New paper: “Does It Pay to Work? The Case for Cutting the Social Security Tax for Workers near Retirement”

I have a new Retirement Policy Outlook released by AEI today. The paper, "Does It Pay to Work? The Case for Cutting the Social Security Tax for Workers near Retirement," focuses on the marginal returns paid by Social Security to workers near retirement. The marginal return is the additional benefits earned for an additional dollar of taxes paid, and is a key incentive affecting decisions to continue working or leave the workforce and retire. Here the opening:

Social Security's 12.4 percent tax is the largest paid by most workers and Social Security benefits are the largest income source for most retirees. An individual considering whether to work or retire might ask, "What's in it for me? If I continue to pay into Social Security, how much additional benefit will I receive?" The answer: not much. The typical individual who works for an additional year before retiring will receive only 2.5 cents in additional benefits for each dollar of extra taxes paid to Social Security. This translates to a marginal rate of return of -49.5 percent. One reform to extend working years and enhance income security in retirement would be to reduce or eliminate the payroll tax for individuals above a given age.

Marginal returns are low for men because the Social Security benefit formula counts only their highest 35 years of earnings in calculating benefits; if an additional year of work isn't in the highest 35 – part time work comes to mind – then no additional benefits are received. Marginal returns tend to be low for women due to the presence of spousal benefits, under which a lower-earning spouse receives the higher of her own benefit or half her spouse's benefit. Women who receive auxiliary benefits, as most do, will in general face a -100 percent marginal return for additional taxes paid.

The argument here is that if we want older Americans to remain in the workforce, we need to give them an incentive to do so. The current Social Security benefit formula pays very little extra benefits to people who choose to work longer, which weakens incentives to delay retirement. While a number of different policies could improve marginal returns, I focused here on reducing the payroll tax for older workers. It's an easily understandable way to improve incentives to work and I think is worth considering as part of larger reforms.

This Retirement Policy Outlook is drawn from a longer paper co-authored with David Weaver and Gayle Reznick of the Social Security Administration, which was released by SSA earlier this week. That paper includes all the RPO's information on marginal returns, as well as analysis of lifetime rates of returns and a third measure we call incremental returns. The incremental return looks at the benefits a married person could receive by working, over and above the spousal benefits they would receive based on their spouse's earnings record. For example, a woman who works might receive only a little bit more benefits based on her own earnings record than she would receive if she had not worked and simply collected a spousal benefit. This structure means that most of the taxes she pays over her lifetime don't generate new benefits for her, and thus serve as a disincentive to work. Married women are generally held to be more responsive to tax rates than unmarried women or men, so it can be counterproductive if married women face the highest net tax rates at the margin.