Why Does The Federal Government Subsidize Retirement?

Source: Forbes

Have you ever wondered why we have a Social Security system? Now that the Obama administration and Congress are facing a “fiscal cliff,” it’s time to rethink that question.

Our federal deficit problem requires reforming the entitlement programs, the biggest of which are entitlements for the elderly. The necessity of reform will force us to ask why we have these programs in the first place. What are we trying to achieve?

Until the modern era, there really was no such thing as retirement. People worked until they could no longer work. At that point they needed a source of non-work income to support them. The income could come from savings, the earnings of other family members or from a pension.

At the time the Social Security system was created, life expectancy was 64 years. The average person wasn’t expected to reach the retirement age of 65. Those that did were generally thought to be too old to work. Yet with the passage of time, life expectancy grew, the health of 60-year olds improved and the system evolved into one that literally subsidized retirement.

People who were physically and mentally able to continue working were rewarded if instead they chose to spend time on the golf course, take cruises and pursue hobbies. Above a minimum amount of wage income seniors lost 50 cents of benefits for every dollar of earnings. This so-called “earnings penalty” was a 50 percent tax on wage income, in addition to the payroll (FICA) tax and state and local income taxes.

Thus seniors with very modest incomes were facing total marginal tax rates that took away two-thirds or more of every dollar they earned. (These same penalties, by the way, still apply to those who choose early retirement.)

In retrospect, it’s hard to imagine why anybody ever defended those policies. No one questions why we provide help to people who are sick or disabled. Or why we provide benefits to people who are temporarily out of work and looking for a job. But why subsidize people who want to play golf? How does that advance any national interest?

In the early 1990s, my colleagues and I at the National Center for Policy Analysis proposed to end this anti-work bias in the Social Security system. Once people reach the “retirement age,” we reasoned, they should be able to claim benefits whether or not they continue working. There should be no additional penalty for contributing to the nation’s output of goods and services.

Our proposal was one of five “pro-growth” reforms we made with the U.S. Chamber of Commerce, and these ideas almost immediately became incorporated in a series of bills introduced in Congress. In 1994, they became the core tax proposals in the House Republican Contract with America and a few years later our Social Security reform became the law of the land.

The reform has liberated millions of senior citizens and encouraged their continued participation in the labor market. More needs to be done.

As the full retirement age is being gradually increased to age 67, more people are choosing to take a reduced benefit and retire somewhere between age 62 and age 67. As mentioned, the earnings penalty for these early retirees is still a draconian 50 percent. But why? Why not let everybody retire — or for that matter re-enter the labor market — whenever they want to, independent of their receipt of Social Security benefits?

Under the current system, the earlier you claim Social Security benefits, the smaller your monthly check. But you can also delay retirement — up to age 70 — and receive a larger than normal benefit. The choice is supposed to be actuarially fair — so that the present value of your expected lifetime benefits is the same, regardless of which age you choose to “retire” at. However, this is true when the calculation is made using the government’s borrowing rate, which is much lower than the rate faced by ordinary mortals. This biases the choice toward early retirement.

As we have argued elsewhere, the government could instead use a higher rate of interest. This would require a lowering of the benefit at age 62 relative to age 70 and would encourage seniors to remain in the labor market for more years.

Then there is Medicare. Once people reach the age of 65 they no longer have to work to get health insurance. The government provides it. People who continue working and who receive health benefits from an employer are actually penalized: the employer plan becomes the payer of first resort. Medicare only pays the bills the employer plan doesn’t pay. So Medicare too is an entitlement program that discourages work and subsidizes retirement.

Is there a better way? Under the Affordable Care Act (ObamaCare), people who obtain health insurance in newly created health insurance exchanges will get federal subsidies. So a 64-year-old with a moderate income will pay only a portion of the cost of his private insurance, just as he will pay only a portion of his Medicare insurance cost when he turns 65.

There ought to be a way to integrate the two subsidy systems so that people are not encouraged to leave the private system as they age. Also, the same subsidies that are offered in the exchange ought to be available to those who get insurance at work — so as not to penalize those who remain employed and who obtain insurance through an employer.

Bottom line: any reform of the system should give people better incentives to work and pay taxes rather than encouraging them not to work.