Outside the Beltway

Blast From The Past: Social Security and Taxes

Steve Verdon · Sunday, January 30, 2005 · 4 comments

I was trolling through the archives of Kevin Drum’s Political Animal and hit upon this post. Now what caught my eye was this part of the post,

After more research than I care to admit to, it suddenly struck me that only one thing really mattered: how big is Social Security? I had been vaguely under the impression that it was a huge program, but in fact it turns out that Social Security amounts to about 4% of GDP today.

4%.

And the pessimistic consensus is that over the next 50 years or so this will gradually increase to about 7%. That means that federal taxes, which today amount to about 20% of GDP, will need to increase to about 23% of GDP.

There are a number of problems here with this. The first and most glaring to me is the idea that simply because Social Security goes up by 3% that taxes must rise by 3%. This completely ignores a very well established concept in public finance economics known as dead weight loss. When taxes are increased it in effect lowers the price for the supplier and raises the price for the demander. The higher price for the demander lowers their demand, and the lower price for the supplier lowers their demand. Thus, the new level of output in the market is lower. This produce a wedge (triangle) that is driven between the demanders and suppliers which are transactions that absent the tax would normally tax place, but with the tax do not. The revenues (taxes, corporate revenues, profits) and benefits (to the demanders) of these trades simply cease to exist. Nobody gets them. Graphically the picture looks like,

The two rectangles in the picture represent government tax revenue. Thus, the tax rate has to be set so that those revenues are large enough recover the revenue necessary to cover whatever spending the government plans on engaging in (unless it plans on deficit spending). So we see that Kevin’s 3% number is too low. By how much depends on the market that is being taxed. In this case it is an income tax and that covers a number of different markets.

But there is yet more to think that Kevin’s number is also too low. Increasing income taxes (or any tax for that matter) also increases both the benefits to evading taxes and lobbying for special loop holes in the tax code. The first one means that to raise the required revenue taxes will have to be higher than the 3% that Kevin is suggesting. The second problem, lobbying for tax loop holes, is actually in my view the more pernicious in that such activities are socially wasteful. That is, it is basically arguing over how to slice the economic pie vs. expanding the size of the economic pie through productive activity (such as making something). So not only will the lobbying for tax loop holes (a.k.a. rent seeking) will lower tax revenues necessitating an even higher tax rate, but it will divert resources from productive activity to non-productive activity. Further, all three of these things will tend to feed on each other. The higher tax rates due to deadweight loss will make evasion and rent seeking look better. The higher tax rates due to rent seeking will make evasion and the deadweight loss worse. Now it wont spiral out of control and lead to armageddon, but the bottom line is that simply because the projected cost of something is x% of GDP does not mean a tax of x% of GDP is going to be sufficient.

Aside from these “technical” issues with Kevin’s post I don’t believe Kevin really means what he says. It is my belief that he simply doesn’t want Bush to reform Social Security. I could be wrong and Kevin really is sincere in his beliefs and it has nothing to do with Bush, but I have some serious doubts. The reason for this is that imagine if the deficit doubled right now. The deficit is a bit higher than 4% (like about 5-6%). Would this be a bad thing? Many argue that the deficit is bad because it diverts funds from private (productive) investments to the government (which may or maynot be productive…my guess is more the latter than the former). Hence the deficit acts like a drag on the economy (like driving with the parking break on). Fair enough. But, in the future when Social Security spending goes up it will be financed either via taxes or debt. If it is the latter we get the same drag effect we would with a deficit today. With an increase in income taxes people will save less, and investments that would normally be made here in the U.S. might be made abroad. Again we get a “drag” (I know it is a popular Liberal belief that higher taxes actually promote growth, but really they don’t). On top of this the increase in Social Security is viewed as being permanent. Some might still think that once the Baby Boomers retire then die, no more problems. Well, the demographics that Kevin is so eager to dismiss indicate that people are going to be living longer so the increase in elderly to young will be arround pretty much forever. So what would Kevin think of increasing the deficit dramatically and permanently? I don’t think he’d view it as a good thing. Hence I have a hard time with his statement that nearly doubling Social Security is no big deal.

Note: The same reasons that are causing some people to view Social Security as having a problem are by and large the same things causing people to view Medicare as being in trouble: Demographics. There it is again, that word that Kevin wants to dismiss. Add on top of the demographic issues is the health care market itself. Unlike most other markets people don’t usually want “last years model” when it comes to medical procedures. They want the latest and greatest and price is no object (especially when the federal government is going to be picking up the bulk of your tab).