they say that if benefits must be cut to restore solvency to Social

Security and Medicare, taxing benefits is the most equitable and efficient way to

implement de facto benefit reductions. They say that taxing benefits concentrates

more of the burden on higher income households, and thus better aligns benefits with

need, than would broader measures that would also affect poorer recipients.

Contents

Current Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Effect on Recipients and Trust Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

P.L. 103-66 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Treatment of Nonresident Aliens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Proposed Changes in Taxation of Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Contract with America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Recent Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Legislation in the 107th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Legislation in the 108th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Arguments for Taxation of Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

The Financial Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Tax Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Alignment of Benefits with Need . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Arguments Against Taxation of Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Deliberalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Special Nature of Social Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Effect on Marginal Tax Rates and Incentives to Work . . . . . . . . . . . . . . . . 13

List of Figures

Figure 1. Total Federal Tax Burden Under Current Law . . . . . . . . . . . . . . . . . . 11

Figure 2. Marginal Tax Rates on Additional Income . . . . . . . . . . . . . . . . . . . . . 14

List of Tables

Table 1. Effect of Taxing Social Security Benefits Under Current Law by Income

Class, 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Table 2. Additional Federal Income Tax Liability in 2003

Under P.L. 103-66 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Social Security: Taxation of Benefits

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.

However, up to 85% of Social Security and tier one Railroad Retirement benefits can

be included in taxable income for recipients whose “provisional income” exceeds

certain thresholds.

“Provisional income” is adjusted gross income, but modified to include

otherwise tax-exempt “interest” income (i.e., interest from tax-exempt bonds), plus

one-half the Social Security benefit. The thresholds below which no Social Security

or tier one benefits are taxable are $25,000 (single), $32,000 (couple filing joint

return) and $0 (couple filing separately).

The tax on benefits when provisional income exceeds these thresholds depends

on the level of the provisional 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 and public pension benefits, in

which all benefits that exceed the nominal amount (i.e., actual dollars unadjusted for

inflation or interest) of the employee’s contribution are fully taxable. It was

projected that about 32% of Social Security recipients paid income tax on their

benefits in 2000.

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

CRS-2

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 below 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 is computed thus: First, provisional income is determined (½ x

$10,000 = $5,000 [one-half of the Social Security benefit], + $32,000 [adjusted gross

income] = $37,000). Because this amount is over the second-level threshold of

$34,000, 85% of the difference between provisional income and the second-level

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.

Example 1: Current Law

Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $32,000

½ of benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +5,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000

Less current law exempt amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -25,000

Excess . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Taxable benefits based on first threshold . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

(lower of 50% of excess,

50% of benefits, or $4,500)

85% of excess above

second threshold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,550

[$37,000 - $34,000) x 85%]

Total benefits taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,050

(taxable portions above first

and second thresholds, or

85% of benefits, if lower)

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 sum is less than the applicable second level

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-level 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, $4,000 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.

CRS-3

Effect on Recipients and Trust Funds

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 levels of income,

the number and proportion of recipients who were estimated to pay taxes on their

benefits in 2000, and the amount of taxes they were 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

Under Current Law by Income Class, 2000

Number of

SS

recipients

(in

thousands)

Number

affected by

taxation of

benefits

(in

thousands)

Percent of

recipients

affected by

taxation of

benefits

Aggregate

amount of

taxes on

benefits

(in millions)

Less than $10,000

7,157

2

0%

0

$10,000 to $15,000

4,845

7

0%

$2

$15,000 to $20,000

3,509

12

0%

$4

$20,000 to $25,000

3,439

22

1%

$14

$25,000 to $30,000

2,854

360

13%

$48

$30,000 to $40,000

5,225

2,237

43%

$650

$40,000 to $50,000

3,918

3,598

92%

$1,948

$50,000 to $100,000

6,705

6,608

99%

$9,424

$100,000 and more

2,737

2,723

100%

$7,386

All

40,390

15,569

39%

$19,476

Level of individual

or couple incomea

Source: Congressional Budget Office, based on the Current Population Survey (CPS).

Note: Aggregate benefits, recipients and revenues are understated by about 10% because of benefits

paid abroad, deaths of recipients before March interview, and exclusion of institutionalized recipients.

a

Cash income (based on income, including Social Security, of tax filing unit), plus capital gains

realizations.

History

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

CRS-4

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 some

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 retirement benefits under private pension plans, the Federal Civil

Service Retirement System (CSRS), and other government pension systems.

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. Using nominal dollars excludes the effects of

inflation or interest, typically making a large portion of these benefits taxable (e.g.,

usually more than 90% of a CSRS benefit is fully taxable).

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 as income when earned. The employer’s contributions to the system,

however, are not considered part of the employee’s gross income and are deductible

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 income 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

CRS-5

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 public pensions. In 1990, the Social Security Administration’s Office of the

Actuary determined that, if these pension tax 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 tax rules for private and public 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 ensure

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. It also would

ensure that no one was taxed twice on the same income (i.e., no “double taxation”).

P.L. 103-66

As part of his plan to cut the federal budget deficit, President Clinton proposed

on February 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 then current law, only Social Security

recipients whose provisional income (modified adjusted gross income plus one-half

of their benefits) exceeded the thresholds of $25,000 (single) and $32,000 (couples)

CRS-6

were to pay tax on their benefits. Also as under current 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 President Clinton’s FY1994 budget. 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 avoided possible

procedural obstacles (budget points of order that can be raised regarding changes to

the Social Security program in the budget reconciliation process). This measure was

included in the 1993 Omnibus Budget Reconciliation Act (OBRA) passed by the

House on May 27, 1993.

The Senate version of the bill adopted the 85% measure, but imposed it only

after an individual’s or couple’s AGI plus one-half of Social Security exceeded new

thresholds of $32,000 and $40,000. 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 level thresholds

at $34,000 (single) and $44,000 (couple). At that time, the proposal was projected

by the Joint Committee on Taxation to produce revenues of $24.6 billion to the HI

trust fund over 5 years, and affect about 13% (about 5 million) Social Security

recipients.1 On August 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 August 10,

1993. Table 2 shows examples of the additional tax liability of recipients in 2003

under P.L. 103-66.

Table 2 also can be used to illustrate the reduction in tax liability that would

occur if the 1993 provision were repealed, effective in 2003.

1

In 2003, the Congressional Budget Office estimates that about 23% of Social Security

recipients (almost 11 million people) are now affected by the 1993 provision, i.e., pay at

least part of the tax on their Social Security benefits at the 85% level.

CRS-7

Table 2. Additional Federal Income Tax Liability in 2003

Under P.L. 103-66

Annual Social Security benefits

$5,000

$10,000

Other incomea

$15,000

$20,000

$25,000

Additional tax liabilityb

Single Filers

$20,000

—

—

—

$25,000

—

—

—

$30,000

—

$52.50

$198.75

$35,000

$472.50

$945.00

$1,140.75

$40,000

$472.50

$945.00

$1,417.50

$50,000

$472.50

$945.00

$1,417.50

$75,000

$517.50

$1,050.00

$1,575.00

$100,000

$525.00

$1,050.00

$1,575.00

c

d

c

d

c

d

c

d

c

d

c

d

c

d

c

d

Joint filerse

$20,000

—

—

—

—

—

$25,000

—

—

—

—

—

$30,000

—

—

—

—

—

$35,000

—

—

—

$52.50

$183.75

$40,000

—

$127.50

$221.25

$315.00

$446.25

$50,000

$262.50

$525.00

$787.50

$1,482.00

$2,254.50

$75,000

$472.50

$945.00

$1,417.50

$1,890.00

$2,362.50

$100,000

$472.50

$945.00

$1,417.50

$1,890.00

$2,362.50

a

Adjusted gross income excluding Social Security, and assuming no tax-free interest is received.

Individuals are assumed to be age 65 or older and use the standard deduction. Illustrations do not

show the effect of the tax cuts enacted later in the year.

c

Very few single individuals currently receive this level of benefits.

d

Virtually no single individual currently receives this level of benefits.

e

Does not include those who might choose to file separately.

b

Because the new law incorporated both old and new rules, the computation of

total taxable benefits can be complicated. (For a detailed explanation of how the

taxable portion of benefits is computed, see archived CRS Report 93-336,

Determination of Taxable Social Security Benefits Under New Law: A Fact Sheet,

by Geoffrey Kollmann.)

CRS-8

Treatment of Nonresident Aliens

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, 30% of 85% of a nonresident alien’s Social

Security is subject to income tax withholding (i.e., the thresholds do not apply).

Proposed Changes in Taxation of Benefits

Contract with America

During the 1994 Congressional campaign, Republican leaders pledged that if

they gained control of the House of Representatives they would enact certain

measures contained in a “Contract with America.” One such measure promised to

repeal the OBRA 1993 provision over a period of 5 years. For nonresident aliens, the

percentage of benefits subject to income tax withholding would likewise drop

gradually to 50%. The measure was included in the version of the 1995 omnibus

budget reconciliation bill (H.R. 2491) approved by the House, but not in the Senate

version, and was not included in the conference agreement or final bill.

Recent Proposals

Subsequently, with Social Security again facing long-range financing problems,

proposals have been made to increase taxation of benefits further. Although the

1994-1996 Advisory Council on Social Security could not agree on a common

solution to Social Security’s long-range financing problems, splitting into three

factions, it did recommend that the income thresholds be eliminated, and two of the

factions also recommended that all benefits in excess of contributions be taxable.

Bills to restore solvency to the system introduced by Senator Moynihan (S. 1792 in

the 105th, and S. 21 in the 106th, Congress) also proposed full taxation of benefits.

There also continues to be pressure to repeal or mitigate the effects of the

taxation of Social Security benefits. In the 106th Congress, 15 bills were introduced

that would liberalize the taxation provision. On July 13, 2000, during consideration

of H.R. 8, the Death Tax Elimination Act, the Senate adopted (58-41) an amendment

by Senator Grams that would have repealed the 1993 provision effective in 2001.

However, this amendment was later dropped in order to make the Senate version of

the bill identical to the House version.

On July 19, 2000, the Committee on Ways and Means approved H.R. 4865, a

bill that, effective in 2001, would have repealed the 1993 provision, thus restoring

the maximum amount of benefits subject to taxation to 50%, by a vote of 22-15. For

nonresident aliens, the percentage of benefits subject to income tax withholding

CRS-9

likewise would drop gradually to 50%. Preliminary estimates were that about 20%

(about 9 million) of Social Security recipients would have been affected by the bill.

The loss of revenue to the Medicare trust funds this would produce was estimated to

be $44.6 billion over 5 years. To compensate, the bill provided that an amount equal

to what the 1993 provision would have generated would be calculated by the

Treasury Department and such amount would be credited to the HI trust fund through

a permanent appropriation from the general fund. On July 27, 2000, the House

approved H.R. 4865 by a vote of 265 to 159. A Democratic alternative, which would

have raised the thresholds at which the 85% taxation applies to $80,000 (single) and

$100,000 (couple), with the general fund reimbursing the HI trust fund for the

resulting foregone revenue, was rejected by a vote of 169-256. The tax reductions

in this proposal would have applied only in years when the non-Social Security and

Medicare surplus (i.e., the budget surplus excluding Social Security and Medicare),

was adequate to cover the general fund reimbursement of the HI trust fund.

Legislation in the 107th Congress. In the 107th Congress, 12 bills were

introduced that would have altered the taxation of Social Security benefits. Seven

(H.R. 122, H.R. 192, H.R. 1018, H.R. 2548, H.R. 4789, H.R. 5568, and S. 237)

would have repealed the 1993 provision, returning the maximum amount that can be

subject to taxation to 50% of benefits. Three, H.R. 1532, H.R. 4790, and S. 181,

would have also repealed the 1983 provision, and thus would have restored the

original tax-free status of Social Security benefits. H.R. 2106 would have increased

the thresholds at which up to 85% of the benefit begins to be taxed by raising them

to $80,000 and $100,000, respectively. H.R. 209 would have excluded income from

municipal bonds from the computation of how much of the benefit is taxable.

Legislation in the 108th Congress. In the 108th Congress, 14 bills have

been introduced that would alter the taxation of Social Security benefits. H.R. 133,

(King), H.R. 378, (Musgrave), H.R. 423, (Paul), H.R. 434, (Sam Johnson), H.R. 860

(Toomey), H.R 2439 (Weldon), S. 514 (Bunning), and S. 767 (Gordon Smith) would

repeal the 1993 provision, returning the maximum amount that can be subject to

taxation to 50% of benefits. H.R. 424 (Paul), H.R. 1897 (Weiner), H.R. 2346 (T.

Franks) and S. 1026 (Shelby) would exempt all Social Security benefits from the

income tax. H.R. 202 (Rep. Stupak), would provide an annual adjustment to the

$25,000, $32,000, $34,000 and $44,000 thresholds so that they would rise in

proportion to inflation. H.R. 2072 (M. Foley), would “eliminate the marriage

penalty” by raising the thresholds for married couples from $32,000 and $44,000 to

$50,000 and $68,000, respectively (i.e., it would make the thresholds for couples

exactly twice those of single individuals). Although it would not affect the taxation

of Social Security benefits, S. 397 by Sen. Ensign would make the Social Security

payroll taxes workers pay tax deductible. One result of doing so would be to mitigate

the argument that taxation of benefits is “double taxation.”

On March 25, 2003, during consideration of tax-cutting measures in the FY2004

budget resolution, the Senate rejected by a vote of 51 - 48 an amendment by Senator

Bunning that would have increased tax cuts by $146 billion over ten years to make

room for repeal of the 1993 taxation of benefits provision.

CRS-10

Arguments for Taxation of Benefits

The Financial Perspective

Those who oppose full or partial repeal of taxation of benefits refer to the large

loss of income that this would impose on Social Security and Medicare. They point

out that it was the projected loss to Medicare of $46 billion over 10 years that led the

Senate and conferees to reject the House measure in the 1995 OBRA bill. The 2003

report of the HI Board of Trustees projects that the HI trust fund will become

insolvent in 2026. The loss of the revenue — $53 billion in the next 5 years, $151

billion in the next 10 years — that would be caused by repealing the 1993 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 above the non-indexed thresholds. They also express

concern that replacing the income from taxing benefits with general revenue

appropriations would weaken the Medicare program. They argue that financing the

program with a dedicated tax is more reliable and buttresses the conception that

Medicare is an “earned right.” They argue that using a general revenue appropriation

weakens this link and makes the program look more like welfare. They also express

fear that the permanent loss of the revenue to the government caused by repeal of the

1993 provision, especially when combined with other recent tax cuts and spending

increases, would expand budget deficits to unsupportable heights.

In addition to the HI trust fund losses, the revenue loss to Social Security also

would be substantial if the taxation of benefits were totally repealed — $80 billion

in the next 5 years, $211 billion (not including interest) over the next 10 years. Over

the next 75 years, it would lose revenue equal to 0.7% of taxable payroll, thus

increasing Social Security’s long-range deficit by 36%.

Many supporters of benefit taxation say that, if anything, taxation should be

increased, not reduced. If Social Security benefits were taxed in the same manner as

private pensions, the long-range financing problem would be reduced by about 20%.

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 income thresholds, and they point out that eliminating these thresholds

would eliminate the distortion in marginal tax rates they cause — see below. 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

CRS-11

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 would get

to exclude all or 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 tax than do current workers, especially when Social Security and

Medicare taxes under the Federal Insurance Contributions Act (FICA) are included.

Chart 1 contains illustrations that compare the total federal tax burden (income and

FICA taxes) of retired versus working couples under current law. It shows, for

example, that a retired elderly couple with an income of $30,000 ($15,000 of which

is Social Security) pays no federal taxes, whereas a working couple with $30,000 of

earnings pays $4,008. A retired elderly couple with an income of $50,000 ($15,000

of which is Social Security) pays about 35% of the federal taxes paid by a working

couple with $50,000 in earnings. Because most states do not tax Social Security and

many grant extra exclusions for pension income and additional exemptions for the

elderly, this disparity is larger when state income taxes are included. If the 1993

provision is repealed, critics say, the advantage higher-income Social Security

recipients would receive relative to workers would be even greater.

Figure 1. Total Federal Tax Burden Under Current Law

$16,000

$14,168

Retired Couple

$14,000

Working Couple

FIC A

$12,000

$8,618

$10,000

$7,692

$8,000

FIC A

$6,000

$4,008

$4,793

$3,045

$4,000

$2,000

$8,813

FICA

$0

$1,793

$0

$30,000

$50,000

$70,000

Annual Income

Retired couple receives $15,000 annually in Social Security benefits. All income of

working couple is from earnings. Each couple takes the standard deduction — retired

couple takes the additional standard deduction for the elderly. Figures are for 2003.

CRS-12

Alignment of Benefits with Need

Proponents say that, if Medicare and Social Security’s long-range financing

problems are to be addressed in part by selective benefit cuts, taxation of benefits is

among the most equitable and effective ways 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.

Arguments Against Taxation of Benefits

Deliberalization

Opponents of taxation of benefits argue that it 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, today a single individual with

a $10,000 annual benefit and other income of $35,000 pays $945 more in income

taxes than he or she would had the 1993 provision not been enacted. Also, these

increases affect many middle-income people, not just the “rich.”

Special Nature of Social Security

Opponents argue that Social Security is different from other government

programs. 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 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

CRS-13

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. To them, the 1993 provision was simply a measure designed

specifically to reduce the budget deficit.

Effect on Marginal Tax Rates and Incentives to Work

Some critics see taxation of benefits as a benefit reduction; others see it as

merely an increased tax. As a tax increase, they say it greatly distorts 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

level 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., 10% becomes 15%, 15% becomes

22.5%, and 27% becomes 40.5%). Under the 1993 provision, for income above the

second level thresholds the effect is to subject $1.85 to tax for each dollar earned

above the second level threshold amount (e.g., 10% becomes 18.5%, 15% becomes

27.75%, and 27% becomes 49.95%). Once fully 85% 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 effect on marginal income tax rates is shown by Chart 2.

As it illustrates, there are large and erratic changes 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.

Figure 2. Marginal Tax Rates on Additional Income

Percent

60

50

40

30

20

10

0

$0

$5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000

Non-Social Security Income

Note: Age 65 Individual with $10,000 Annual Social Security Benefit

CRS-14

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.

Opponents say the 1993 law particularly discourages work effort when its

interaction with the Social Security earnings test is included. The earnings test

reduces the benefits of recipients who earn income from work above a certain sum

(the “exempt amount”). With modifications, this “earnings test” has been in place

since the beginning of the program, but, effective in 2000, it no longer applies to

individuals when they attain the full retirement age.2 For recipients below the full

retirement age, the law provides that recipients who will not attain the full retirement

age in 2003 may earn up to $11,520 a year in wages or self-employment income

without having their benefits affected. For earnings above these amounts, recipients

lose $1 of benefits for each $2 of earnings. There is a different reduction factor and

exempt amount in the year recipients attain the full retirement age. In 2003, these

individuals can earn up to $30,720 a year in the months before they attain the full

retirement age. For earnings above these amounts, they lose $1 in benefits for each

$3 of earnings. Another way of looking at it is that each dollar of income above the

exempt amount reduces a dollar of benefits by 50% (in the year a person attains the

full retirement age, the reduction is 33% for months before attainment). 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 benefit 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 of 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 archived CRS Report 89-40, 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 (earning

test plus federal, state, and local income taxes and Social Security taxes) to over

100%, so that the individual loses money from working.

2

For more on the earnings test and proposals to liberalize or eliminate it, see CRS Report

98-789, Social Security: Proposed Changes to the Earnings Test, by Geoffrey Kollmann,

updated regularly.