MCF and Social Security Benefits

Wildasin (1992) made a calculation of the net benefits in the US of having future government transfer payments (social security benefits paid when one has retired) for the cohort of current workers who must pay taxes for it now. In the US, social security covers pensions and health insurance for the elderly (Medicare). Part of the costs was an estimate of the MCF caused by the income (payroll) taxes. Wildasin’s study provides insights into the ingredients of the MCF and how it impacts outcomes in an important, general health policy setting.

122 CM and CBA

Social cost of taxation 123 Table 5.2: Estimates of the marginal cost of funds for US state

governments (MCF_S)

State Property Sales Income Other Charges Average

taxes taxes taxes taxes and misc. MCF

(%) (%) (%) (%) (%) (%)

Alabama 1.69 19.26 25.08 25.79 28.20 1.218

Alaska 2.36 0.00 12.08 22.58 62.99 1.280

Arizona 3.82 36.68 22.17 18.19 19.14 1.187

Arkansas 0.22 29.10 28.97 21.01 20.70 1.196

California 4.03 25.63 42.03 11.27 17.03 1.206

Colorado 0.21 18.13 34.86 16.91 29.90 1.224

Connecticut 0.00 33.26 20.12 23.97 22.65 1.190

Delaware 0.00 0.00 33.91 31.85 34.25 1.251

District Columbia 25.98 15.67 27.77 12.56 18.03 1.239

Florida 1.66 48.76 4.63 24.47 20.48 1.164

Georgia 0.30 27.24 43.79 14.00 14.67 1.198

Hawaii 0.00 34.39 28.72 11.27 25.62 1.196

Idaho 0.01 26.85 32.41 19.05 21.68 1.202

Illinois 1.56 26.63 31.29 20.82 19.70 1.201

Indiana 0.04 33.35 28.78 14.11 23.72 1.195

Iowa 0.00 22.07 32.58 20.16 25.19 1.212

Kansas 0.96 25.60 33.11 19.60 20.74 1.204

Kentucky 5.44 20.18 27.46 24.87 22.05 1.215

Louisiana 0.45 20.84 16.29 25.74 36.68 1.222

Maine 1.36 24.61 31.78 17.96 24.29 1.209

Maryland 2.05 18.94 37.52 19.34 22.15 1.216

Massachusetts 0.01 18.07 47.49 13.10 21.33 1.218

Michigan 2.29 21.51 38.87 13.85 23.48 1.216

Minnesota 0.10 22.00 36.97 20.18 20.75 1.208

Mississippi 0.67 35.91 18.77 24.40 20.25 1.184

Missouri 0.19 30.46 33.32 16.85 19.18 1.195

Montana 3.36 0.00 29.51 33.91 33.22 1.252

Nebraska 0.20 24.06 27.20 19.63 28.92 1.212

Nevada 0.98 43.39 0.00 38.80 16.83 1.164

New Hampshire 0.90 0.00 17.21 37.93 43.96 1.257

New Jersey 0.18 22.56 30.06 22.26 24.94 1.210

New Mexico 0.01 25.54 13.58 21.18 39.70 1.218

New York 0.00 17.59 48.51 15.22 18.68 1.216

North Carolina 0.98 19.24 43.19 19.90 16.69 1.210

North Dakota 0.10 19.85 13.26 26.36 40.43 1.226

Ohio 0.09 24.04 31.87 19.91 24.09 1.208

Oklahoma 0.00 17.77 23.88 34.02 24.33 1.212

Oregon 0.01 0.00 48.03 17.93 34.04 1.256

Pennsylvania 0.93 25.78 26.68 26.30 20.32 1.200

As the focus is on monetary effects, the evaluation is of transfer payments themselves, which we referred to in our earlier discussion as repayments R.

However, the repayments are not symmetrical in terms of gains and losses, because the sum that is paid out when a person is retired may differ in value from the taxes that are paid now. As repayments are not symmetrical on both sides, criterion (5.1) which results in R canceling out to form B ⫺C⬎0, does not apply. Instead, we treat R as leading to separate values for benefits and costs. These values, relating as they do to transfer payments, are immediately expressed in monetary terms. The cost values relate to taxes paid. Since these taxes generate a MCF, the appropriate criterion for evaluating the cash ben-efits and costs is B⬎C.MCF, which is relation (5.5).

The cash benefits are received in the future when a person retires and so must be discounted at the rate r. The future is considered one period away from the current period when a person is working. (Essentially, Wildasin was using a two-period model for a worker aged 45 years with each period roughly 20 years.) For each dollar of social security, the benefit is simply:

B⫽$1/(1⫹r).

This benefit is less costly to current workers when more other workers are around to pay the income taxes and there are fewer retirees. Let n be the number of other young workers per person who retires. Then (1⫹n) is the total number of workers per retiree. Costs are inversely related to (1⫹n), seeing that, for a dollar of future benefit, the current cost for each worker

124 CM and CBA

Table 5.2(cont.)

State Property Sales Income Other Charges Average

taxes taxes taxes taxes and misc. MCF

(%) (%) (%) (%) (%) (%)

Rhode Island 0.50 23.10 29.24 15.06 32.10 1.219

South Carolina 0.17 28.23 30.72 18.64 22.25 1.201

South Dakota 0.00 29.78 3.38 26.57 40.27 1.210

Tennessee 0.00 43.20 9.02 26.31 21.48 1.172

Texas 0.00 37.82 0.00 38.25 23.93 1.178

Utah 0.01 26.34 27.98 14.45 31.22 1.213

Vermont 0.04 13.76 26.04 25.82 34.34 1.231

Virginia 0.31 14.37 38.49 20.61 26.23 1.225

Washington 12.55 48.83 0.00 19.82 18.79 1.173

West Virginia 0.07 23.09 26.89 26.28 23.67 1.207

Wisconsin 1.69 23.07 36.95 16.57 21.72 1.210

Wyoming 7.30 13.86 0.00 31.73 47.11 1.244

Source: Brent (2003)

paying taxes for the social security benefit is: C$1/(1n). For example, if there are four other workers for every retiree then n4. An individual worker has four others paying taxes on their incomes in addition to the tax that he or she is paying. So 1n5 is the total number of people sharing the tax bill. Thus, for each dollar of social security benefits, an individual worker must pay $1 / 5 (i.e., $0.20 or 20 cents).

If we ignore the effect of the MCF, the result so far is that net benefits of a dollar’s worth of social security financed by an income tax will be posi-tive for a current worker if 1 / (1r)1/(1n), i.e., if rn. This would seem to be easily satisfied. But note two points. First, the rate of discount here is an intergenerational one covering a 20-year period. In this context, for example, a 5% annual interest rate makes 1r1.05 and this com-pounded for 20 years becomes 2.65. The intergenerational r in this case would be 1.65 (as 1r2.65). So r would probably be a number greater than 1 and not a small fraction. Second, the workers-to-retirees ratio n is not likely to be a constant over time. Fertility rates are falling in most indus-trialized countries. This factor, which eventually lowers the number of young workers, means that n will probably fall over time. So, even if for today’s cohort of workers rn, there may be a future cohort for which this inequality is reversed and net benefits of an extra dollar of social security would be negative.

Column (2) of Table 5.3 (which combines parts of Wildasin’s Tables 1 and 2) shows the tax cost that existed in the US in 1985 and how it is likely to change over time using three alternative demographic and economic scenarios. Alternative I is ‘optimistic’, alternative III is ‘pessimistic’ and alternative II is in between. In all three scenarios, n falls over time, which means that the tax cost 1 / (1n) will rise.

Now let us consider the effect of incorporating the excess burden of tax-ation into the calcultax-ations of tax costs. An important way that there is an excess burden from wage taxes is that, by lowering the net wage, the effec-tive price of leisure is reduced. So one can expect that the labor supply will be reduced. That is, people will work less (e.g., fewer hours). The less people work, the less will be wage earnings and so the tax rate necessary to pay for any level of benefits will rise, causing the tax cost to rise. This distortionary impact on leisure of changes in net wages is quantified (as in the Ballard et al. study) by the elasticity of supply of labor.

Wildasin makes the point that for an activity like social security, where the benefits are cash transfers, it does not make any sense to adopt the stan-dard assumption that government expenditures will be revenue neutral.

The incomes of workers will initially rise due to the cash benefits. The workers can afford to buy more leisure and work less, which is to say that they will choose to earn less subsequent income. When taxable income falls,

Social cost of taxation 125

tax revenues will fall. So the labor supply distortion per unit of revenue (which is the MCF in the Wildasin model) will go up when the revenues fall.

Columns (3) and (5) in Table 5.3 show the effect on the tax cost to finance $1 of future benefits of both the labor supply distortion and the loss of revenues due to the income effect. Wildasin combined alternative estimates for the labor supply elasticity (0.07 and 0.27) with alternative estimates of the decrease in tax revenues per dollar of social security ben-efits (⫺0.20 and ⫺0.17 ). (Case 1 pairs 0.07 with ⫺0.20; while case 2 pairs 0.27 with ⫺0.17.)

Wildasin does not present his MCF estimates explicitly. But we can deduce the estimates from columns (3) or (5), which relate to MCF.C, and column (2) in Table 5.3, which records C on its own. For example, in 1985, if we multiply the unadjusted cost of 0.200 in column (2) by 1.05 we get the MCF adjusted cost of 0.210 in column (4). So the lower bound (case 1) MCF estimate is 1.05. The upper bound MCF estimate (case 2) is 1.35, i.e., the 0.200 in column (2) multiplied by 1.35 leads to the 0.270 figure in

126 CM and CBA

Table 5.3: Net benefits of a permanent $1 increase in social security (1985–2060)

Year Tax cost Tax cost Net benefit Tax cost Net benefit

1 / (1⫹n) with MCF with MCF

2025 0.339 0.370 ⫺0.030 0.370 ⫺0.13

2050 0.393 0.440 ⫺0.050 0.630 ⫺0.29

column (5). Over time the MCF estimates rise dramatically, so much so that in 2060, the lower bound for the MCF is 1.28 and the upper bound is 6.15.

The result, i.e., the net benefits of a permanent (every year) increase by

$1 in social security benefits for the two cases, is shown in columns (4) and (6) of Table 5.3. The discount rate applied to the benefits was 3% per annum. In either case, after 2025, the net benefit of social security for current workers becomes negative.