Net marginal social security tax rates over the life cycle.

INTRODUCTION

In an exhaustive and influential study, Feldstein and Samwick (1992) document a substantial variation in net marginal social security tax rates across age, sex, dependency status, retirement plans and income. Although workers generally face the same statutory tax rate over their lifetimes, the complex rules governing the relationship between benefits and tax payments result in large differences in the net marginal tax rate, which is the difference between statutory tax rates and the additional benefits associated with an additional dollar of earnings. (1) This paper focuses on one of their most striking results: younger workers in 1990 faced considerably higher net marginal tax rates than older workers. In their benchmark case, Feldstein and Samwick find that for single men, the net marginal tax rate was 6.7 percent at age 25, but only 2.3 percent at age 60, a gap of 4.4 percentage points. The gap was even greater for single women (5.0) and men with dependent spouses (5.7). (2) Feldstein and Samwick's empirical conclusions led them to suggest adjusting statutory tax rates to equalize the net marginal tax rates faced by younger and older workers.

Although disparate treatment of younger and older workers under the Social Security Program raises a number of policy issues, Feldstein and Samwick's focus on differences in marginal tax rates reflects a concern over the potential for labor supply distortions. A pattern of high net marginal tax rates on younger workers and lower tax rates on older workers could affect the allocation of work effort within households and may affect the allocation of work effort over a worker's lifetime. These labor supply distortions would remain a policy concern even if intergenerational distribution effects were mitigated by the presence of altruistically linked households. (3)

This paper reexamines how net marginal tax rates vary with age in light of a number of significant changes that have occurred over the ten years since Feldstein and Samwick's study. First, since the time of their study, estimated survival rates have increased. Because younger workers are more likely to survive to retirement age, this has differentially increased expected marginal retirement benefits to younger workers. Second, the scheduled phase-in of the higher retirement age (from age 65 to age 67) has progressed through the age brackets. The higher retirement age has begun to be applied to older workers, lessening one source of the disparity in net marginal tax rates. Finally, and most significantly, the Disability Program, which Feldstein and Samwick's study ignores, has grown dramatically. (4) Marginal benefits rates under the Disability Insurance program turn out to be higher for younger workers than for older workers. Including Disability Insurance taxes and benefits serves to make the profile of net marginal Social Security tax rates significantly more equal across age groups.

Perhaps the most significant finding of this study is that marginal benefit rates under the Disability Insurance program are much higher for younger workers relative to older workers. Two key features of the Disability Insurance program account for this somewhat surprising result. First, disability awards are based not on the level of contributions in the year of disability, but on all contributions up to the time of disability. Second, disability awards and benefits last only up to retirement age. These features mean that additional income earned by 25-year-old workers has a contingency value for any disability award over the subsequent 40 years. Income earned by 55-year-old workers only influences the level of awards made in the subsequent ten years. The value of disability payments is higher for the young simply because they are more likely to receive those benefits. (5) Further, workers who receive disability awards while young are more likely to remain on disability rolls for lengthy time periods. The length of disability spells for older workers is limited to the years until retirement. The expected time on disability for a 25-year-old worker is approximately four times that of a 55-year-old worker. (6)

Basing Disability Insurance benefits on the worker's average earnings further increases marginal benefit rates faced by the young. Additional earnings of younger workers can have dramatically larger effects on average income and, hence, larger effects on the level of benefits. If benefits are based on five years of earnings, each additional dollar of earnings raises average earnings by 20 cents. For an older worker with benefits based on 35 years of earnings, each additional dollar of earnings raises average earnings by less than three cents. Disability awards while young are, therefore, much more sensitive to the level of contributions in each year. In summary, the marginal benefit of Disability Insurance contributions is greater for the young because they have a greater chance of eventually receiving benefits, they have a greater chance of remaining disabled for lengthy time periods, and their contributions can have a greater effect on the actual level of benefits.

The first section of the paper reviews the tax and benefit rules for the OASI and DI programs. The second section derives an approximation for the marginal retirement and disability benefits from covered Social Security earnings. The third section focuses on how including the DI program reduces the age gap in net Social Security tax rates and the fourth section focuses on the effects of projected declines in mortality rates. The final section estimates how marginal tax rates will evolve over the years 2000 to 2030, accounting for declines in mortality rates and the scheduled phase-in of higher retirement ages. A discussion and conclusion follow.

SOCIAL SECURITY RULES AND THE MARGINAL BENEFITS OF DISABILITY AND RETIREMENT

This section provides a brief discussion of the rules for contribution and benefit rates under the OASI and DI programs. See Feldstein and Samwick for a more comprehensive discussion and the Social Security Handbook for a full explanation. I consider the three distinct types of workers studied by Feldstein and Samwick: male workers with no dependent spouse, female workers with no dependent spouse, and male workers with a dependent spouse. In the latter case, the dependent spouse is two years younger than the worker and there are no children. Focusing on these cases avoids some of the complicated provisions for potential auxiliary beneficiaries, i.e., dependent parents and children.

The discussion of Social Security benefits is simplified in several respects. First, I focus on rules affecting those working in 2000 and beyond. This allows me to ignore the many special rules applying only to those already retired in 2000. Second, because my concern is with marginal tax rates, I ignore any benefits that are not tied to the level of contributions.

The full, statutory payroll tax rate on covered employment is 15.3 percent, with shares equally split between the employee's share of 7.65 percent and employer's share of 7.65 percent. Self-employed workers pay the full 15.3 percent. Of this 15.3 percent, 2.9 percent goes to the Medicare fund, 1.8 percent to the Disability Insurance fund and 10.6 percent to the Old-Age and Survivors trust fund. The 12.4 percent combined rate for DI and OASI is levied up to a maximum income that is, in 2000, $76,200, but there is no upper income limit on the Medicare portion.

The distinction between the statutory tax rate and the net marginal tax arises because OASI and DI benefits, in many cases, depend on the level on contributions. The net marginal tax rate takes into account the increase in the expected value of future retirement, survivors and disability benefits associated with additional tax payments. From the standpoint of labor supply decisions, these net marginal benefits serve to reduce the net marginal tax rate. Like Feldstein and Samwick, I omit the Medicare portion because Medicare benefits are not tied to the level of contributions.

Workers are first eligible for retirement at age 62 with reduced benefits, but must wait for the "normal retirement age" for full benefits. Normal Retirement Age (NRA) is 65 for workers born before 1937. It rises in two-month increments for workers born between 1938 and 1943, is 66 for workers born between 1943 and 1954, rises again in two-month increments for workers born between 1955 and 1960, whereupon it reaches the new, normal retirement age of 67. In estimating benefits, I assume all workers and spouses retire at the normal retirement age.

To determine the level of retirement benefits, the Social Security Administration first computes a measure of lifetime earnings--Average Indexed Monthly Earnings (AIME). Annual earnings from covered employment, from age 21 to age 60, up to the maximum subject to OASDI taxes, are adjusted to reflect changes in the average wage level. Specifically, earnings in each year prior to age 60 are multiplied by the ratio of the National Average Wage Index (NAWI) in the year the worker turned 60 to the NAWI in that year. Earnings from age 60 onward are included without adjustment. The top 35 years (the computation years) are then averaged and divided by 12 to obtain the worker's AIME.