During the campaign President-Elect Trump promised to eliminate the federal income tax on Social Security retirement benefits. While doing so would benefit millions of Americans, it could leave a gaping hole in federal government revenue. Is this policy viable? First, we’ll look at a brief history of Social Security. Then we’ll examine how and when Social Security became taxable. Finally, we’ll take a brief look at the impact of making Social Security retirement benefits nontaxable.
Social Security: A Brief History, Including Taxation
The Social Security Act of 1935 was signed into law by FDR 89 years ago. For nearly 50 years, benefits were not subject to federal income tax. Then, in 1983, Congress amended the law to include up to 50% of benefits in a person’s taxable income. Finally, in 1993, Congress passed the Omnibus Budget Reconciliation Act (OBRA), which allowed the inclusion of up to 85% of a person’s Social Security benefit to be subject to federal income tax.
The Cost of Eliminating the Federal Income Tax from Social Security-as Trump Promised
To determine if this course of action is viable, we must make certain assumptions. Here’s what we know. According to the Social Security Administration (SSA), there were 47,292,977 individuals receiving Social Security retirement benefits at the end of 2021, with an average benefit of $21,228 annually. Multiplying these numbers suggests the total amount paid by Social Security was just over $1 trillion (47,292,977 x $21,228 = $1,003,935,315,756).
Now for the assumptions. Let’s assume 75% of total benefits paid were subject to taxation ($1,003,935,315,756 x .75 = $752,951,486,817) with half of that in the 50% inclusion group and half in the 85% group. Further assume the 50% group is in the 12% marginal tax bracket and the 85% group has a marginal bracket of 24%.
Using these assumptions, the tax savings accruing to each group would be $45,177,089,209 for the 50% group and $90,354,178,418 for the 85% group. Thus, the total tax savings would be about $135.53 billion, which equates to 2.7% of total federal government revenue. To put it another way, federal government receipts would be about 2.7% lower if Social Security retirement benefits were no longer taxable. Now we’ll look at the economic benefit of putting more money into the hands of consumers.
With an additional $135.5 billion in the pockets of Social Security recipients free from federal income tax, it’s safe to assume that some of this money would be spent, which would boost the economy. Social Security recipients at the upper end of the economic spectrum are less dependent on Social Security and may be more likely to save, but most would spend the tax savings on traveling, various purchases, to help support their lifestyle, etc.
Let’s introduce the multiplier effect. In simple terms, the multiplier effect measures the effect of spending on the economy by the government as well as in the private sector. For example, if the government spends a dollar, does it boost GDP by more than a dollar, or less? While there are conflicting views, the prevailing thought is that the government’s multiplier effect is less than a dollar while a dollar spent in the private sector boosts the economy by more than a dollar. In other words, government spending is an inefficient way to boost the economy whereas private sector spending leads to economic growth.
The uncertainty here is how much economic benefit there would be if retirees no longer had to pay a portion of their Social Security to the federal government. This additional money in the private sector would certainly boost the economy, but it’s hard to say by how much. The extra money could increase demand for products and services and could put upward pressure on prices. However, if the supply of these products is adequate, then inflation may not be affected.
Another economic benefit of a tax-free Social Security benefit would be the expansion of businesses, and hence, the labor force. As retirees spend more, businesses will need to increase staff, and new businesses may emerge. With greater demand for workers, the rate of unemployment should fall. However, technology that replaces workers could mute some of the benefits.
The bottom line? More money in the private sector is a good thing for economic prosperity. More money in the hands of the federal government typically leads to more government spending, which as many experts suggest, is not an efficient way to stimulate economic growth. Thus, as the federal government continues to overspend, politicians will be looking for new and innovative ways to extract more taxes from Americans.
While rampant overspending in Washington may make it harder to pass legislation to omit Social Security retirement benefits from federal tax, with President-Elect Trump in the White House and Republicans in control of Congress, there should be no material roadblocks to bringing this campaign promise to millions of retirees. We’ll see.