The best way to protect Social Security and Medicare is to balance the budget – Center for Retirement Research
New book argues that equilibrium requires the richest 1% to start paying taxes again
Some observers point to the poor state of our federal finances as justification for cuts to Social Security and Medicare — not to mention programs for the most vulnerable, such as Medicaid and the Supplemental Nutrition Assistance Program. In fact, federal spending in 2025 is set at $7 trillion, tax revenue is only $5.2 trillion, and the deficit is $1.8 trillion as far as the eye can see. How did we get here and how do we get out? A wonderful new book from Boston College Law School by Ray Madoff – The Second Estate: How the Tax Code Created an American Aristocracy – provides clear answers to both. We got here because the top 1 percent, with $52 trillion in wealth, no longer pay taxes, and we can fix the problem by restructuring the income tax to make sure they pay taxes.
Rich people avoid taxes by engaging in three strategies: 1) avoiding earning income; 2) investing in high-return assets and enjoying favorable treatment of capital gains under income tax (specifically the ability to avoid taxes by avoiding sales); 3) and most importantly, inheriting money.
Avoiding earned income is an effective strategy because federal revenue comes primarily from taxes on wages and salaries: income and payroll taxes account for 84% of federal revenue (see Figure 1). Even if wealthy people earn their income through earnings, they can escape most payroll taxes because the Social Security payroll tax only applies to the first $176,100. There is no upper limit on income tax, with the maximum rate levied on income being 37%. But 2021 IRS tax returns leaked to Pro Publica show that many of the wealthiest Americans essentially avoided paying income taxes by avoiding taxable income. As a result, today the money to pay for government programs and the interest on the massive debt must come from the nation's working class.
Instead of earning a salary, wealthy people acquire investment assets that often provide higher rates of return. If they must sell these assets, the income tax rate on long-term capital gains is typically up to 20%. But there is no tax until the assets are sold, allowing wealth to grow uninterrupted for decades. At the same time, the holders of this growing wealth can support their lifestyles simply by using these assets as collateral for tax-free loans. Additionally, for those who hold investments until death, the tax code erases the gains accumulated during the deceased's lifetime, known as the “step-up in basis.” Therefore, heirs can immediately sell inherited assets tax-free.
Inheritance is obviously the best way to get money. The fact that we have estate and gift taxes makes it sound like we're taxing these intergenerational transfers at the donor level. But as deductions (now about $14 million for individuals and $28 million for couples) have increased, estate taxes have eroded, and smart tax attorneys have created many ways to avoid estate taxes. As a result, estate and gift taxes now account for less than 1 percent of federal revenue, despite a sharp increase in wealth concentration. In fact, keeping the estate tax is actually harmful because it sends the message that the wealthy are heavily taxed—when in fact they are not. Additionally, while a deceased person's estate is virtually tax-free, an individual who receives an estate of $10 million or $100 million is not required to pay taxes on that amount.
So, what does Ray Madoff suggest we should do? First, we should abolish the estate tax. It no longer generates meaningful revenue and leads average Americans to believe that wealthy people are contributing to the running of the federal government. Second, we should impose income taxes on estates. An individual can receive a tax-free estate of up to $1 million, but all income above that amount will be included in income. Third, she will be taxed on capital gains when the assets are transferred as a gift or upon death. Such proposals have been around for decades, with Presidents Richard Nixon and Obama proposing such changes, and Canada enacting such regulations.
Why is this all about retirement? The main reason is that as long as our federal finances are in disarray, the well-being of Social Security and Medicare is at risk. We cannot eliminate the deficit by raising regressive payroll taxes on already overburdened wage earners. For high-income earners who already pay more than 50% of their wages through state, local and federal income taxes, raising income tax rates makes no sense. Moreover, it is impossible to impose a wealth tax on the rich. The only way out of financial chaos is to get the wealthy back in the game, by taxing inheritances under income tax and eliminating the basis tax on assets transferred as a gift or upon death.
