Tag: volatility

Note: this post has been updated. The changes corrected various minor errors and did not make any substantive changes. If you previously read the post, there is no reason to re-read it.

The Strib published John James’ and my op-ed on legislative proposals to exempt more social security benefits from taxation.  After writing the op-ed and my earlier blog post, I had a couple more thoughts about the topic and this post records them, focusing on two items: revenue volatility and “declining returns” on social security for younger workers.  Space limitations, as well as a lack of general interest by newspaper readers, did not make either of these topics appropriate to address in the op-ed.

Revenue volatility. A point that I failed to make in my blog post was that exempting social security benefits from taxation would make Minnesota’s tax revenues more volatile, as well as less elastic (the latter point was made in both pieces).

A little discussed fact is that the last three major states tax changes –the 2013 increases by the DFL, the 2017 GOP tax cuts, and 2019 compromise tax bill – all made Minnesota’s tax revenues more volatile.  The combined effects of those changes was to increase volatile revenue sources, while reducing more stable revenue sources.

To my knowledge, no one has tried to measure the resulting effects on volatility.  When we’re in a period of steady economic growth (the situation since 2010), interest in volatility or how much revenues rise and fall with the business cycle declines. One way to calculate volatility is with standard deviations (or any of a variety of related statistical measures of variance) or with the cyclical swing index, a measure which a couple of coauthors and I calculated about 30 years ago for some of Minnesota tax revenues [House Research Department publication not available on the Internet].

Here’s why the 2013 – 2019 tax changes increased volatility:

2013 tax increase.  The 2013 increase had three main components: (1) adding a fourth rate bracket at the top the individual income tax rate schedule, (2) a cigarette excise tax rate increase, along with indexing the rate for inflation in cigarette prices, and (3) a corporate tax increase implemented by expanding the base mainly to more income related to foreign operations.  Two of these changes yield relatively volatile revenues –

1. The income tax rate increase applies to filers with the highest incomes (> $250K).  These filers have a very large share of the most volatile sources of income – capital gains and business income.  The volatility of revenues from taxing capital gains is quickly revealed by skimming a few MMB forecast write-ups – both how difficult they are to predict and how much they fluctuate.  It’s like tying your revenues to the stock market.
2. The corporate tax is the most volatile of the state’s major sources of tax revenue.  Twice over the last four decades it has experienced 50% drops in its revenues – in the double dip recession of the early 1980s and during the Great Recession. In any recession, it typically declines in nominal terms.

The third change, a large increase in the cigarette excise tax rate, by contrast, yields stable revenues since it is a per cigarette amount and smokers are addicted, dampening down their ability to avoid the increase by stopping or reducing their smoking.  (The tax is a declining revenue source, however, because smoking is declining despite its addictive nature.) The 2013 bill did eliminate the fixed dollar feature of the tax by indexing its rate for price increases in cigarettes, making the revenue less inelastic.  Most of the money in the 2013 tax bill was in the income tax rate increase.

2017 tax reduction. When the GOP controlled both houses of the legislature in 2017-18, they maneuvered Governor Dayton into signing their 2017 tax cut bill.  This bill focused much of its reduction on the most stable source of state tax revenues by reducing the state general tax levy and eliminating its indexing.  The state general tax is as a fixed dollar levy that is paid almost without regard to underlying economic conditions.  By repealing the indexing of both cigarette taxes and the state general tax, the bill also reduced the elasticity of tax revenues.

2019 tax bill. This was a compromise bill whose principal features were to conform to TCJA’s changes (the 2017 federal tax act) and to enact a modest individual income tax rate cut.  The rate cut is pretty much neutral on volatility, although income tax revenues are more volatile than sales tax revenues (so a sales tax rate cut would have increased volatility more than an income tax rate cut).  The bigger effect resulted from TCJA conformity.  TCJA changes included a substantial number of business base expansions, which were used to help offset its revenue losing provisions (mainly rate cuts and faster cost recovery).  Minnesota conformed to these base expansions – in other words, corporate and business income tax increases – and used the revenue to help offset the individual income tax changes.  The net effect makes Minnesota’s tax revenues more volatile because of the volatility of taxes based on corporate profits and business income.

Thus, the legislature has been increasing volatile revenue sources and cutting stable ones, while taking some of the elasticity out of the system by repealing indexing provisions that preserve the tax base from eroding with inflation.  With regard to the latter, no one seems to be concerned about or attempting to repeal the indexing provisions that protect taxpayers in the individual income tax – suggesting the GOP aversion to indexing is just really a feature of their general tax aversion, not some sort of philosophical principle (e.g., that the legislature should be compelled to vote on any and all inflation adjustments because otherwise tax policy would be on autopilot or something like that).

By contrast, the tax on social security benefits is a very reliable and stable revenue source.  Since these federal government payments are required by law, they are almost as reliable as collecting treasury bond interest.  Not quite – they depend upon the recipient’s other income sources and if the social security trust fund is ever allowed to run dry, the law provides for an automatic haircut in benefits.  That is now estimated to occur in about 15 years, but Congress seems unlikely to let it occur because of the political blowback.

Bottom line: exempting social security benefits from taxation does not score well on the reliability element of the revenue adequacy principle. By eliminating a very stable revenue source, exempting more social security benefits from taxation will make Minnesota tax revenues more volatile.  No one seems to ever talk or care much about these issues until a deep recession hits and, then, concerns rise.  Changes over the last 7 years have tended to make Minnesota tax revenues more volatile. Given recent events related to COVID-19, I would not be surprised if this doesn’t become a topic for legislative discussion sooner, rather than later.

Relevance of “declining returns” on social security for younger workers.

A few people responded to John and my op-ed with disbelief that the 15% allowance actually allows a fair and full recovery of their employee contributions to social security, negating the double taxation argument that is often made.  This skepticism is fueled by media coverage about how bad a “deal” social security now is for current workers with “negative returns” for some, particularly those with high lifetime earnings.  I can easily see how the typical media stories could lead to the expressed skepticism about John’s and my assertion.  So, I decided it would be useful to gather and state my thoughts on it.

It is a case of comparing apples and oranges.  The Social Security Actuary’s estimate of the 15% allowance and the estimates of how “good a deal” social security is for today’s workers are measuring or calculating two related but crucially different things. That is apparent by analyzing what each is doing and why.

Estimates or calculation of the “return” on social security.  I tend to see estimates of these hypothetical “returns” presented in three different contexts:

• The Social Security Actuary has long prepared estimates of “Money’s Worth Ratios” for various hypothetical Social Security participants.  Here’s a link to the most recent version that I could find on SSA’s website (published January 2019).  You can see in its tables (##1 – 6) how younger workers are paying in more and getting out less than older generations.
• Economists evaluating Social Security make similar calculations.  Social security is, of course, not a pension plan, but rather a complex social insurance program that by design redistributes income from some groups to others.  In addition to retirement income, it provides de facto life insurance and disability protection and is a pay-as-you-go program, not a pre-funded insurance or pension plan.  Economists, of course, are interested in measuring exactly what that program does and in evaluating its effects.  See here for an analysis along those lines by economists at the Urban Institute.  These analyses, like the SS Actuary’s, show declining returns if getting a “return” for your contributions (as well as your employer’s contributions on your behalf) is how you want to characterize social insurance protections.  I tend to think of it as society making sure that all of its members have a basic safety net protecting them – whether because of matters beyond their control or simply because they failed to appropriately prepare.  The latter, of course, irritates those with more libertarian sensibilities than mine.
• When privatization of social security was a hot topic (e.g., during and shortly before the second Bush administration), advocates of it often made a big deal about how workers would be financially better off if they could just keep their money and invest it in private accounts like a 401(k).  There are many heroic assumptions in all of that, of course.  These sorts analyses were popular publications by right-leaning or conservative organizations like Heritage (see the “A Bad Investment” section).

What all these estimates or calculations have in common is estimating or measuring the sum of three things: (1) employee contributions (e.g., the after-tax employee FICA payments), (2) employer contributions (e.g., employer FICA or the deductible portion of SECA), and (3) some sort of assumed return or present value calculation.  Different approaches are used for (3).  Advocates for private accounts base their calculations on some sort of assumed investment return (typically a mixture of stock and bond returns) that parallels how individuals might invest a defined contribution retirement account, like an IRA or 401(k). By contrast, actuaries and economists more typically discount the employee and employer contributions to present value using government bond interest rates.  In any case, depending upon the assumed rates used, the value of (3) can overwhelm (1) and (2) amounts.

I can illustrate this with an example from my personal life. Before we married, my wife worked for a nonprofit which had no retirement plan. At the recommendation of her tax preparer she annually made traditional (deductible) IRA contributions to reduce her tax liability.  These amounted to $8,000 of contributions, which she invested in bank CDs and earned a few hundred dollars of interest.  When we married in 1990, the IRA was worth less than $8,400.  To get better returns, I recommended that she move the money to a mixture of stock and bond mutual funds.  In the 29 years since, the $8,400 has grown to over $240,000.  (No Warrant Buffet was investing the money – just me in plain vanilla mutual funds.) The ratio of contributions to current value is 3.5%.  This simply illustrates how important the assumed return or discounting to present value calculations are, given the long periods of time involved, and why 15% is not as low a ratio as it may initially seem.

A second factor to consider is that, as noted above, Social Security also functions as a quasi-life insurance policy by providing dependent benefits if the worker dies and as a disability policy, if the worker becomes disabled.  Effectively, one could argue, some sort of annual deduction from the contributions should be made to pay for premiums on that insurance.  The estimates typically do not do that (particularly those making the case for private accounts), so they overstate how much is being contributed to the pure retirement/pension-like portion of the program.

The Actuary’s estimate of 15%.  By contrast, the Social Security Actuary’s estimate of a pension equivalent recovery ratio (i.e., the 15%) looks at only one of the three components – i.e., employee FICA or the nondeductible part of SECA – and, then, must determine how much those raw amounts contribute actuarially to the payment of old age benefits. These are the only amounts on which tax has already been paid.  If one has a background in finance, you can intuitively see why these amounts would be so low relative to benefits paid.  The important point is that the Actuary, according to the description (p. 16) by the Congressional Research Service, made the estimates for workers entering the work force in 1993 (the year the estimate was made).  Thus, the estimate takes into account the declining “returns” documented in the Money’s Worth Ratios.  And, as I noted in my original post, there have been no material changes in social security’s tax or benefit rules that would suggest that these calculations are no longer valid. Longevity has increased and interest rates (and inflation) have declined, offsetting factors.  It would be good to update the estimates, but in the absence of that, I see no reason to conclude that the 1993 one is still not valid.

Bottom line:  The declining “returns” on social security participation for younger workers says nothing about the validity of the Social Security Actuary’s estimate of the 15% ratio.  It continues to be the best estimate of the appropriate amount to allow recovery of after-tax employee contributions.