Today in the Introduction to Federal Income Taxation class it was time to tackle section 86 of the Internal Revenue Code, which specifies the extent to which social security benefits are included in gross income. Though the students may think I delight in dragging them into the morass of computational complexity and policy pitfalls that characterize the provision, I wish it did not need to be done. Until this point in the course, one which inspires high anxiety or fears of boredom for many students, the experience, though a bit obscure at times, generally is positive. Students learn that much of tax is not simply "just numbers," that there are unresolved issues, that tax affects almost everything in life, and that it can, at times, be fun.
Then section 86 appears. And dark clouds cover us.
Why?
Section 86 is a testament to legislative inefficiency. The first step is easy. Should social security benefits be taxed? There are good arguments for yes, and for no. The better outcome is yes, because after all, it isn't all that different from a pension. The next question is, what should be taxed? The answer should be, the excess of what a person gets over what a person pays in. In other words, the net gain, or profit. That's pretty much how pensions are taxed.
Did Congress do it that way?
Of course not.
Congress decided that it would be too complicated to have people figure out how much they had put into the system. Hmmm. Every year we get a statement from the Social Security Administration that tells us what its records show, and gives us a chance to correct the records. So that information exists. What's the problem? Probably the realization that a lot of people would have a lot of social security gross income. And they'd be unhappy. And Congress fears the outcome.
So Congress made two decisions. First, it would tax 50% of social security benefits. It's not a rough approximation. It guarantees that almost no one would be taxed on as much as they gained. Second, it decided not to tax social security benefits if the taxpayer's modified adjusted gross income, increased by tax-exempt income, which I'll call "modified aggregate income," does not exceed a base amount ($25,000 for unmarried taxpayers). Why? Because "poor people shouldn't be taxed on social security." Well, poor people shouldn't be taxed on ANY KIND OF INCOME. Congress avoided the real issue, which was the need to increase the standard deduction and/or personal exemption so that a poor person, no matter the type of income, would not be taxed. The notion that different kinds of income should be taxed at lower rates is not something new that arrived with the low rates on dividends. The folks that enacted low rates for dividends had mentors... the ones who decided social security income should be treated differently.
Then Congress realized that if a taxpayer's modified aggregate income was $25,100, it would trigger taxation of 50% of social security benefits, which is quite a high price for that extra $100 of income. So Congress limited the social security gross income to the lesser of 50% of the benefits or 50% of the excess of modified aggregate income over the base amount.
Complex, but manageable. Tough to defend as a matter of policy, or efficiency in administration. But at least I could teach it, and the students could understand it well enough to comprehend the underlying sausage factory environment, in about half a class (25 minutes) plus the time they need to invest outside of class (another hour to hour and a half in preparation and assimilation).
But then someone in Congress needed a revenue raiser to offset a revenue loser, and their eyes turned to section 86. It was proposed to raise the 50% to 85%, an amount much closer to an "average" rate of gain for the typical social security benefits recipient. Others howled. Horrible idea. So we get a compromise. Use 85% rather than 50% if the social security benefits exceed an "adjusted base amount" ($34,000 for the unmarried taxpayer). But, again, a few dollars of modified aggregate income could push someone from 50% being taxed to 85% being taxed, so an absurdly complex provision was added to ensure that the inclusion rate scaled or stepped smoothly from 50% to 85%. They put it in section 86(a)(2), drafted it as an alternative, and then labelled it as an additional tax. It's an alternative, not an addition to what's in section 86(a)(1), so what's the problem with using some accurate language?
We didn't get to the 85% stuff today. That's on Friday's schedule.
By this point students are in mental pain. I risk being in physical pain when things fly (but that's never happened). I give them a bunch of examples. I don't and won't test them by asking them to do the computation. Computer software can do that. They can, too, though they don't believe it, for all they need to do is to follow the form.
But following the form makes much more sense if one understands WHY one is doing what the form asks. That's one of the things I want the students to figure out. The WHY of it.
But there's something else I want them to understand. It's the bubble effect. Only after I explain this mess can I explain the bubble. The bubble happens when someone with modified aggregate income under the base amount (or adjusted base amount) has an increase in income, which happens if the retiree needs to go back into the workforce in order to make ends meet or to pay extraordinary expenses. The person's taxable income increases not only by the amount of the additional income, it increases by the increased social security gross income caused by the increase in the person's aggregate modified income. Instead of having a tax liability increase equal to the additional income multiplied by the marginal tax rate, the person ends up with a tax liability increase equal to the additional income multiplied by as much as 185% of the additional income. I'm not going to do the computations here, but in a law school class I'm not going to say "trust me" to the students. I want them to see the WHY of it, to look at the arithmetic so that they can understand the phenomenon. I want them especially to understand the significance of the question, "So why is this retiree couple scraping by on a few tens of thousands being taxed at an effectively marginal rate far greater than that imposed on a multimillionaire picking up a few more thousand dollars of income?" How can that be justified under any philosophical, moral, or theological canon?
After all, it is the inability of most Americans to understand the bubble phenomenon that permitted certain members of Congress to enact phaseouts and scale-downs that, to quote one of them, "let's us increase taxes without increasing rates" so that people will think taxes were not raised when in fact they were. We don't reach the phaseouts until late in the semester. About the time we cover marriage penalties and marriage bonuses. By then the students are either rolling along with me or sick to their stomachs, or both. And yet I continue to insist we ought to be teaching Real Civics in our high schools.
When we begin this topic there usually are some questions about social security. Some students know what it is and how it works, and others have only a vague idea. So I explain it, of course with my bias that emphasizes the "I" in FICA. The word Ponzi is heard. References are made to the problem that looms when the number of social security recipients will be only 1.4 times the number of workers rather than the 41.9 to 1 it was in 1945 or the 16.5 to 1 it was in 1950 or the 3.something to 1 it's been recently.
Most of my students are in their early 20s. Most have held jobs, but mostly as part-timers. They're just about ready to enter the full-time workforce. The idea that each group of three of them must support two retirees doesn't appeal to them. The fact that the funding of the social security program has been woefully inadequate, costing far more than its proponents admitted, doesn't sit well with them. Or me, but I don't count, because I won't be around when these students are in their 80s. If I am, I'll be so old and decrepit I won't know that I'm around, that I'm old, or that I'm decrepit.
The date is voluminous and worth a read. Take a look at the
2004 OASDI Trustees Report, especially at
IV, B, 1 Annual Income Rates, Cost Rates, and Balances. Lots of numbers, some nice charts, intense text, and alarming news. But we knew that because Alan Greenspan drew our attention to it, as I pointed out in one of
social security posts. Or at least he tried. Most folks weren't and aren't listening. Those that are try to soundbite the issue and play to the electorate.
The impending doom of the Social Security program doesn't stand alone on the horizon. It's wrapped up with general government revenues and expenditures, simply because for a while the program has had a surplus. It's far too small, of course to fund its obligations, but it exists and it was invested. In what? Mostly in loans to the rest of the government. What happens when social security needs to tap its surplus when social security tax revenues begin to slip behind payments to beneficiaries? The government will need to issue debt. I'm not going to do the entire macroeconomic analysis. Suffice it to say, it won't be pretty. My guess is that China will own the nation. Yes, that's alarming, but go look at the numbers. There are numbers in the TENS OF TRILLIONS. That's a LOT of money. Even for Bill Gates. Well, hmm, now that I mention him, if China doesn't own us by then, Bill will.
Some serious reform is needed. Not just of tax, but of expenditures and programmatic decisions. Should social security be treated as an entitlement or as insurance? How should it be financed? Bruce Bartlett points out the alarming truth in
A New Money Machine for the U.S.; The old ways can't keep up. We need a value-added tax to meet revenue demands. We need SOMETHING.
Politicians speak of tax reform. Yes, speak. And they get hard-working, intelligent officials in Treasury to prepare
tax reform proposals. Proposals that are unlikely to become law, even if they generate discussion in the political arena and find a temporary home in a Congressional committee. The proposals are alternates so there's a lot to read and ponder. Each one has its advantages and disadvantages. Some I like more than others, and some I dislike. Does it matter? Practitioners generally want to, and need to, deal with the law as it exists. Some get involved in studies to refine or repair a narrow technicality. A few pay attention to the big picture and lift their eyes to the horizon. Politicians can't think past the next election. In the meantime, the tax system has become more complex, more inequitable, and more inefficient. Tick tick tick
It's sad, but we have a long history of a nation of being unprepared and then needing to scramble, quickly, painfully, expensively, and fatally, to solve the problem. Oh, and then there will be a commission to figure out what went wrong. But this time perhaps there won't be any money to fund a commission. Or a Congress.
That doesn't sound very optimistic, does it? And supposedly I'm am optimist, a Saggitarian who when getting a box of pony dung figures the gift of the pony isn't far behind. (Someone told me that years ago and it stuck. The analogy, not the pony stuff.)
It's not as though the system CAN'T be fixed. It's that too many people can't or won't set aside personal agendas for the common and better good. When asked what I would do if I were the "tax czar" my response usually includes a comment that it wouldn't matter, because reform needs to come from within each citizen rather than being imposed from above (or below, depending on one's perspective).
I hang on to one shred of hope. Modern technology, linking people together in ways far different from the communications of the past, provides an opportunity for people to organize and coalesce around issues that matter. Perhaps I'm wrong and most Americans like the current system, look forward to the impending economic failure of social security, await with glee the financial collapse of the nation, and think Grandpop and Grandmom should indeed be taxed on their part-time earnings at two or three times the rate the millionaires and multi-millionaires are taxed on their capital gains and dividends. I could, after all, be wrong. It wouldn't be the first time.
But if most Americans share my fears about the tax system and the larger national economic situation, and want true tax reform, it will require that many of those who understand the smoke and mirrors be willing to explain the game to the tens of millions who don't. Those who are invested in the current tax system, even though its failure will take down rich as quickly as it takes down poor, include too many who understand (and created) the smoke and mirrors and who have the skills to use them to their advantage.
And, so, it comes back to the need for education. I guess as long as I keep trying to explain section 86 to second and third year law students I must think, at least deep down inside, that there is indeed some glimmer of hope.
