Can FDR help John Edwards?

Last Thursday in the Democrats' debate, John Edwards told us about something he doesn't understand:

I don't understand why somebody who makes fifty million a year pays social security tax on the first ninety-seven thousand and not on the rest, while somebody who makes eighty-five thousand a year pays social security tax on every dime of their income.

After I pondered his admission, I decided there are only two possible scenarios.  Either...

1. Edwards was being honest: he really doesn't understand why, and he would therefore benefit from Franklin Delano Roosevelt's explanation of the social security system; or...

2. Edwards was not being honest: he really does understand why, but instead chose to play the class warfare card for political gain. 

I'll assume Edwards was being honest, and could therefore use some help understanding why every worker pays the same amount into social security up to a predetermined level.  It's really pretty simple: FDR wanted social security to be thought of as an insurance system, not a welfare system. 

Seventy subsequent years of presidents and congresses have not altered that original justification.  In FDR's system, each worker contributes to the old-age insurance system, subsequently collecting benefits proportional to those contributions.  The benefits were meant to be a minimum, anti-poverty safety net; that's why a worker's contributions stopped after that worker had paid a predetermined amount into the system. 

That's how the system was sold to the public seventy years ago, anyway.  Here are a few excerpts from FDR's Statements on Social Security:

[Nov. 14, 1934: ]  We must not allow this type of insurance to become a dole through the mingling of insurance and relief. It is not charity. It must be financed by contributions, not taxes...

As Governor of New York, it was my pleasure to recommend passage of the Old-Age Pension Act which, I am told, is still generally regarded as the most liberal in the country. In approving the bill, I expressed my opinion that full solution of this problem is possible only on insurance principles. It takes so very much money to provide even a moderate pension for everybody, that when the funds are raised from taxation only, a "means test" must necessarily be made a condition of the grant of pensions. 

[Aug. 15, 1938:]  The amount of the pension depends upon wages received and taxes paid by both employers and employees.

FDR wanted everyone to picture each worker "contributing" to his or her own old-age insurance.  That's why each worker's FICA "contribution" (6.2%) stops at $97,500 of wages, as does the employer's contribution (6.2%) for each worker.  It's supposed to be thought of as an insurance system, not a charity or welfare system.  [If John Edwards now wants us to start thinking of social security as a welfare system, he should simply say so.]

The problem of regressive taxation
A regressive tax is one that extracts a higher percentage (average, not marginal) from lower income taxpayers than it does from those with higher incomes; the FICA tax is regressive.  [Notice the subtle change in terminology.  What we pay into the social security system is no longer called "contributions"; that wording was important to get the program sold to the public seventy years ago, but now we're calling those payments what they really are: "taxes."] 

But when we debate the effect of federal taxes on individuals, full disclosure requires us to include at least the two most significant taxes: both the payroll (FICA) tax and the income tax.  Neither side of the debate has a habit of doing that, however.  When conservatives isolate the income tax to make a point about the large share of taxes paid by a small portion of taxpayers, the regressive effect of the payroll tax is not getting full disclosure.  Likewise, when liberals talk of the FICA tax in isolation, to make a point about unfair regressivity, the progressive income tax is not getting full disclosure.  An objective debate would include both the income tax and the payroll tax—but most politicians are apparently more interested in scoring cheap points than in laying out an objective, full-disclosure argument. 

If you and I truly want a progressive, growth-friendly taxation system that does away with the tax-avoidance games enabled by the current, impossibly complex system, then we should demand a full-disclosure debate that includes both the payroll tax and the income tax.  The logic behind the regressive FICA tax has deep historical roots; proposed changes should be debated (a) with that history in mind, and (b) in the context of the total tax system—including the monstrosity of an income tax system five decades of Congresses have given us. 

Candidates who demagogue one side (or the other) of our tax system are dodging the bigger issue, and debate moderators who let them get away with it aren't doing their journalistic duty.  If enough of us voters lazily keep falling for rhetorical tricks like the class warfare tactic, we'll end up getting precisely the crummy leaders we will so richly deserve.  And we'll only have ourselves to blame. 

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End note:
My personal favorite alternative tax system (growth-friendly, continuously progressive, simpler, anti-game-playing) is the inappropriately-named "Dual-rate Flat Tax."  The inappropriate word is "flat"—as I explained in an article titled The Flat Tax is Progressive.  I like the proposal partly because the second, higher rate on the income tax kicks in exactly where the FICA tax stops, ensuring continual progressivity for the whole system.  Here's a graphic from a past article, showing the continual progressivity of one possible dual-rate system:

Simplicity nostalgia
I especially like the above proposal because of the simplicity the flat rates and minimal deductions bring to the system.  Tax-system simplicity eliminates opportunities for game-playing and for cheating—and, believe it or not, our system used to be simple.  It worked well until the mid-1950s—at which time, unfortunately, our politicians learned they could use the income tax system to dish out political goodies to special interests. 

The dual-rate flat tax would bring simplicity back—and that is growth-friendly.  I wonder how many in our current crop of candidates understand why growth-friendly policies are important?  Wouldn't it be more productive for our politicians to spend their time figuring out how to make poor people rich, instead of the other way around? 

Comments

[Kevin]

I once heard Ted Kennedy on TV echoing the myth that SS is a personal insurance entitlement thingy, so I'm pretty sure Democrat senators are familiar with the theory.

Me, I would LOVE for the cap on Social Security taxes to be removed without corresponding increase in later benefits because a) I don't currently make enough to be affected, but most importantly b) this would decouple benefits from contributions, once and for all destroying the myth that Social Security is some kind of sensible personal account with an acceptably good return.

It would piss off a lot of affluent people, and perhaps God willing clear the path for privatization reform.

My compromise idea is that the incremental increase in SS taxes on high-income earners be assigned to the "private account" component of low-income peoples' social security "account". (I've already drafted idiot-proof asset allocation pie charts for social security forms).

[mark]

Correct me if I am wrong, but I believe in FDR's time marginal tax rates on the wealthy were very high (>75%) and the rest of the population paid almost no income tax. Contrast that with today when upper middle class are paying 25% marginal federal income tax plus 15% for FICA/Medicare while the wealthy are paying around 35% marginal federal income tax and 0% marginal SS tax due to the cap. Toss in local and state taxes and the upper middle class are getting killed with taxes. If we toss in the fact that the wealthy get a good portion of their income from capital gains and dividends taxed at 15%, the situation is amplified. Times have changes since FDR made his statement (not to mention we now have a fiat money system with floating exchange rates - but that's a subject for another day).
Love your idea Steve, but I don't see a major overhaul happening. Kevin, removing the cap makes it look like the welfare/charity state Steve mentioned. But a good compromise would be removing the cap on the employer portion. If these companies can afford to pay execs these huge salaries, another 6% is not going to break the bank (or if it will then they should scale back on these compensation packages).

[Jason]

Social Security should be a welfare program if there's any justification for it existing. Why should the government run any sort of consumer insurance or financial planning company? 401(k)s and IRAs offer more than enough saving incentives and expected returns are usually positive.

I'm very skeptical of so-called privatization. Those plans essentially keep the system in place. Everyone is still forced to contribute their 12.4% into some sort of hybrid savings plan. I'm afraid it would turn into the same system with a lot more overhead.

"another 6% is not going to break the bank" This is a dangerous logic that leads to wasteful decisions. Taxes up to 100% on profits wouldn't break the bank either.

[Andrew]

Just like it would be more productive for our politicians to spend their time figuring out how to make poor people rich... it would be more productive for those trying to get rich to spend their time on their business, rather than wasting days or weeks (and lots of accountant fees) to deal with their taxes four times a year. The savings just from doing away with so much compliance overhead would be incredible for small businesses and individuals, and rather marginal for big businesses, so that in itself is progressive.

[Kevin]

Of course another alternative is remove the tax cap, but also allow benefits to increase proportionately for those payers.

I'm pretty sure this would accomplish nothing, since the eventual benefits would eat up the extra contributions. But it would make the soak-the-rich folks happy for now.

And it would be downright funny if the result of Democrat demagoguery is that Bill Gates at 80 is receiving a social security check of about $100,000 a month.

[Bob]

Go to just about any blog and you'll read stuff similar to what Steve writes about politicians, government , taxes....all of it.

Thing is, most people, IMO, are very good at leaving comments about this or that. That's nice if you're interested in venting or perhaps giving an alternate view. However, it does nothing, N-O-T-H-I-N-G, to persuade politicians to change. And, PUHlease, don't come back at me with the "politicians ARE interested in what bloggers say", that's bullhockey because if they were we wouldn't have such a mess and the pollsters wouldn't have such a stranglehold.

One President will do little to get us out of this mess. If anyone really wants to get things moving
you call your congressman or senator. You keep calling and calling until they get it.

How many people are willing to do that? See?

Look we wind up with a government we tolerate. Until enough people have finally had enough, nothing, I mean nothing, will change.

You can take that to the bank, Frank.

[m.jed]

Steve,

There's a problem with your statement:
"A regressive tax is one that extracts a higher percentage (average, not marginal) from lower income taxpayers than it does from those with higher incomes; the FICA tax is regressive."

While the FICA tax itself is regressive, the benefits paid to recipients are progressive. Various studies, including one from the CBO have concluded that Social Security in aggregate, accounting for taxes and benefits, is progressive. Saying the FICA tax is progressive is acknowledging that a coin has a head, but failing to acknowledge it also has a tail.
link: (warning pdf)
http://www.cbo.gov/ftpdocs/77xx/doc7705/12-15-Progressivity-SS.pdf

[m.jed]

last sentence should read:

Saying the FICA tax is REGRESSIVE is acknowledging that a coin has a head, but failing to acknowledge it also has a tail.

[Steve]

m.jed:
Good point, and it applies to income taxes as well. A good illustration of the net effect is the "Net Fiscal Incidence" chart a few pages down in this article:
http://tinyurl.com/3ypdw8

Unfortunately, I think the chances of getting the politicians to debate the implications of that chart are even less than getting them to put FICA and income taxes together on just the taxation side. (Both are near zero, however.)

[JIMB]

Level of Social Security tax wouldn't be a problem if it were voluntary ...

[Ken]

Your forgetting the earn income tax credit which is supposed to be a "rebate" of sorts for the employee portion of the FICA tax. Factor that in and the low income wage earner essentially pays zero tax up to a certain income.

[Luis]

I am not that familiar with the tax system of your income in the USA.

In Spain, there are also two things that you take out of your payroll:
- Social Security. I am not sure that it is the same as yours. which has a minimum and a maximum in absolute terms. It gives you access to the public health system. Certainly this is much different than the USA as in Spain public health is usually much better than private health . It also gives you access to a retirement payroll made by the Spanish state once you meet the requirements (over 60 at least).
- IRPF (Country tax) which is progressive and if you earn more than a determined sum. The money that you earn above this threshold that is upwards will still be paying a 45%.

Are there differences with the USA?

[Phil]

Remember, also, that the "income" tax was on "income" -- literally, the passive monies that, at the time, only the "rich" were privvy to -- dividends and such.

This is juxtaposed to a "salary" or "wage," which, theoretically, may have never been supposed to be taxed by the federal "income" tax.

Other than that exercise in taxation theory, I believe you are correct. Social Security was meant to be insurance, not someone's life savings. It was supposed to be used "in addition to" what someone had dutifully already saved up.

Also, regarding tax reform, remember, too, that an income tax encourages spending, whereas a consumption (use) tax encourages savings. What might be the best political alternative? Revert back to having a two-tier income tax along with a phased-in privatized Social Security savings account.

[Deborah]

The problem with this is that insurance programs should be self funding and this one clearly is not, so it is wrong to say that it is an insurance program.

It did not plan for life expectancy to increase, probably to the point that it has tripled the amount of money being paid out per person than the plan was designed to pay and there was no mechanism to fix that aspect of the plan, and hence, it is no longer an insurance program, but a gross level of wealth transference from those currently paying in to those collecting, or perhaps those collecting more than 5-7 years or somewhere in there.

[Kevin]

Luis: pretty much the same concepts apply in the US. One paycheck tax is our "Income Tax", like your IRPF. Due to built-in deductions and exemptions, the first $8750 (at least) is not taxed, and beyond that it's progressive with tax brackets from 10% to 35%.

A second paycheck tax is for Social Security (FICA), which has 2 components. One is OASDI, which is the retirement pension available at age 62 (or more if you wait longer to start receiving it); it also serves as a limited form of insurance in case of death or disability. The other component is Medicare, which is public health insurance for people 65 or older.

This FICA tax amounts to about 15.3% of your wage, though half of that is paid "pre-paycheck" by the employer so as to try to hide the real cost from the unwary public. The OASDI portion of that tax is capped when a person's income reaches $97,500, though the Medicare part is not capped.

[Laurent GUERBY]

To be fully honest, a tax discussion should include ALL taxes, not just income or payroll (that is sales tax, VAT, property taxes, capital gain taxes, ...) and put that in balance with the other side of the same coin: government provided benefits and services, and their quality.

You can perfectly have a regressive tax system with a whole tax+benefit system being progressive.

You can also have a progressive tax system with an overall regressive tax+benefit system.

For example in France we pay "health insurance" government tax on our income, but overall we ALL get near top of the world quality of healthcare for about half of the price paid by USA citizens.

A very good use of tax money and overall progressive: tax is proportional to income and benefit about the same for all irrespective of income.

[Kevin]

***To be fully honest, a tax discussion should include ALL taxes, not just income or payroll (that is sales tax, VAT,.... ****

If you are trying to talk about everything at once, you are talking about nothing. No, there is nothing "dishonest" about focusing on one issue in a conversation.

Such focus, for example, keeps you from meandering off on irrelevant tangents about healthcare when you are discussing whether or not a Senator actually understands why a specific component of payroll taxes are capped at a certain income level.

[A Tanatar]

Kevin, keeping the focus straight: it's not evident from Roosevelt's speach if the tax should be flat or not. What is evident from the speach is that the payouts should be proportional to the contribution and the cost should be shared between workers and employers.

Let us say I make $0 on odd years and $200 000 on even years. Should I be entitled to less taxes and less social security benefits than my neighbour who makes $100 000 annually?