Beware of Means Tests As a Way to Reduce the Budget Deficit

Conservatives are considering means tests on Social Security and Medicare benefits, which seemingly offer billions in savings while targeting only high income retirees who need benefits the least. But a means test is equivalent to a tax on work and saving, precisely the things Americans should do to reduce their dependence on government benefits.

A means test reduces a government benefit based upon the means -- that is, the current income or assets -- available to the beneficiary. While means test tasks can target benefit reductions to spare the poor, in doing so they impose an implicit tax on work and saving. An individual who loses 10 cents of benefits for each additional dollar of income effectively pays a 10% marginal income tax, on top of any other federal or state taxes.

Many government benefits for low earners and tax deductions for middle earners are effectively means tested by phase-outs as incomes rise. While not desirable, these implicit taxes generally have modest effects on working age individuals, who often will continue to work regardless because they have families to feed and mortgages to pay.

Retirees are a different story. Middle and high income seniors, in particular, have the income and resources to cease working if the incentives to work are poor. Economic research has shown that retirees are far more sensitive to marginal tax rates than are working age individuals.

Social Security's retirement earnings test, which reduces benefits by 50 cents for each dollar of earnings above $14,000, is a case in point. Retirees perceive the earnings test as a 50% tax on top of the other taxes they pay. As a result, many work only until they hit the $14,000 earnings threshold. This dynamic makes means tests on retirement benefits, like Social Security and Medicare, highly problematic from a policy perspective.

Nevertheless, the need to reduce entitlement outlays has caused many conservative commentators, policy analysts and lawmakers to reconsider means-testing Social Security and Medicare benefits. Two recent proposals highlight the benefits and pitfalls of applying means tests to higher income retirees.

A Medicare reform proposal from Republican Sen. Tom Coburn and Democratic Sen. Joseph Lieberman applies a means test to Medicare premiums and out-of-pocket costs, reducing Medicare outlays by $500-$600 billion over 10 years. Individuals with incomes up to $85,000 would pay Part B premiums of around $140 per month while those with incomes over $150,000 would pay about $400 per month. An increase in monthly income of $5,400 would imply increased Part B premiums of $260, a 5% implicit tax rate.

The Coburn-Lieberman proposal also would cap total out-of-pocket health spending at $7,500 annually for retirees with incomes up to $85,000, $12,500 for single retirees with incomes between $85,000 and $107,000, $17,500 for retirees with incomes from $107,000 to $160,000, and $22,500 for retirees with incomes from $160,000 to $213,000. This implies up to a 23% implicit tax on individuals with incomes from $85,000-$107,000, and around 8% on incomes above $107,000. Unlike the Part B premiums, these implicit taxes would apply only to the degree that retirees incurred health costs, complicating the incentives. However, a retiree with an income near the $85,000 threshold would think twice before exceeding it.

A second proposal goes further. A budget plan released by the Heritage Foundation would reduce Social Security and Medicare benefits for retirees with non-Social Security incomes exceeding $55,000 and eliminate benefits for retirees with incomes over $110,000. Around 9% of retirees would see some reduction with around 4% losing their benefits entirely.

This means test would generate significant budgetary savings -- at least on paper -- but it would subject retirees' incomes to onerous implicit tax rates. Retirees would lose approximately 45 cents of Social Security and Medicare benefits for each dollar of income above $55,000, an implicit tax rate of 45%. Coupled with a 25% tax rate enacted as part of Heritage's tax reforms, total taxes on affected retirees would reach 70%.

No one will willingly pay such high taxes. Where possible, retirees would reduce their incomes to avoid the means test, which means that retirees lose the income and much of the budget savings may not materialize. That's a lose-lose proposition. Heritage's overall budget proposal is solid -- reforming the tax code, fixing Social Security and shifting Medicare to a more sustainable premium support model. But the means test seems unwise as policy and unlikely to survive political scrutiny.

There is an alternative. Instead of limiting benefits based on current income, benefits could be reduced based on the individual's lifetime earnings, which Social Security already tracks as a way to calculate retirement benefits. Benefit reductions or premium increases based upon past earnings are not a means test. Instead of an implicit tax, this approach would give high earning individuals the incentive to work or save more to make up for reduced government benefits.

Entitlement costs must be reduced significantly and it makes sense to focus reductions on middle and high income individuals who can work and save more to make up the difference. But individuals won't work and save more if subjected to excessive means tests.

Andrew G. Biggs is a resident scholar at AEI.

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