Bryan Caplan  

Gerald Prante on Means-Testing

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Gerald Prante of the Tax Foundation, author of the best dissertation I ever chaired, emailed me some interesting comments on means-testing.  Reprinted with his permission:

Saw your post with regards to means-testing Social Security and Medicare. Such a system would likely be tied to income in retirement.  A lot of retirement income of the "retired rich" is based on how their investments performed. In other words, it is to some degree a selection bias of the winners of the stock market (in addition to those with high labor income and high savings rate as has been pointed out by critics).

So the question then becomes to a large extent the economic effects of an increased tax on the return of stock market winners. Part of this retirement winnings comes from inframarginal investment returns that have no deadweight loss.  The rest would be reflected mostly in the risk portion of the return to investment as opposed to the normal part of the return to saving (i.e., the time value of money return).  Government reducing the net payout from the risk return has no effect if they decrease the loss portion of the risk return as well.  (For example, capital gains taxes with no loss limit would simply be equivalent to government being a "partner" in the investment.)  So if government is largely redistributing from stock market winners to stock market losers, then it doesn't really change much economic activity as the expected return stays the same.

The behavioral assumption you raised is probably the best critique, and I've thought about this issue for a while now and from an economic perspective, I'm convinced that means-testing has a significantly smaller DWL than present-day marginal tax hikes.


In a follow-up email, Gerald adds:

The behavioral critique you raised is the number one argument against the implicit means-testing tax argument.  Thaler and Sunstein even argue that government needs to mandate employers make 401k participation yes by default because workers otherwise don't save enough (despite the tax advantages of 401k savings).



COMMENTS (7 to date)
Larry Willmore writes:

To the extent that good incomes in retirement are the result of luck in the stock market rather than hard work and savings, there is a case for taxing incomes of the wealthy elderly at a higher rate than incomes of equally wealthy young.

I am not convinced that retirement incomes depend largely on luck, but even if this were true, it would only justify collection of a surtax on income in old age. It would not justify means-tested Medicare. Why should a person who has the misfortune to be in bad health pay more taxes than than someone with the same income who enjoys good health? This is what means-tested health care is equivalent to. The percentage of benefits clawed back would be the same for each, but the sick person require more medical services, so receives more Medicare 'benefits' than a healthy person does.

Jim Glass writes:

The entitlement funding gap, in our progressive world, will be closed primarily via either...

* tax increases on the upper incomed to protect transfers to the upper incomed, or

* benefit cuts for the upper incomed to avoid tax increases on the upper incomed.

I have a hard time imagining how funding more transfers to the better off with more taxes on the better off could possibly *not* result in more deadweight cost to the economy.

Peter writes:

My support for a means test for Social Security (SS) and Medicare is rooted in the fact that program is not on the best financial footing, and action must be taken. When I envision means testing, I believe it ought to apply to the people who are not going to notice the loss of benefits. The people who can live comfortably in retirement without social security and medicare ought to do so. These programs were originally set up as insurance, not everyone collects on insurance.

Is it possible to have a voluntary means testing of SS & Medicare? The government could do something like offer a lower income tax rate to the people who are eligible for, but do not sign up for SS and Medicare. In example, if a person voluntarily chooses not to collect SS & Medicare, their income tax rate could be lowered by say 50%. This would encourage people to keep more of what they save, and lower the number of people collecting off the system.

Congressman Paul Ryan says the US has a spending problem, not a taxation problem. I agree with him. The question is how to reduce spending in all programs. Regarding SS and Medicare, I think it reasonable that the people who do not need them could be enticed not to collect them. I will let the experts figure out the best way to make it happen.

Milton Recht writes:

It is not a selection bias of winners over losers in the stock market. While individual stocks gain and lose different amounts over time, it is extremely unlikely that there are winning and losing retiring investors, as opposed to investment managers. Unless one is a wealth creator, such as Gates, Jobs, Zuckerberg, almost all investors own a diversified portfolio of stocks. Diversification proceeds very quickly and a portfolio is fairly well diversified by the time one holds in the neighborhood of 10 to 20 different stocks (simultaneously or over time), or a single mutual fund with holdings in several industries, even before one considers the diversifying effects of insurance, labor skills and education.

The disparate retirement income is much more related to different yearly savings rates and amounts (related to labor income) over the years of a worker's earnings, especially the early years, with higher early year savings leading to higher compounding effects.

Means testing is equivalent to giving a put option to low savers at the expense of high savers. The high savers are the counterparties to the put option and they will be taxed when the puts are exercised, means testing occurs.

By having the government write put options to low savers, the low savers portfolio value increases by the value of the put (the closer to exercise --the closer to retirement -the more valuable the put for low savers), and lowers the volatility (risk) of their retirement earnings stream.

Because the put is given and available as part of the low saver's portfolio at the beginning of his work years (though not exercisable at that time), the worker will save less than if the means tested put were never given.

At the same time, the government means tested put decreases the value of the higher saver's retirement portfolio and puts him/her in the position of deciding whether the government will write more puts (tax or means test his/her retirement income more) if his/her retirement portfolio increases. The government means tested puts will most likely also decrease the savings rate and savings amount of the higher savers.

If there is no means testing, then no put option is written against high savers, especially if all workers are taxed during their working years and the retirement benefit payout is close to a fair return on their working years retirement investment (retirement benefit related taxes).

TomO writes:

Peter:

Voluntary means testing through enticement is going to have very limited benefit. Its only going to be helpful to the government bottom line if the enticement is worth less (at least to the government) than the benefit. For upper income people this means the government could maybe spend less on them, but still needs to tax them for the amount to spend on lower income people. Its not likely to be a very attractive deal. And it likely raises administrative costs compared to a straight means test.

Jim Glass writes:

The entitlement funding gap, in our progressive world, will be closed primarily via either...

* tax increases on the upper incomed to protect transfers to the upper incomed, or

* benefit cuts for the upper incomed to avoid tax increases on the upper incomed.

I have a hard time imagining how funding more transfers to the better off with more taxes on the better off could possibly *not* result in more deadweight cost to the economy.

Floccina writes:

In a means tested SS world if you have a very good relationship with your children would you in some cases transfer wealth to their children and have the children give it back? IE if loss of SS is $100/month but the additional taxes on the children is less that $100/month. I believe that a person can transfer $10,000 per year per child tax free.

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