Edward Lotterman

So what would lead Angie Craig, a three-term member of Congress, to think she is smarter than Alan Greenspan, Daniel P. Moynihan, Bob Dole and the head of the AFL-CIO, not to mention Ronald Reagan?

And why should anyone pay attention to her Social Security bill, which is based on misunderstanding, if not ignorance, and on four decades of demagogy? A bill that apparently has not attracted even a single additional sponsor?

Well, yes, people should pay attention, and not just suburban voters in Minnesota’s Second District. Craig’s “You Earned It, You Keep It Act,” first introduced in 2022, is a very useful bill for improving Social Security’s financing. It does not have any chance of passage in the current Congress.

But, like Republican presidential candidate Nikki Haley’s Social Security funding suggestions, Craig’s bill is a courageous move that may help force us to face the long-foretold and now-imminent crisis in the popular program’s funding.

So what’s in the bill? It is simple. End any income taxes on Social Security benefits. Make up the tax-revenue shortfall by nearly eliminating the cap on income to which FICA taxes for old age, survivors’ and disability insurance (OAS&DI) are applied. So more rich people will pay it.

While the bill has zero chance in the current clown-car atmosphere of the U.S. House, I’d bet that a strong majority of U.S. citizens would give a thumbs up to both halves of her bill mentioned above.

So what about my barbs of “misunderstanding,” “ignorance” and “demagogy?”

Well, the taxation of Social Security benefits comes from legislation passed four decades ago that grew out of a thorough review of the program and its problems, initiated in 1979 by the administration of Democratic President Jimmy Carter plus the follow-up report of the “Greenspan Commission,” established by Carter’s successor, GOP President Ronald Reagan, to recommend specific legislation. This effort was genuinely bipartisan; the commission included the head of our largest labor union, a prominent Democratic senator plus an old New Deal populist who in his 50 years in the House had established a reputation as a dogged defendant of the underdog, especially those over age 60, in addition to noted Republicans like Bob Dole and John Heinz.

Among other measures, the commission recommended taxation of a fraction of benefits. Reagan endorsed the group’s proposals which passed both houses of Congress on a bipartisan basis and were signed into law by this popular president.

There were two reasons why income taxation was included. The first was an effort to give equal tax treatment to all retirement programs. The second was to minimize the needed increase in FICA taxes paid by everyone.

Up to this time, federal income tax had not applied to OAS&DI benefits. But benefits from private and public defined-benefit pensions always had been taxed. This included military retirements, union and corporate pensions and local, state and federal government pensions.

Payouts were taxable from defined contribution plans like the 403(b) option set up for nonprofits in 1958 and the similar 401(k)s 20 years later. The rationale was that no income should be taxed twice, but all of it should be taxed once. Legislation had already extended income taxation to unemployment benefits. Bringing Social Security into the same fold made sense to the commission, and to Congress.

Unfortunately, no well-intended effort goes unpunished. The “I already paid taxes on that” demagogy began almost immediately and has continued unabated right up to forming the basis for Rep. Craig’s bill. But no, the bellyachers and others have not paid taxes on all that income. Employees did pay income tax on the 6.2% of earnings withheld as FICA. But they did not pay any taxes on the matching half paid by their employers. That does not appear anywhere on pay stubs or W2s. Nor did beneficiaries pay tax on the implicit interest earned by their “contributions” between withholding and the time benefit payments began.

For the average recipient, the sum of FICA paid came to about 15% of benefits received. Taxes were paid on that. Employers pain in an equal amount. “Interest” accounted for about 70% of benefits. So 15% of benefits had already been taxed but the rest had not. The reform act thus limited income taxation to a maximum of 85%.

Note that self-employed people did pay tax on all the money they had to pay in FICA and no allowance was made for that. Also understand that the “15% of benefits” figure was an average across all recipients. For low-income people whose benefits largely are from the “95% of average indexed monthly earnings” first step, this percentage is much lower. For high-income people with near-maximum benefits with a lower “replacement ratio,” the percentage is much higher.

So rich people legitimately can complain they are being taxed twice. But the whole subject of the degree to which Social Security and Medicare redistribute income between households is one about which we seldom talk.

Thus from 1984 on, up to 85% of benefits were taxable income for some but not all people. A threshold amount exempted about 60% of all beneficiaries completely. For 2023, a single filer paid nothing if other income was under $25,000. From that point to $34,000, 50% of Social Security benefits are taxed. Above that second breakpoint 85% are. So no one pays taxes on all their benefits.

The equal treatment Congress wanted four decades ago holds. I get military retirement that is fully taxable. Ditto for a pension from the years I worked for the Federal Reserve. I also draw from 403(b) and 401(k) accounts for which my contributions were before taxes. But all of my withdrawals, contributions plus accrued earnings, are taxable. And I pay taxes on some of my Social Security benefits. I am not subject to any unjust double taxation.

Moreover, I worked for decades without having had to pay the higher FICA rates that would have been needed in 1984 if no benefits had been subject to income taxation.

So if the whole premise of Rep. Craig’s bill is a misunderstanding of the 40-year-old overhaul, why is it worth paying attention to?

The answer is because it calls forth a problem which most politicians refuse to confront. Despite good faith efforts decades ago, the program’s funding is not sustainable. Simply put, we have to cut benefits or raise taxes.

We can cut benefits either by again raising retirement ages, as candidate Haley wants, or by tweaking the benefits formula to pay lower amounts relative to earnings records. We can raise taxes by raising FICA rates or by making more income subject to FICA. That could come from raising or removing ceilings on annual earnings subject to FICA taxes, the second part of Craig’s proposal.

Or we could get away from the original 1935 Social Security Act’s fixation on “earned income” of wages and salaries or self-employment income and instead also apply FICA to interest, rent dividends and profits. Since most of the increase in national income over the past 30 years has come in those “unearned” rubrics, this seems a good option. But that must be left to a future column.

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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.