Pros and Cons of the Earnings Test Repeal

March 24, 2000

by Andrew G. Biggs

On March 1st, the House of Representatives voted unanimously to repeal Social Security's earnings test, which reduces benefits for some retirees who continue to work. The legislation has passed on to the Senate, where support is overwhelming, for an expected March 22 vote. The President himself calls eliminating the earnings test "a first step toward Social Security reform." But before the politicians get sore hands from patting themselves on the back, it's worth considering what is wrong with the earnings test in the first place and whether the new legislation really helps.

Under current law, a Social Security recipient aged 65 to 70 who continues working loses one dollar in benefits for every three dollars he earns over $17,000, creating a marginal income tax rate of 33 percent. For early retirees (those aged 62 to 65) the benefit loss is one dollar for every two earned over $10,000, for a marginal rate of 50 percent. When state and federal income taxes and payroll taxes are counted, a middle-income beneficiary could face marginal income tax rates approaching 90 percent.

Backers of the earnings test repeal see tax rates this high as both economically inefficient and morally unfair. "As we look out 10, 20 or 30 years from now, there will be a growing need for workers in our economy," says Kenneth Apfel, Social Security Administration commissioner. Repealing the test "provides a much greater incentive for seniors to work." House Ways and Means Committee chairman Bill Archer (R-TX) adds that "repealing the earnings penalty is based on the fundamental principles of fairness and freedom: seniors should be free to work without penalty and be treated fairly by a program they've paid into their entire lives."

Both Apfel and Archer are correct, but how does the legislation making its way through Congress measure up? Unfortunately, not well. In fact, it does relatively little to address either of these issues. The new legislation eliminates the earnings test, but only for workers reaching what Social Security calls the "normal retirement age," which is slated to rise from 65 to 67. (The normal retirement age is when a worker is eligible to receive his full retirement benefits. Those who retire earlier receive reduced benefits, while those deferring retirement receive extra benefits.) Beneficiaries aged 62-65 would still be taxed at the 50 percent early retirement rate, while those aged 67-70 would face no earnings test, down from the 33 percent rate at present.

But because the normal retirement age is rising from 65 to 67, future workers aged between 65 and 67, who today pay 33 percent taxes on their retirement incomes, would face marginal tax rates of 50 percent. Workers who today are considered to be of normal retirement age will in the future be treated as early retirees and face higher tax rates because of it. The new legislation does nothing for these individuals aged 65 to 67, who make up the largest group of post-retirement workers. They would have less incentive to work and would keep less of their incomes if they did choose to work. On these individuals, the earnings test will bite even harder on some in the future than it does today.

In other words, the new legislation cuts taxes for the older individuals who are less likely to work but does nothing to stop a tax increase for those retirees who are. If the rationale behind repealing the earnings test is to increase incentives to work, the new legislation does little. Future retirees aged 65-67 have less incentive to work than today. And if the rationale is to protect a worker's right to keep his own money, for these workers the new bill does nothing.

Repealing the earnings test for workers over 67 is a good step. Repealing it for all workers over 65 would ensure that no one faced higher marginal tax rates in the future than at present. But the larger lesson is that so long as American workers' retirement incomes depend on a political entitlement rather than a property right in their own savings, their economic security will be subject to the whims and the complications of the political class. The solution is to reform Social Security through a system of personal retirement accounts, in which the worker owns the payroll taxes he deposits in his account and he owns the money he withdraws in retirement. There would be neither complicated benefit formulas to consider, nor the need to lobby Congress for changes. Instead, a worker would simply invest his payroll taxes while working. When his account was large enough to provide a minimum monthly benefit for life, he could retire without penalty. Alternately, he could continue forever without giving up a cent in benefits. Either way, because he would own his savings he would have the security of knowing that Congress couldn't touch them.

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