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Economic Brief

November 2017, EB17-11

Can We Tax Social Security Benefits More Efficiently?
By Helen Fessenden and John Bailey Jones

Many seniors pay taxes on their Social Security benefits due to a provision in
the program’s 1983 reform, under which the portion of benefits that’s taxable
rises with total income. This tax structure can impose high marginal rates on
seniors even if their other income sources are modest. These high marginal
rates, in turn, can determine whether beneficiaries decide to keep working
or retire. Research suggests that several policy alternatives are more likely to
keep seniors in the workforce and to generate more revenue for the Social
Security Trust Fund.
Many older Americans are hit with a surprise
once they start collecting Social Security — they
find that a portion of benefits are taxable. In fact,
more and more seniors pay taxes on their benefits each year. But this wasn’t always the case.
From Social Security’s inception in 1935 through
decades of expansion, the federal government
never taxed the program’s benefits. In the 1970s,
however, Social Security came under considerable financial duress due in part to the decade’s
economic weakness, the disruption of high inflation, and policy missteps. In 1983, a bipartisan
group of policymakers and experts (including
future Federal Reserve Chair Alan Greenspan)
hashed out a comprehensive deal to place the
program back on the path toward solvency. They
also tried to shore it up for the decades to come
so that it could absorb the strains of a declining
U.S. birth rate and the impending retirement of
the baby boomer generation.1 The overhaul was
widely seen as successful, although the Social
Security Trust Fund still faces long-term solvency
issues. (It’s projected to run out in 2035, at which

EB17-11 - Federal Reserve Bank of Richmond

point benefits would still be paid, but at lower
levels, unless there’s a policy fix.)2
That 1983 deal included several provisions, such
as gradually hiking the full retirement age from
sixty-five to sixty-seven, to stave off insolvency. It
also sought to find some new sources of revenue
for the Trust Fund. One of those was taxing a
portion of Social Security benefits for relatively
better-off seniors for the first time. The idea was
that lower-income seniors would remain exempt,
while those in the middle and upper tiers would
pay tax on some of their benefits according to
a formula based on their other income. In 1993,
Congress established a second, higher threshold so that wealthier seniors would pay an even
greater share.3
This tax on benefits, while providing revenue to
the program, has had some significant consequences on how seniors plan the trade-off
between work and leisure. Because policymakers never indexed the original thresholds set

Page 1

in 1983 and 1993 to inflation, these taxes apply to
more and more seniors each year. By 2014, nearly
half of all beneficiaries owed taxes on their Social
Security benefits.4 (See Table 1.) And due to how
the thresholds are structured, some of these seniors
face marginal tax rates that exceed their statutory
rates by 85 percent, even if their total income puts
them only in the middle class.
At the same time, an increasing number of Americans are opting to work in their later years. In 1983,
for example, only 12 percent of those over sixty-five
were in the labor force; in 2016, that share had risen
to 19 percent. Yet many seniors (more than onethird) decide to claim benefits early, starting from
age sixty-two, and by age sixty-six, more than 90
percent claim benefits. Taken together, these trends
mean that many seniors have both wage income and
benefit income.5 This fact underlies the key question
in this Economic Brief: How do the marginal tax rates
on Social Security benefits affect a senior’s decision
on whether to work, and if so, how much to work?

In other words, does the current approach to taxing
benefits reduce a Social Security beneficiary’s incentive to stay in the labor force, given the prospect of
low after-tax pay?
Research by one of this Economic Brief ’s coauthors,
John Bailey Jones, in conjunction with Yue Li of the
University at Albany, State University of New York,
has found that taxation of Social Security benefits
does influence seniors’ decisions regarding work,
even if many are initially unfamiliar with how benefit
taxation exactly works. After testing multiple scenarios on how benefits could be taxed differently,
Jones and Li discovered that taxing benefits in the
same way as normal income would slightly diminish seniors’ labor force participation overall because
some lower-skilled workers would tend to drop out.
But more highly skilled workers would tend to work
more, which on net would bring more revenue into
the Trust Fund via the payroll tax on wages. This
alternative would allow policymakers to reduce the
payroll tax rate without losing revenue.6

Table 1: Taxes on Social Security Benefits by Income Class

			
Income Levels1

Percent of Recipients2		 I N B I L L I O N S O F D O L L A R S
Affected by Taxation		 Benefits Taxes on Benefits

Taxes on Benefits
As Percent of Benefits

Less than $10,000

--

26.0

--

--

$10,000 to $15,000

--

53.6

--

--

$15,000 to $20,000

--

64.0

--

--

$20,000 to $25,000

--

48.2

--

--

$25,000 to $30,000

2

43.6

--

--

$30,000 to $40,000

26

84.7

0.4

--

$40,000 to $50,000

57

71.1

1.5

2.0

$50,000 to $100,000

92

234.1

20.6

9.0

More than $100,000

99

137.3

28.8

21.0

All Recipients

49

762.5

51.3

6.7

Data are from tax year 2014. -- Denotes numbers that are less than 0.5
1
Income levels are for individuals or couples. “Income” is defined as adjusted gross income plus statutory adjustments,
tax-exempt interest, and nontaxable Social Security benefits.
2
“Recipients” is defined as everyone age sixty-two and over who claimed Social Security benefits.
Source: Congressional Budget Office

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A Tale of Two Taxpayers
So how does benefit taxation actually work? The 1983
reform established an income threshold of $25,000
for an individual ($32,000 for couples) so that those
below it would be completely exempt from benefit
taxation. Then, in 1993, a higher threshold of $34,000
for individuals ($44,000 for couples) was introduced,
so that those seniors earning above those totals
would see a greater share of their benefits taxed. As
noted above, more and more seniors are subject to
these taxes, with the greatest impact on those with
incomes over $50,000.
The first step in calculating the taxable share of
Social Security benefits is adding one’s basic income
(for example, wages, investment earnings, and other
pension income) to one-half of total Social Security
benefit income. If the result exceeds the initial 1983
threshold, the difference between that sum and the
threshold is divided in half (that is, multiplied by 50
percent). The result, in turn, is the taxable amount of
benefits. But if the higher 1993 threshold is crossed,
the amount in excess of that second cut-off is multiplied by 85 percent rather than 50 percent.7
As an example, take two individuals, John and Mary.
John has a basic income of $26,000, while Mary’s is
$32,000. Each collects an additional $16,000 annually in Social Security benefits, around the average
in 2016. This means that half of those benefits, or
$8,000, is added to their basic income to determine
whether the initial thresholds are crossed. Accordingly, John’s new “provisional income” is $34,000,
and Mary’s is $40,000.8
This calculation means that John crosses the first
threshold of $25,000 but stops exactly at the second
threshold. By contrast, Mary crosses both thresholds,
with a total well over $34,000. So John must list $4,500
of his benefits as taxable income (half of $9,000, or the
difference between $34,000 and $25,000). This lifts his
adjusted gross income — basic income plus taxable
benefits — to $30,500. But Mary must list $9,600 in
taxable benefits ($4,500, like John, plus an additional
$5,100, or 85 percent of the difference between
$40,000 and $34,000). This boosts her adjusted gross
income to $41,600. These adjusted gross income to-

tals are very important because they determine how
much tax John and Mary actually pay.
In effect, then, a much larger share of Mary’s benefits
is subject to taxation even though they both collect
the same amount in Social Security payments, and the
difference in their basic income (outside of benefits)
is only $6,000. So how do these differences in taxable
income translate into taxes owed? Based on the Internal Revenue Service’s 2016 tax tables and assuming
that John and Mary both take a standard deduction
of $6,300, claim a personal exemption of $4,050, and
apply no other adjustments, John would owe $2,563
in tax on his $30,500 in adjusted gross income, while
Mary would owe $4,228 in tax based on her $41,600
in adjusted gross income. In other words, Mary’s additional $6,000 of basic income results in an additional
$1,665 of tax owed.
Suppose Mary is working a part-time job that earns
her that extra $6,000 a year. Once Mary sees the difference between her tax bill and John’s, she might
rethink her income strategy. In the absence of the
Social Security benefits, Mary would fall in the second lowest income tax bracket and pay a marginal
tax rate of 15 percent on her earnings. Because of
the benefit taxation formula, however, Mary’s effective tax rate is 27.75 percent. That jump means that
benefit taxation increases Mary’s marginal income
tax rate by 85 percent.9 In short, she may decide to
scale back her hours or even quit.
If Mary does cut back on hours or quit, that outcome
is what economists call the substitution effect: she
substitutes more leisure in exchange for relatively
little after-tax pay. Alternatively, the taxation of her
Social Security benefits could encourage Mary to
work more while receiving benefits to offset the relatively large tax bill. This outcome is what economists
call the income effect. Because households differ in
their benefits, earnings, and other income, the substitution and income effects of benefit taxation can
vary greatly.10
Making Work Pay
An important insight for understanding these tradeoffs is the concept of labor elasticity, or how much

Page 3

a person’s incentive to work changes depending
on pay and other circumstances. Prime-age workers tend to be labor-inelastic. Wage income is their
primary means of support, and they don’t have many
options for replacing that income with other revenue. Seniors, by contrast, typically have other sources
of support, such as Social Security, asset income, or
private pension income. Accordingly, they’re more
likely to have some flexibility on whether they want
to substitute work for leisure, everything else being
equal. (They also tend to not be supporting dependents at that point, and they have guaranteed health
care through Medicare starting at age sixty-five.)11
To test the outcomes of different tax policy alternatives, Jones and Li constructed a model based on the
parameters of the U.S. economy in 2006. By analyzing
data on work and retirement decisions, and on when
seniors claimed benefits, they ran six different scenarios on taxation alternatives, two of which are discussed in detail here. They found that whether benefits are taxed as normal wage income, or not taxed at
all, labor force participation and hours worked among
higher-skilled seniors rises in both cases. Indeed, in
the latter case — not taxing benefits at all — the fiscal impact is effectively neutral because the increased
share of seniors working means more revenue for the
Trust Fund from the payroll tax.12
So what would the outcome be if most benefits —
in this case, 85 percent — were treated like wage
earnings, with 6.2 percent dedicated to the payroll
tax and the rest taxed as normal income? Jones
and Li found that on net, labor force participation
among those sixty-two and over would fall slightly,
from 28.8 percent to 28.3 percent. But a more
important finding concerns what Jones and Li term
“efficiency units.” This measure takes into account
not just the straightforward questions of labor force
participation and hours worked, but how workers’
skills differ, as well as how much they increase when
workers stay in full-time jobs rather than transitioning to part-time positions.13 In this scenario, total
efficiency units of labor increase by more than 8
percent, reflecting the increased participation and
hours worked among higher-skilled seniors. But perhaps the most dramatic effect would be on the fiscal

side: the extra money coming from more highly
skilled seniors contributing payroll tax means that
the current 12.4 percent levy (which is split between
workers and employers) could be lowered to 11.54
percent while staying revenue neutral. This would
benefit all workers.
What if Social Security benefits were simply tax-free,
like they were before the 1983 reform? Here, too,
Jones and Li found positive effects. Labor force participation among those sixty-two and older would
rise in this case, from 28.8 percent to 32.3 percent,
while total efficiency units for the group would jump
almost 16 percent. As for the fiscal effect, the current
payroll tax basically could be left unchanged: even
though the Trust Fund would no longer get revenue
from benefit taxation, most of that would be made
up by more seniors paying payroll taxes. (In 2016,
benefit taxation generated 3.4 percent of the Trust
Fund’s total income.)14
Opting In, Opting Out
Regarding these findings, Jones and Li note an important caveat with important policy implications.
In their model, they assume that seniors have perfect
knowledge of how Social Security benefits are taxed.
In the real world, many seniors are unaware of these
taxes until they start claiming benefits, and even
then, some don’t fully understand the complex calculations needed to evaluate the trade-offs. Indeed,
other research has shown that only 57 percent of
prime-age workers know that benefits are taxable.15
To see how much this knowledge matters, Jones and
Li run another calculation under a “limited information” model, in which seniors become aware of
benefit taxation only after they have received Social
Security for one year. Jones and Li find a modest
income effect — on net, seniors work more, so that
they can earn more income to offset the unexpected new taxes — but this effect is smaller than the
effects of the policy alternatives described above.
Their findings also suggest that seniors who are
aware of benefit taxation prior to claiming are more
likely to delay taking benefits.
Jones and Li’s other key findings relate to the nature
of labor supply: the impact of Social Security taxa-

Page 4

tion is primarily seen through a worker’s decision
to stay in the labor force (what economists call the
“extensive margin”) rather than adding or reducing
hours worked per week (the “intensive margin”). This
is because the fixed time costs of working (commuting, etc.) encourage most people to work either
many hours or none at all. In other words, when a
senior faces benefit taxation, it’s likely that his or her
main decision is whether to stay employed full time
or quit altogether. Even though seniors may not
know exactly how benefit taxation works, it’s clear
that working will lead to significantly higher taxes,
regardless of whether they adjust hours worked per
week. This may well be enough to inform their labor
supply decisions.16
In sum, this research shows that potential policy
solutions exist that might induce more seniors to
stay in the workforce, perhaps even boosting Social
Security’s solvency. Even though benefit taxation is
complex, it has a clear impact on important lifecycle decisions in one’s later years given the longer
life expectancy and increased labor participation
among today’s seniors. The subject merits more research among economists to better understand
how these decisions are made.
Helen Fessenden is an economics writer and John
Bailey Jones is a senior economist and research
advisor in the Research Department of the Federal
Reserve Bank of Richmond.

5

T he 1983 reform kept intact the option to claim benefits early,
starting at age sixty-two, with the trade-off that the monthly
payouts are smaller. But it gradually lifted the full retirement
age for Social Security from sixty-five to sixty-seven. In general,
the share of seniors claiming early has been dropping by birth
cohort, but it remains popular. See Alicia H. Munnell and Anqi
Chen, “Trends in Social Security Claiming,” Center for Retirement Research at Boston College Issues in Brief No. 15-8, May
2015.

6

S ee John Bailey Jones and Yue Li, “The Effects of Collecting Income Taxes on Social Security Benefits,” Federal Reserve Bank
of Richmond Working Paper No. 17-02R, September 19, 2017.

7

S ee Social Security Administration, “Benefits Planner: Income
Taxes and Your Social Security Benefits.”

8

T his comparison has different income figures but is based on
a similar example in Liou and Whittaker, 2016.

9

I n a real-world case, Mary would pay payroll taxes on these
part-time wage earnings as well. To keep the calculations in
this article simple, however, payroll taxes are not included in
the estimates for Mary and John.

10

J ones and Li suggest that the substitution effects of the benefit tax can dominate the income effects across quintiles. But
other researchers suggest a stronger income effect for high
earners. In other words, they find that the introduction of
benefit taxation in 1983 caused more high-income seniors to
stay in the labor force. See Timothy F. Page and Karen Smith
Conway, “The Labor Supply Effects of Taxing Social Security
Benefits,” Public Finance Review, May 2015, vol. 43, no. 3,
pp. 291–323 (available with subscription).

11

F or an analysis of labor elasticity and how tax policy affects
decisions across the life cycle, see Marios Karabarbounis,
“A Road Map for Efficiently Taxing Heterogeneous Agents,”
American Economic Journal: Macroeconomics, April 2016, vol. 8,
no. 2, pp. 182–214 (available with subscription).

12

T he findings described in this section are explained in fuller
detail in Jones and Li, 2017. That paper also elaborates on
four other policy scenarios: eliminating the earnings test for
benefits; eliminating the earnings test and benefit taxation;
eliminating the higher tax threshold of 1993; and keeping
both thresholds but indexing them to inflation. All of these are
de facto forms of tax cuts for most beneficiaries, and all would
increase labor force participation to varying degrees.

13

T ypically, when older workers transition from full-time to parttime work, their hourly wages fall. See Daniel Aaronson and
Eric French, “The Effect of Part-Time Work on Wages: Evidence
from the Social Security Rules,” Journal of Labor Economics, April
2004, vol. 22, no. 2, pp. 329–352 (available with subscription).

14

B
 enefit taxation revenues are split between the Social Security
and Medicare Trust Funds. See Liou and Whittaker, 2016, p. 9.

15

M
 atthew Greenwald, Arie Kapteyn, Olivia S. Mitchell, and Lisa
Schneider, “What Do People Know about Social Security?”
Financial Literacy Consortium Working Paper, October 2010.

16

S ee Eric B. French and John Bailey Jones, “Public Pensions and
Labor Supply over the Life Cycle,” International Tax and Public
Finance, April 2012, vol. 19, no. 2, pp. 268–287 (available with
subscription). Older workers also tend to divide their late ca-

Endnotes
1

2

3

4

F or a concise overview of the program’s history, including
the 1983 overhaul, see Patricia P. Martin and David A. Weaver,
“Social Security: A Program and Policy History,” Social Security
Bulletin, 2005, vol. 66, no. 1.
E ach year, the government provides an updated account of
the health of the program. See Social Security Administration, 2017 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability
Insurance Trust Funds.
 obert M. Ball, a key Democratic architect of the program in
R
the postwar years and commissioner of Social Security in the
1960s, made the case that year for hiking taxes on benefits.
See “Raise Social Security Taxes,” New York Times, July 2, 1993.
S ee Wayne Liou and Julie M. Whittaker, “Social Security: Calculation and History of Taxing Benefits,” Congressional Research
Service Report, October 27, 2016.

Page 5

reers into phases, often finding a “bridge job” that is a transition between their former full-time career and retirement.
See Michael D. Giandrea, Kevin E. Cahill, and Joseph F. Quinn,
“Bridge Jobs: A Comparison across Cohorts,” Research on
Aging, September 2009, vol. 31, no. 5, pp. 549–576 (available
with subscription).

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and not necessarily those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.

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