Why pensions tax cap should remain

Most people resolve in the new year to fix things in their personal lives - their 5km race time, their bunion. My resolution, though, is about economics. In 2005, I will do what I can to save the cap.

The cap - as technicians refer to it - is the earnings ceiling above which US workers' income is free of government pension taxes. Currently, workers pay intoSocial Security 6.2 per cent in tax on only the first $90,000 they earn. Their employer matches that, taking the total contribution to 12.4 per cent. Since the amount of pension higher earners may receive from Washington after they retire is limited, the cap makes sense.

This year the obscure cap will be at the centre of the pensions debate. Social Security privatisation is on the national agenda now but, to privatise, lawmakers need revenue. Naturally, they are eyeing the cap. If the administration goes along, it will be undoing much of what it has achieved through its five years of taxcuts.

Here is the scenario that imperils the cap: Republicans will push forprivatising a maximum share of the New Deal programme - one, or two, or four percentage points, say, out of the 6.2. After all, it is rarethat you have the opportunity to reduce the public-sectorshare of gross domestic product through a single pieceof legislation. Bu t they will find strong opposition.

Democrats abhor the idea of privatising Social Security -Social Security is fundamental to their notion of a collectivesociety. Still, they know theymay have to go along with the plan. They will only do sotherefore if they can win concessions in the name of anotherof their fundamental principles: economic redistribution. Cap-lifting suits them perfectly.

They have already established a precedent: they lifted another cap, a much smaller one, onMedicare contributions, in the 1990s. It is all the sweeter that the act provides an opportunity to slam the wealthy in the name of prudent budgeting.

Republicans may give in. Relatively few Americans earn more than $90,000 a year - about 7 per cent of the workforce.

Still, cutting such a deal would be crazy. For while the marginal tax increase involved sounds minor, it would affect not only households but also engines of small growth such as the "S corporation", a common format for many small companies. Senator Robert Bennett of Utah, an avid cap defender, started a time management company called Franklin Quest a few decades ago as an S corporation. He believes much of its very strong growth was connected with the low marginal income tax rate of 28 per cent set in 1986 by Congress and President Reagan. "Everyone assumes this is about taxing Michael Jordan or Warren Buffett," he tells me. "But really it is a massive hidden tax on small business." Massive is the accurate word. Lifting the cap represents a 12.4 per cent increase in the marginal tax rate overall (employer side plus employee side). This dwarfs the scale of Mr Bush's top income tax rate reductions, commonly derided as "massive".

Lifting the cap would turn the US into a country that is much more heavily taxed - and therefore less enterprising. As the Nobel Prize winner Edward Prescott points out, studies comparing high-tax societies in Europe with the lower-tax US show that workers respond to the incentives supplied by marginal tax rates. Europeans in the market sector, by which Mr Prescott means the taxable private sector, work a full 50 per cent less than Americans. This is a change from the early 1970s, when individual Europeans worked harder than did Americans.*

Europeans, who pay so much for their versions of Social Security - and an enormous extra slab on top of that in healthcare - no longer desire to participate in the legal labour market as strongly as Americans. And this makes their own pensions that much smaller.

In contrast, the US's relatively light tax burden fosters a pro-work attitude. What is more, the cap on Social Security does much to offset the progressivity of America's income tax schedule. Even those who never earn more than $90,000 a year are aware that, generally, things aren't so bad in the higher ranges.

When you add in overtime - the bonus of the working man - the US culture still says: work harder, keep more. It is not too cynical to say that is what the Bush income tax cuts were aiming for.

The best plan for Republicans therefore is to privatise as much as they can get away with. It would be fine to accept increases in the retirement age and to peg the base pension formula to inflation - which more or less takes care of the worry that, as things stand, Social Security is projected to go into deficit around the middle of the century. But Congress must not allow an increase in the share of income subject to pension tax.

If members can manage to get four or two or even a single percentage point of Social Security contributions privatised without raising the tax ceiling, they will be free-market heroes down the centuries. And to that ideal, we can all lift our caps.

*Why Do Americans Work So Much More than Europeans? Minneapolis Federal Reserve

© Copyright 2005 Financial Times

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