Answer this question, please. You meet two people. They are the same age and sex. They live in identical condos, owned free and clear. Both are retired, collecting Social Security. They even drive cars of the same model and year. They could be twins, except for two details.
- Person A has Social Security of $18,000 a year and investments of $500,000, but no pension.
- Person B has Social Security of $24,000 a year, only $50,000 in savings and a pension of $40,000 a year.
Which one is better off?
If you follow the conventional wisdom, Person A is the wealthy one. With $500,000 in investments compared to the $50,000 of Person B, he has ten times more financial assets than Person B. The pension counts for nothing. Social Security isn’t counted, either. They aren’t counted because they are “income rights,” not assets.
But if you include the virtual wealth of pensions and Social Security, Person B is better off on two counts. The obvious one is Social Security: $24,000 in benefits trumps $18,000.
The pension is less obvious. You would need to invest $600,000 to have a life annuity of $40,000 a year. So when the virtual wealth of pensions is considered, Person B has the equivalent of $650,000 in assets. That puts him $150,000 ahead. Not to mention the 33 1/3 percent Social Security advantage. (Valuation was based on a 65 year-old-male.)
When you count rights to income--- the virtual wealth of Social Security and pensions--- the effective wealth and lifetime spending power can change radically. Indeed, as a study I wrote about last year clearly showed, the biggest wealth leveler we have is Social Security.
A new study by three economists, Professor Alan J. Auerbach at UC Berkeley, Professor Laurence J. Kotlikoff at Boston University and Darryl Koehler at The Fiscal Analysis Center, has taken an even broader look at the question. They have examined the distribution of lifetime spending and how it is changed by taxation, Social Security and pensions.
Auerbach and Kotlikoff are the prime movers in generational accounting, a discipline that sorts out the lifetime impact of public spending and taxing policies.
Their findings should inform any discussion we have of future tax policies and Social Security benefits. Here are the biggies:
- We’re a highly taxed nation. Calculated over a lifetime, we pay more in taxes than many people believe. Some of those high tax rates appear in unexpected places. One example they cite is of a low-income couple eligible for Medicaid. With income of $21,000, an additional $1,000 a year causes them to lose Medicaid benefits. The loss is the equivalent of a 933 percent tax rate on that $1,000.
- Lifetime tax rates are progressive. Lifetime net tax rates for the bottom 40 percent of the population are negative or very small. Nearly half the population receives more in lifetime spending benefits than it ever pays in taxes.
The lifetime net tax rate for the middle quintile was 12.3 percent. The lifetime net tax rate for the top 20 percent was 32.5 percent. And the top one percent paid at 45 percent rate. That’s pretty progressive. A major source of the difference is the redistributive power of Social Security.
- Lower life expectancies for lower income people reduce lifetime tax progressivity. When the researchers adjusted years of life to reflect the differences between high-income and low-income households, progressivity was reduced somewhat--- the poorer people collected Social Security for fewer years and the richer people collected longer.
- Current year tax rates reveal little about the lifetime impact of a tax policy or spending program. This is important. Political debates about taxes focus on current rates, not lifetime rates. In effect, we talk a lot, but fly blind.
Finally, since Social Security is such a powerful redistributor of lifetime spending, we ought to recognize that steps to raise the age for full benefits, changing cost of living indexes and other moves to control benefit spending would also further aggravate the growing disparities between rich and poor. Not a good idea.
So here’s a modest notion: The best way to reduce unhappiness about the distribution of wealth may be to focus on ways to have a sound Social Security system, with higher benefits for lower wageworkers.