Blast From The Past: Social Security and Taxes

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,

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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).

FILED UNDER: Economics and Business
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Kevin Drum says:

    Say, Steve, you did notice that this post was from May 2003, long before Bush’s latest drive to privatize Social Security, didn’t you? It could hardly have anything to do with Bush’s current plans since I wrote it nearly two years ago.

    Off the top of my head, SS today is 4.2% of GDP. In 50 years it will 6.5% of GDP. That’s an increase of 2.3 percentage points. The United States is a very low tax country, and the deadweight loss from a tax increase like that is probably on the order of .3% of GDP if the CBO is to be believed. That gets you a total of 2.6 percentage points, which is actually less than my 3 percentage point guess from two years ago. It might amount to 3% over the entire next century, though.

    As for deficits, I really don’t know what you’re talking about. I’ve never suggested increasing the deficit permanently. Rather, I’ve suggested (a) waiting around a while to see if we really have an SS problem at all, and (b) raising taxes modestly and cutting benefits modestly if it turns out we do have a problem. If it were up to me, this tax increase (if it turns out to be necessary) would be equal to about 1.5% of GDP. Even the most ardent supply siders don’t think an increase like that would have anything more than a trivial impact on the economy, if it even had any impact at all.

    On Medicare, demographics is only a part of its problems, and a relatively small part at that. The bigger issue is spiraling medical costs. That’s a far, far bigger contributor to future Medicare costs than the increase in the retired population.

    By the way, did you find what you were looking for while you were trolling through my archives? I hope so.

  2. Just Me says:

    Not to point out the obvious, but Bush also ran on a plan, very similar to his current one, in 2000, so it isn’t like reforming social security is a new idea, or the partial privatization is new. Bush is just pushing it more right now, then he did in his first term.

  3. Steve says:

    As for deficits, I really don’t know what you’re talking about. I’ve never suggested increasing the deficit permanently.

    Well somebody sure didn’t understand my post.

    On Medicare, demographics is only a part of its problems, and a relatively small part at that. The bigger issue is spiraling medical costs.

    Yep, somebody really does need a cluefinder. Your pretty good at reiterating my points Kevin. Good job.

    Say, Steve, you did notice that this post was from May 2003, long before Bush’s latest drive to privatize Social Security, didn’t you? It could hardly have anything to do with Bush’s current plans since I wrote it nearly two years ago.

    Say Kevin, did you notice that Bush’s plan is basically the same one he came up with in his first term? No? Geez, I’m not surprised.

    Off the top of my head, SS today is 4.2% of GDP. In 50 years it will 6.5% of GDP. That’s an increase of 2.3 percentage points. The United States is a very low tax country, and the deadweight loss from a tax increase like that is probably on the order of .3% of GDP if the CBO is to be believed. That gets you a total of 2.6 percentage points, which is actually less than my 3 percentage point guess from two years ago. It might amount to 3% over the entire next century, though.

    Thank you for verifying that I was indeed correct thank you. That is kind of you.

  4. dondo says:

    As stated eloquently in the Washington Post:

    Over the next 75 years [the Social Security] shortfall will amount to just 0.7 percent of national income, according to the trustees. [This is] a real chunk of change, but it pales alongside the 75-year cost of Bush’s Medicare drug benefit, which is more than twice its size, or Bush’s tax cuts if permanently extended, which would be nearly four times its size.

    I believe the current design of Social Security — pay as you go, with some attempt to amortize future shortfalls with limited savings — is the ideal way to run this sort of program. It’s worked well for decades; if the Government is fiscally responsible, there’s nothing to fear. The crux, the problem, the crisis, the horror is that the Bush administration is so fiscally irresponsible. The issue isn’t whether or not Social Security is in trouble; if the Governmetn is solvent, we can make minor adjustments for demographics.

    The debate is this simple: either you believe the deficits are a problem, in which case there is a BIG problem; or you believe the deficits are not a problem, in which case there is NO problem. You can’t point at a fabricated problem in Social Security while ignoring the rest of the budget.

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