Implicit Taxes on Work at Older Ages.

• Author: Goda, Gopi Shah
• Position: Research Summaries

The biggest financial challenge for most Americans is funding their retirement. In recent decades, working lives have not kept pace with increasing life expectancies, leading to longer retirements. (1) Longer retirements are more challenging to finance, whether through private savings or federal entitlement programs such as Social Security and Medicare. The structure of retirement programs can produce large implicit taxes and subsidies for work at older ages as well as for alternative strategies to tap into retirement resources. These implicit taxes and subsidies can distort behavior, and failure to understand them can result in households passing up six-figure arbitrage opportunities.

The three of us, together with a set of outstanding coauthors, have been writing about these issues for more than a decade. This article summarizes our work, drawing on the results of several studies.

We first describe the implicit taxes on wages earned by the elderly that are embedded in Social Security retirement and disability insurance and Medicare. Then we cover the subsidy or actuarial advantage of delaying the commencement of Social Security, a decision that for many people will involve working longer. A clearer understanding of the work and claiming incentives embodied in federal programs can help policymakers improve their design and avoid unintended consequences.

Implicit Taxes for Older Workers

Our earliest study of implicit taxes on wages earned at older ages focuses on the Social Security retirement program. The study documents that current Social Security tax and benefit rules lead to an increasing implicit tax on work at longer career lengths. (2) Social Security benefits are based on the average of the highest 35 years of earnings, indexed for economy-wide average wage growth. A progressive formula is applied to this average to arrive at the monthly Social Security benefit. We show that as career length increases and career average earnings rise, benefits rise less quickly than earnings and taxes, resulting in implicit net taxes. Once 35 years of earnings are reached, additional years of earnings have little or no effect on Social Security benefits, resulting in an implicit tax that approximates the full 10.6 percent payroll tax rate. The implicit tax rates for four stylized workers are shown in the left panel of Figure 1. (3)

We also analyze three policy changes that could collectively reduce implicit taxes: (1) basing benefits on the highest 40 years of indexed earnings; (2) changing the benefit formula so that short careers with high earnings are treated differently than long careers with low earnings; and (3) eliminating the payroll tax for individuals who have reached 40 years of work. The resulting implicit taxes generated by the retirement program of Social Security are shown in the right panel of the figure. These changes could be implemented in a revenue-neutral way that maintains average benefits.

We find a similar effect for Social Security disability insurance. (4) To be eligible for disability insurance, a claimant must have worked in at least five of the past 10 years. Thus, workers who are within five years of full retirement age--at which point disability benefits are converted to retirement benefits--can maintain eligibility for disability benefits regardless of whether they work, although they continue to pay the 1.8 percent payroll tax to fund the program. Moreover, even though workers who are more than five years from full retirement age will lose eligibility if they stop working entirely, the incentive to earn income beyond the minimum required to maintain coverage weakens as they age because the length of time over which any potential disability benefits would be paid shrinks.

We have also studied the implicit taxes resulting from the Medicare as Secondary Payer (MSP) provision. (5) Requiring employer-sponsored health insurance to be the primary payer for Medicare-eligible workers increases the cost to employers of hiring these workers and reduces the pay they are willing to offer. The provision effectively forces Medicare-eligible individuals to forgo their Medicare coverage if they work for an employer that offers health insurance. Using data on Medicare costs, we estimate that this implicit tax is between 15 and 20 percent of wages at age 65 for average earners. It increases to 25-35 percent by...