The most clever tax is one that you feel but don’t see.
Few taxes qualify as clever. There is no such thing as a clever sales tax— it’s always there, added to your bill and making the numbers uneven. Nor is there a clever income tax: most people see it every week when they examine their paystub.
But there is one very clever tax. So clever that most people don’t know that it exists.
What is it?
The Tax Hidden in Social Security
The invisible tax on Social Security benefits— one that millions of Americans have paid for decades without knowing about it. This invisible tax reaches the highest effective rate of any tax in America— an estimated 56 percent. Watch closely while I make it visible.
The employment tax seems very simple. If you work, you pay the tax. It doesn’t matter what you do, where you do it, or when you do it. If you work and are paid, you pay the employment tax. The tax is 15.30 percent of your wages if you are self employed or the same amount, split between you an your employer, if you are an employee. Either way, the tax comes to 15.30 percent but most of us see it as 7.65 percent which makes life easier for politicians.
The good news about the employment tax is that it is flat and has a limit. It applies to the first dollar of your earnings and you continue paying it until you reach a figure the system calls “the wage base maximum.” That was $60,600 in 1994 and will be $61,200 this year, a rate high enough that 93 percent of all workers earn less than the wage base maximum.
Nothing invisible about that, right?
Wrong.
We pay the employment tax in exchange for promised benefits for retirement, disability, and medical care. We pay the invisible tax when we go to collect benefits: your benefits will not be directly related to what you paid in. Instead, your benefits are related to a formula that puts a higher value on the first dollars of earnings and a lower value on the higher value of earnings. As a result, retirement benefits paid to a worker at the wage base maximum are only 44 percent of the retirement benefits paid to a lower wage worker. In effect, the higher wage worker has paid an invisible tax of 56 percent. That’s an AVERAGE tax rate, not a marginal tax rate— the tax you pay on the last dollar.
All this happens through an arcane set of calculations. The Social Security Administration bases your benefits on a single figure, the Primary Insurance Amount (PIA) and that, in turn, has three parts. In 1994 the formula credited 90 percent of the first $422 in average monthly earnings; 32 percent of the next $2,123 in average monthly earnings; and 15 percent of any amount over $2,545 a month, up to the wage limit. In other words, you got 6 TIMES as much in benefits for the first $422 of monthly income as for any income over $2,545.
Did that go by a little fast? Look at it this way: if your earnings were $422 a month, you faced an effective tax rate of 10 percent. But if you earn over $2,545 a month or $30,540 a year you face a marginal tax rate ( a loss of benefits per tax dollar paid) of 90 percent. Talk about steeply graduated tax systems…
Confused? Then lets examine how that effects the benefits paid. Here are the benefits estimated for different wage levels in the 1994 Mercer Guide to Social Security an Medicare:
Benefits Rise Slower Than Income
| Annual Income | $12,000 | $20,000 | $30,000 | $44,000 | $60,600 |
| Est. Benefits | $6,264 | $8,580 | $11,436 | $13,140 | $14,004 |
| Replacement Percentage | 52.2% | 42.9% | 38.1% | 29.9% | 23.1% |
| Index | 100 | 82 | 73 | 57 | 44 |
| Implied Tax | 0% | 18% | 27% | 43% | 56% |
Source: 1994 Mercer Handbook
As you can see, a worker who earns $60,600 a year— or 5 times as much as a $12,000 a year worker— doesn’t receive 5 times as much in benefits. In effect, the higher income worker pays a graduated tax. There is no exact way to calculate the effective tax because it all depends on your starting income— but however it is calculated, the highest income workers receive much less in benefits for every dollar of employment tax they pay than lower income workers.
It should be noted that this invisible tax is entirely seperate from the very real and visible tax on the benefits some Social Security recipients receive— THAT tax works to increase the effective rate still further.
Why am I telling you all this?
Because one of the Great Rumblings Out There is that Entitlements ( mostly Social Security) are bankrupting us and should be reduced or not paid to “the rich”. The real truth is that the most powerful redistributive “tax” we have is the invisible one, the Social Security benefit formula. At an apparent rate in excess of 50 percent and a marginal rate of 90 percent for the $30,540 a year Fat Cats, it already “soaks the rich”.
© A.M. Universal, 1995