Taxes to Pay for Highways: A Switch from the Tax on Gallons of Fuel Burned to a Tax on Miles Driven Would Be Stupid

Impact of Switching from Fuel Tax on Gallons Burned to Tax on Miles Driven

A.  Introduction

According to a recent report in the Washington Post, a significant and increasing number of state public officials and politicians are advocating for a change in the tax system the US uses to support highway building and maintenance.  The current system is based on a tax on gallons of fuel burned, and the proposed new system would be based on the number of miles a car is driven.  At least four East Coast states are proposing pilots on how this might be done, some West Coast states have already launched pilots, and states are applying for federal grants to consider the change.  There is indeed even a lobbying group based in Washington now advocating it:  The Mileage-Based User Fee Alliance.

There is no question that the current federal gas tax of 18.4 cents per gallon of gasoline is woefully inadequate.  It was last changed in 1993, 23 years ago, and has been kept constant in nominal terms ever since.  With general prices (based on the CPI) now 65% higher, 18.4 cents now will only buy 11.2 cents at the prices of 1993, a decline of close to 40%.  As a result, the Highway Trust Fund is terribly underfunded, and with all the politics involved in trying to find other sources of funding, our highways are in terrible shape. Basic maintenance is simply not being done.

An obvious solution would be simply to raise the gas tax back at least to where it was before in real terms.  Based on where the tax was when last set in 1993 and on the CPI for inflation since then, this would be 30.3 cents per gallon now, an increase of 11.9 cents from the current 18.4 cents per gallon.  Going back even further, the gasoline tax was set at 4 cents per gallon in 1959, to fund the construction of the then new Interstate Highway system (as well as for general highway maintenance).  Adjusting for inflation, that tax would be 32.7 cents per gallon now.  Also, looking at what the tax would need to be to fund adequately the Highway Trust Fund, a Congressional Budget Office report issued in 2014 estimated that a 10 to 15 cent increase (hence 28.4 cents to 33.4 cents per gallon) would be needed (based on projections through 2024).

These fuel tax figures are all similar.  Note also that while some are arguing that the Highway Trust Fund is underfunded because cars are now more fuel efficient than before, this is not the case.  Simply bringing the tax rate back in real terms to where it was before (30.3 cents based on the 1993 level or 32.7 cents based on the 1959 level) would bring the rate to within the 28.4 to 33.4 cents range that the CBO estimates is needed to fully fund the Highway Trust Fund.  The problem is not fuel efficiency, but rather the refusal to adjust the per gallon tax rate for inflation.

But Congress has refused to approve any such increase.  Anti-tax hardliners simply refuse to consider what they view as an increase in taxes, even though the measure would simply bring them back in real terms to where they were before.  And it is not even true that the general population is against an increase in the gas tax.  According to a poll sponsored by the Mineta Transportation Institute (a transportation think tank based at San Jose State University in California), 75% of those polled would support an immediate increase in the gas tax of 10 cents a gallon if the funds are dedicated to maintenance of our streets, roads, and highways (see the video clip embedded in the Washington Post article, starting at minute 3:00).

In the face of this refusal by Congress, some officials are advocating for a change in the tax, from a tax per gallon of fuel burned to a new tax per mile each car is driven.  While I do not see how this would address the opposition of the anti-tax politicians (this would indeed be a totally new tax, not an adjustment in the old tax to keep it from falling in real terms), there appears to be a belief among some that this would be accepted.

But even if such a new tax were viewed as politically possible, it would be an incredibly bad public policy move to replace the current tax on fuel burned with such a tax on miles driven.  It would in essence be a tax on fuel efficiency, with major distributional (as well as other) consequences, favoring those who buy gas guzzlers.  And as it would encourage the purchase of heavy gas guzzlers (relative to the policy now in place), it would also lead to more than proportional damage to our roads, meaning that road conditions would deteriorate further rather than improve.

This blog post will discuss why such consequences would follow.  To keep things simple, it will focus on the tax on gasoline (which I will sometimes simply referred to as gas, or as fuel).  There are similar, but separate taxes, on diesel and other fuels, and their levels should be adjusted proportionally with any adjustment for gasoline.  There is also the issue of the appropriate taxes to be paid by trucks and other heavy commercial vehicles.  That is an important, but separate, issue, and is not addressed here.

B.  The Proposed Switch Would Penalize Fuel Efficient Vehicles

The reports indicate that the policy being considered would impose a tax of perhaps 1.5 cents per mile driven in substitution for the current federal tax of 18.4 cents per gallon of gas burned (states have their own fuel taxes in addition, with these varying across states). For the calculations here I will take the 1.5 cent figure as the basis for the comparisons, even though no specific figure is as yet set.

First of all, it should be noted that at the current miles driven in the country and the average fuel economy of the stock of cars being driven, a tax of 1.5 cents per mile would raise substantially more in taxes than the current 18.4 cents per gallon of gas.  That is, at these rates, there would be a substantial tax increase.

Using figures for 2014, the average fuel efficiency (in miles per gallon) of the light duty fleet of motor vehicles in the US was 21.4 miles per gallon, and the average miles driven per driver was 13,476 miles.  At a tax of 1.5 cents per mile driven, the average driver would pay $202.14 (= $.015 x 13,476) in such taxes per year.  With an average fuel economy of 21.4 mpg, such a driver would burn 629.7 gallons per year, and at the current fuel tax of 18.4 cents per gallon, is now paying $115.87 (= $.184 x 629.7) in gas taxes per year. Hence the tax would rise by almost 75% ($202.14 / $115.87).  A 75% increase would be equivalent to raising the fuel tax from the current 18.4 cents to a rate of 32.1 cents per gallon.  While higher tax revenues are indeed needed, why a tax on miles driven would be acceptable to tax opponents while an increase in the tax per gallon of fuel burned is not, is not clear.

But the real reason to be opposed to a switch in the tax to miles driven is the impact it would have on incentives.  Taxes matter, and affect how people behave.  And a tax on miles driven would act, in comparison to the current tax on gallons of fuel burned, as a tax on fuel efficiency.

The chart at the top of this post shows how the tax paid would vary across cars of different fuel efficiencies.  It would be a simple linear relationship.  Assuming a switch from the current 18.4 cents per gallon of fuel burned to a new tax of 1.5 cents per mile driven, a driver of a highly fuel efficient car that gets 50 miles per gallon would see their tax increase by over 300%!  A driver of a car getting the average nation-wide fuel efficiency of 21.4 miles per gallon would see their tax increase by 75%, as noted above (and as reflected in the chart).  In contrast, someone driving a gas guzzler getting only 12 miles per gallon or less, would see their taxes in fact fall!  They would end up paying less under such a new system based on miles driven than they do now based on gallons of fuel burned.  Drivers of luxury sports cars or giant SUVs could well end up paying less than before, even with rates set such that taxes on average would rise by 75%.

Changing the tax structure in this way would, with all else equal, encourage drivers to switch from buying fuel efficient cars to cars that burn more gas.  There are, of course, many reasons why someone buys the car that they do, and fuel efficiency is only one.  But at the margin, changing the basis for the tax to support highway building and maintenance from a tax per gallon to a tax on miles driven would be an incentive to buy less fuel efficient cars.

C.  Other Problems

The change to a tax on miles driven from the tax on gallons of fuel burned would have a number of adverse effects:

a)  A Tax on Fuel Efficiency:  As noted above, this would become basically a tax on fuel efficiency.  More fuel efficient cars would pay higher taxes relative to what they do now, and there will be less of an incentive to buy more fuel efficient cars.  There would then be less of an incentive for car manufacturers to develop the technology to improve fuel efficiency.  This is what economists call a technological externality, and we all would suffer.

b)  Heavier Vehicles Cause Far More Damage to the Roads:  Heavier cars not only get poorer gas mileage, but also tear up the roads much more, leading to greater maintenance needs and expense.  Heavier vehicles also burn more fuel, but there is a critical difference.  As a general rule, vehicles burn fuel in proportion with their weight: A vehicle that weighs twice as much will burn approximately twice as much fuel.  Hence such a vehicle will pay twice as much in fuel taxes (when such taxes are in cents per gallon) per mile driven.

However, the heavier vehicle also cause more damage to the road over time, leading to greater maintenance needs.  And it will not simply be twice as much damage.  A careful early study found that the amount of damage from a heavier vehicle increases not in direct proportion to its weight, but rather approximately according to the fourth power of the ratio of the weights.  That is, a vehicle that weighs twice as much (for the same number of axles distributing the weight) will cause damage equal to 2 to the fourth power (=16) times as much as the lighter vehicle.  Hence if they were to pay taxes proportionate to the damage they do, a vehicle that is twice as heavy should pay 16 times more in taxes, not simply twice as much.

(Note that some now argue that the 2 to the fourth power figure found before might be an over-estimate, and that the relationship might be more like 2 to the third power.  But this would still imply that a vehicle that weighs twice as much does 8 times the damage (2 to the third power = 8).  The heavier vehicle still accounts for a grossly disproportionate share of damage to the roads.)

A tax that is set based on miles driven would tax heavy and light vehicles the same.  This is the opposite of what should be done:  Heavy vehicles cause far more damage to the roads than light vehicles do.  Encouraging heavy, fuel-thirsty, vehicles by switching from a tax per gallon of fuel burned to a tax per mile driven will lead to more road damage, and proportionately far more cost than what would be collected in highway taxes to pay for repair of that damage.

c)  Impact on Greenhouse Gases:  One also wants to promote fuel efficiency because of the impact on greenhouse gases, and hence global warming, from the burning of fuels. By basic chemistry, carbon dioxide (CO2) is a direct product of fuel that is burned.  The more fuel that is burned, the more CO2 will go up into the air and then trap heat. Economists have long argued that the most efficient way to address the issue of greenhouse gases being emitted would be to tax them in proportion to the damage they do.  A tax on gallons of fuel that are burned will do this, while a tax on miles driven (and hence independent of the fuel efficiency of the vehicle) will not.

An interesting question is what level of gasoline tax would do this.  That is, what would the level of fuel tax need to be, for that tax to match the damage being done through the associated emission of CO2.  The EPA has come up with estimates of what the social cost of such carbon emissions are (and see here for a somewhat more technical discussion of its estimates).  Unfortunately, given the uncertainties in any such calculations, as well as uncertainty on what the social discount rate should be (needed to discount costs arising in the future that follow from emitting greenhouse gases today), the cost range is quite broad. Hence the EPA presents figures for the social cost of emitting CO2 using expected values at alternative social discount rates of 2.5%, 3%, and 5%, as well as from a measure of the statistical distribution of one of them (the 95th percentile for the 3% discount rate, meaning there is only an estimated 5% chance that the cost will be higher than this).  The resulting costs per metric ton of CO2 emitted then range from a low of $11 for the expected value (the 50th percentile) at the 5% discount rate, $36 at the expected value for the 3% discount rate, and $56 for the expected value for the 2.5% discount rate, to $105 for the 95th percentile at a 3% discount rate (all for 2015).

With such range in social costs, one should be cautious in the interpretation of any one. But it may still be of interest to calculate how this would translate into a tax on gasoline burned by automobiles, to see if the resulting tax is “in the ballpark” of what our fuel taxes are or should be.  Every gallon of gasoline burned emits 19.64 pounds of CO2.  There are 2,204.62 pounds in a metric ton, so one gallon of gas burned emits 0.00891 metric tons of CO2.  At the middle social cost of $36 per metric ton of CO2 emitted (the expected value for the 3% social discount rate scenario), this implies that a fuel tax of 32.1 cents per gallon should be imposed.  This is surprisingly almost precisely the fuel tax figure that all the other calculations suggest is warranted.

d)  One Could Impose a Similar Tax on Electric Cars:  One of the arguments of the advocates of a switch from taxes on fuel burned to miles driven is that as cars have become more fuel efficient, they pay less (per mile driven) in fuel taxes.  This is true.  But as generally lighter vehicles (one of the main ways to improve fuel economy) they also cause proportionately far less road damage, as discussed above.

There is also an increasing share of electric, battery-powered, cars, which burn no fossil fuel at all.  At least they do not burn fossil fuels directly, as the electricity they need to recharge their batteries come from the power grid, where fossil fuels dominate.  But this is still close to a non-issue, as the share of electric cars among the vehicles on US roads is still tiny.  However, the share will grow over time (at least one hopes).  If the share does become significant, how will the cost of building and maintaining roads be covered and fairly shared?

The issue could then be addressed quite simply.  And one would want to do this in a way that rewards efficiency (as different electric cars have different efficiencies in the mileage they get for a given charge of electricity) rather than penalize it.  One could do this by installing on all electric cars a simple meter that keeps track of how much it receives in power charges (in kilowatt-hours) over say a year.  At an annual safety inspection or license renewal, one would then pay a tax based on that measure of power used over the year.  Such a meter would likely have a trivial cost, of perhaps a few dollars.

Note that the amounts involved to be collected would not be large.  According to the 2016 EPA Automobile Fuel Economy Guide (see page 5), all-electric cars being sold in the US have fuel efficiencies (in miles per gallon equivalent) of over 100 mpg, and as high as 124 mpg.  These are on the order of five times the 21.4 average mpg of the US auto stock, for which we calculated that the average tax to be paid would be $202.  Even ignoring that the electric cars will likely be driven for fewer miles per year than the average car (due to their shorter range), the tax per year commensurate with their fuel economy would be roughly $40.  This is not much.  It is also not unreasonable as electric cars are kept quite light (given the limits of battery technology) and hence do little road damage.

e)  There Are Even Worse Policies That Have Been Proposed:  As discussed above, there are many reasons why a switch from a tax on fuel burned to miles driven would be a bad policy change.  But it should be acknowledged that some have proposed even worse. One example is the idea that there should be a fixed annual tax per registered car that would fund what is needed for highway building and maintenance.  Some states in fact do this now.

The amounts involved are not huge.  As was calculated above, at the current federal gasoline tax of 18.4 cents per gallon, the driver of a car that gets the average mileage (of 21.4 mpg) for the average distance a year (of 13,476 miles) will pay $115.87 a year.  If the fuel tax were raised to 32.1 cents per gallon (or equivalently, if there were a tax of 1.5 cents per mile driven), the average tax paid would be still just $202.14 per year.  These are not huge amounts.  One could pay them as part of an annual license renewal.

But the tax structured in this way would then be the same for a driver who drives a fuel efficient car or a gas guzzler.  And it would be the same for a driver who drives only a few miles each year, or who drives far more than the average each year.  The driver of a heavy gas guzzler, or one who drives more miles each year than others, does more damage to the roads and should pay more to the fund that repairs such damage and develops new road capacity.  The tax should reflect the costs they are imposing on society, and a fixed annual fee does not.

f)  The Cost of Tax Collection Needs to be Recognized:  Finally, one needs to recognize that it will cost something to collect the taxes.  This cost will be especially high for a tax on miles driven.

The current system, of a tax on fuel burned, is efficient and costs next to nothing to collect.  It can be charged at the point where the gasoline and other fuels leaves in bulk from the refinery, as all of it will eventually be burned.  While the consumer ultimately pays for the tax when they pump their gas, the price being charged at the pump simply reflects the tax that had been charged at an earlier stage.

In contrast, a tax on miles driven would need to be worked out at the level of each individual car.  And if the tax is to include shares that are allocating to different states, the equipment will need to keep track of which states the car is being driven in.  As the Washington Post article on a possible tax on miles driven describes, experiments are underway on different ways this might be done.  All would require special equipment to be installed, with a GPS-based system commonly considered.

Such special equipment would have a cost, both up-front for the initial equipment and then recurrent if there is some regular reporting to the center (perhaps monthly) of miles driven.  No one knows right now what such a system might cost if it were in mass use, but one could easily imagine that a GPS tracking and reporting system might cost on the order of $100 up front, and then several dollars a month for reporting.  This would be a significant share of a tax collection that would generate an average of just $202 per driver each year.

There is also the concern that any type of GPS system would allow the overseers to spy on where the car was driven.  While this might well be too alarmist, and there would certainly be promises that this would not be done, some might not be comforted by such promises.

D.  Conclusion

While one should always consider whether given policies can be changed for the better, one needs also to recognize that often the changes proposed would make things worse rather than better.  Switching the primary source of funding for highway building and maintenance from a tax on fuel burned to a tax on miles driven is one example.  It would be a stupid move.

There is no doubt that the current federal tax on gasoline of 18.4 cents per gallon is too low.  The result is insufficient revenues for the Highway Trust Fund, and we end up with insufficient road capacity and roads that are terribly maintained.

What I was surprised by in the research for this blog post was finding that a wide range of signals all pointed to a similar figure for what the gasoline tax should be. Specifically:

  1. The 1959 gas tax of 4 cents per gallon in terms of current prices would be 32.7 cents per gallon;
  2. The 1993 gas tax of 18.4 cents per gallon in terms of current prices would be 30.3 cents per gallon;
  3. The proposal of a 1.5 cent tax per mile driven would be equivalent (given current average car mileage and the average miles driven per year) to 32.1 cents per gallon;
  4. The tax to offset the social cost of greenhouse gas emissions from burning fuel would be (at a 3% social discount rate) 32.1 cents per gallon.
  5. The Congressional Budget Office projected that the gasoline tax needed to fully fund the Highway Trust Fund would be in the range of 28.4 to 33.4 cents per gallon.

All these point in the same direction.  The tax on gasoline should be adjusted to between 30 and 33 cents per gallon, and then indexed for inflation.

The Rate of Return on Funds Paid Into Social Security Are Actually Quite Good

Social Security Real Rates of Return - Various Scenarios

 

A.  Introduction

The rate of return earned on what is paid into our Social Security accounts is actually quite good.  It is especially good when one takes into account that these are investments in safe assets, and thus that the proper comparison should be to the returns on other safe assets, not risky ones.  Yet critics of Social Security, mostly those who believe it should be shut down in its current form with some sort of savings plan invested through the financial markets (such as a 401(k) plan) substituted for it, often assert that the returns earned on the pension savings in Social Security are abysmally poor.

These critics argue that by “privatizing” Social Security, that is by shifting to individual plans invested through the financial markets, returns would be much higher and that thus our Social Security pensions would be “rescued”.  They assert that by privatizing Social Security investments, the system will be able to provide pensions that are either better than what we receive under the current system, or that similar pensions could be provided at lower contribution (Social Security tax) rates.

There are a number of problems with this.  They include that risks of poor financial returns (perhaps due, for example, to a financial collapse such as that suffered in 2008 in the last year of the Bush administration, when many Americans lost much or all of their retirement savings) would then be shifted on to individuals.  Individuals are not in a good position to take on such risks.  Individuals are also not financial professionals, nor normally in a good position to judge the competency of financial professionals who offer them services.  They also often underestimate the impact of high and compounding fees in depleting their savings over time.  For all these reasons, such an approach would serve as a bad substitute for the Social Security system such as we have now, which is designed to provide at least a minimum pension that people can rely on in their old age, with little risk.

But there is also a more fundamental problem with this approach.  It presumes that returns in the financial markets will in general be substantially higher than returns that one earns on what we pay into the Social Security system.  This blog post will show that this is simply not true.

The post looks at what the implicit rates of return are under several benchmark cases for individuals.  We pay into Social Security over our life time, and then draw down Social Security pensions in our old age.  The returns will vary for every individual, depending on their specific earnings profile (how much they earn in each year of their working career), their age, their marital situation, and other factors.  Hence there will be over 300 million different cases, one for each of the over 300 million Americans who are either paying into Social Security or are enjoying a Social Security pension now.  But by selecting a few benchmarks, and in particular extreme cases in the direction of where the returns will be relatively low, we can get a sense of the range of what the rates of return normally will be.

The chart at the top of this post shows several such cases.  The rest of this post will discuss each.

B.  Social Security Rates of Return Under Current Tax and Benefit Rates

The scenarios considered are all for an individual who is assumed to work from age 22 to age 65, who then retires at 66.  The individual is assumed to have reached age 65 in 2013 (the most recent year for which we have all the data required for the calculations), and hence reached age 62 in 2010 and was born in 1948.  The historical Social Security tax rates, the ceiling on wages subject to Social Security tax, the wage inflation factors used by Social Security to adjust for average wage growth, and the median earnings of workers by year, are all obtained from the comprehensive Annual Statistical Supplement to the Social Security Bulletin – 2014 (published April 2015).  Information on the parameters needed to calculate what the Social Security pension payments will be are also presented in detail in this Statistical Supplement, or in a more easy-to-use form for the specific case of someone reaching age 62 in 2010 in this publication of the Social Security Administration.  It is issued annually.

The Social Security pension for an individual is calculated by first taking the average annual earnings (as adjusted for average wage growth) over the 35 years of highest such earnings in a person’s working career.  For someone who always earned the median wage who reached age 62 in 2010, this would work out to $2,290 per month. The monthly pension (at full retirement age) would then be equal to 90% of the first $761, 32% of the earnings above this up to $4,586 per month, and then (if any is left, which would not be the case in this example of median earnings) 15% of the amount above $4,586.  Note the progressivity in these rates of 90% for the initial earnings, then 32%, and finally 15% for the highest earnings.  The monthly Social Security pension will then be the sum of these three components.  Since it is then adjusted for future inflation (as measured by the CPI), we do not need to make any further adjustments to determine the future pension payments in real terms.  The pensions will then be paid out from age 66 until the end of their life, which we take to be age 84, the current average life expectancy for someone who has reached the age of 65.

The historical series of payments made into the Social Security system through Social Security taxes (for Social Security Old-Age pensions only, and so excluding the taxes for Disability insurance and for Medicare) are then calculated by multiplying earnings by the tax rate (currently 10.6%, including the shares paid by both worker and employer).  The stream of payments are then put in terms of 2010 dollars using the historical CPI series from the Bureau of Labor Statistics.

We can thus calculate the real rates of return on Social Security pensions under various scenarios.  The first set of figures (lines A-1) in the chart above are for a worker whose earnings are equal to what median wages were throughout his or her working life.  (A table with the specific numbers on the rates of return is provided at the bottom of this post, for those who prefer a numerical presentation.)  The individual paid into the Social Security pension system when working, and will now draw a Social Security pension while in retirement.  One can calculate the real rate of return on this stream of payments in and then payments out, and in such a scenario for a single worker earning median wages throughout his or her career who retired at age 66 in 2014, the real rate of return works out to be 2.9%.  If the person is married, with a spouse receiving the standard spousal benefit, the real rate of return is 4.1%.

Such rates of return are pretty good, especially on what should be seen as a safe asset (provided the politicians do not kill the system).  Indeed, as discussed in an earlier post on this blog, the real rate of return (before taxes) on an investment in the S&P500 stock market index over the 50 year period 1962 to 2012, would have been just 2.9% per annum assuming fees on 401(k) type retirement accounts of 2.5% (which is typical once one aggregates the fees at all the various levels – see the discussion in section E.3 of this blog post).  But investing in the stock market, even in a broad based index such as the S&P500, is risky due to the volatility.  Retirement accounts in 401(k)’s are generally a mix of equity investments, fixed income securities (bonds of various maturities, CDs, and similar instruments), and cash.  Based on the recent average mix seen in 401(k)’s, and for the same 50 year period of 1962 to 2012, the average real rate of return achieved after the fees typically charged on such accounts would only have been 1.2%.  Social Security for a worker earning median wages is far better.

As noted above, there is a degree of progressivity in the system, as higher income earners will receive only a smaller boost in their pension (at the 15% rate) from the higher end of their earnings.  Thus the rates of return in Social Security for high income earners will be less.  The rates of return they will earn are shown on lines A-2 of the chart.  This extreme case is calculated for a worker who is assumed to have earned throughout his or her entire work life an amount equal to the maximum ceiling on wages subject to Social Security tax (which was $113,700 in 2013).  Note also that anyone earning even more than this will have the same rates of return, as they will not be paying any more into the Social Security system (it is capped at the wage ceiling subject to tax) and hence also not withdrawing any more (or less) in pension.

Such high income earners will nonetheless still see a positive real rate of return on their Social Security contributions, of 1.4% for a single earner and 2.8% if married receiving a spousal benefit.  That is, while there is some progressivity in the Social Security system, it is not such that the returns turn negative.  And the returns achieved are still better than what typical 401(k) retirement accounts earn.

One should also take into account that high income earners are living longer than low income earners.  Indeed, the increase in life expectancies have been substantial in the last 30 years for high income earners, but only modest for those in the bottom half of the earnings distribution.  While I do not have data on what the life expectancies are for a person whose earnings have been at the absolute top of the Social Security wage ceiling over the course of their careers, for the purposes here it was assumed their life expectancy (for someone who has reached age 65) would be increased to age 90 from the age of 84 for the overall population.

In such a scenario, the real rates of return for someone who paid into the Social Security system always at the wage ceiling over their entire life time and then drew a Social Security pension up to age 90 would be 2.2% if single and 3.4% if married with a standard spousal benefit.  These are far better than typical 401(k) returns, and indeed are quite good in comparison to an investment in any safe asset (once one takes into account fees).

C.  Social Security Rates of Return Assuming Higher Social Security Tax Rates

The rates of return calculated so far have been based on what the actual historical Social Security tax rates have been, and what the current benefit formula would determine for future pensions.  But as most know, at current tax and benefit rates the Social Security Trust Fund is projected to be depleted by about 2034 according to current estimates.  The reason is that life expectancies are now longer (which is a good thing), but inadequate adjustments have been made in Social Security tax rates to allow for pay-outs which will now need to cover longer lifetimes.  The problem has been gridlock in Washington, where an important faction of politicians opposed to Social Security are able to block any decision on how to pay for longer life expectancies.

There are a number of ways to ensure Social Security could be adequately funded.  One option, which I would recommend, would be simply to lift the ceiling on wages subject to Social Security tax (which was $113,700 in 2013, $118,500 in 2015, and will remain at $118,500 in 2016).  As discussed in section E.2 of this earlier blog post, it turns out that this alone should suffice to ensure the Social Security Trust Fund remains adequate for the foreseeable future.  The extra funding needed is an estimated 19.4% over what is collected now (based on calculations from an earlier post on this blog, but with data now a few years old), and it turns out that ending the wage ceiling would provide this.  At the ceiling on wages subject to Social Security tax of $113,700 in 2013, the share of workers earning at this ceiling or more was just 6.1%, but due to the skewed distribution of income in favor of the rich, untaxed wages in excess of the ceiling accounted for 17.3% of all wages paid.  That is, Social Security taxes were being paid on only 82.7% of all wages.  If the taxes were instead paid on the full 100%, Social Security would be collecting 21% more (= 100.0 / 82.7).

The extremely rich would then pay Social Security taxes at the same rate as most of the population, instead of something lower.  It should also be noted that it is the increase in life expectancy of those at the upper end of the income distribution which is driving the Social Security system into deficit at the current tax rates, as they are the ones living longer while those in the lower part of the income distribution are not.  Thus it is fair that those who will be drawing a Social Security pension for a longer period should be those who should be called on to pay more into the system.

To be highly conservative, however, for the rate of return calculations being discussed here I have assumed that the general Social Security tax rate will be increased by 19.4% on all wages below the ceiling, while the ceiling remains where it has been.  These calculations are for historical scenarios, where the purpose is to determine what the rates of return on payments into Social Security would have been had the tax rates been 19.4% higher on all, to provide for a fully funded system.  Finally, note that while these scenarios assume a higher Social Security tax rate historically, they also set the future pension benefits to be paid out to be the same as what they would be under the current benefit rates.  That is, the pay-out formulae would need to be changed to leave benefits the same despite the higher taxes being paid into the system.

The real rates of return would then be as shown in Panel B of the chart above.  While somewhat less than before, the real returns are still substantial, and still normally better than what is earned in a typical 401(k) plan.  The returns for someone earning at the median wage throughout their career will now be 2.4% if single and 3.6% if married (0.5% points less than before).  The returns for someone earning at or above the ceiling for wages subject to Social Security taxes would now be earning at the real rate of 0.8% if single and 2.2% if married for the age 84 life expectancy (0.6% points less than before), or 1.6% and 2.9% (for single and married) if the life expectancy of such high earners is in fact age 90 (also 0.6% points less, before round-off).

The real rates of return all remain positive, and generally good compared to what 401(k)’s typically earn.

D.  Conclusion

As noted above, the actual profile of Social Security taxes paid and pension received will vary by individual.  No two cases will be exactly alike.  But the calculations here indicate that for someone with median earnings, and still even in the extreme case of someone with very high earnings (where a degree of progressivity in the system will reduce the returns), the rates of return earned on what is paid into and then taken out of the Social Security system are actually quite good.  They generally are better than what is earned in a typical 401(k) account (after fees), and indeed often better than what would earn in a pure equity investment of the S&P500 index (and without the risk and volatility of such an investment).

Social Security is important and has become increasingly important.  Due to the end of many traditional defined benefit pension plans, with a forced switch to 401(k) plans or indeed often to nothing at all from the employer, Social Security now accounts (for those aged 65 or older) for a disturbingly high share on the incomes of many of the aged. Specifically, Social Security now accounts for half or more of total income for two-thirds of all those age 65 or older, and accounts for 100% of their income for one-quarter of them. And for the bottom 40% of this population, Social Security accounted for 90% or more of their total income for three-quarters of them, and 100% of their income for over half of them.

The problem is not in the Social Security system itself.  It is highly efficient, with an expense ratio in 2014 of just 0.4% of benefits paid.  Private 401(k) plans, with typical expenses of 2.5% of assets (not benefits) each year will have expenses over their life time that are 90 times as great as what Social Security costs to run.  And as seen in this post, the return on individual Social Security accounts are quite good.

The problem that Social Security faces is rather that with longer life expectancies (most importantly for those of higher income), the Social Security taxes being paid are no longer sufficient to cover the payouts to cover these longer lifetimes.  They need to be adjusted. There are several options, and my recommendation would be to start by ending the ceiling on wages subject to Social Security taxes.  This would suffice to solve the problem.  But one could go further.  As discussed in an earlier blog post (see Section E.2), not only should all wages be taxed equally, but one should extend this to taxing all forms of income equally (i.e. income from wealth as well as income from wages).  If one did this, one could then either cut the Social Security tax rate sharply, or raise the Social Security benefits that could be paid, or (and most likely) some combination of each.

But something needs to be done, or longer life spans will lead the Social Security Trust Fund to run out by around 2034.  The earlier this is resolved the better, both to ensure less of a shock when the change is finally made (as it could then be phased in over time) and for equity reasons (as it is those paying in now who are not adequately funding the system for what they will eventually drawdown).

 

============================================================

Annex:  Summary Table

Real Rates of Return from Social Security Old-Age Taxes and Benefits

A)  Social Security Scenarios – Current Rates

  1)  Earnings at Median Throughout Career

   a)  Single

2.9%

   b)  Married

4.1%

  2)  Earnings at Ceiling Throughout Career

   a)  Single

1.4%

   b)  Married

2.8%

  3)  Earnings at Ceiling, and Life Expectancy of 90

   a)  Single

2.2%

   b)  Married

3.4%

B)  Social Security with 19.4% higher tax rate

  1)  Earnings at Median Throughout Career

   a)  Single

2.4%

   b)  Married

3.6%

  2)  Earnings at Ceiling Throughout Career

   a)  Single

0.8%

   b)  Married

2.2%

  3)  Earnings at Ceiling, and Life Expectancy of 90

   a)  Single

1.6%

   b)  Married

2.9%

C)  Comparison to 401(k) Vehicles

  1)  S&P500 after typical fees

2.9%

  2)  Average 401(k) mix after typical fees

1.2%

Facts vs. Polemics on Unauthorized Immigration of Mexicans to the US

Stock of Mexican Unauthorized Immigrants in the US, 1995 to 2014, #2

Annual Net Flow of Mexican Unauthorized Immigrants to US, 1996 to 2014

In the heated rhetoric of the current Republican presidential campaign, one would think that the US is being flooded by illegal immigrants from Mexico, slipping through a porous border with President Obama unwilling to do anything about it.  Calls are being made for a bigger, taller, and longer wall, more aggressive policing of the border, and the forced deportation of those who are already living here.  These calls have been a centerpiece of Donald Trump’s campaign from the day he announced his candidacy (when he asserted Mexico is “sending” criminals, drug pushers, and rapists to the US).  More recently, in the November 10 Republican presidential debate and in more detail in the days after, Trump called for the creation of a new special police force, a “massive deportation force”, which would aggressively pursue and deport those in the US who were believed to be illegal. Yet Trump has for some time now been at the top of polls of Republicans as their choice for president.

But what are the facts?  The US is actually not being flooded by illegal immigrants from Mexico. Nor has the supposed “problem” become far worse under President Obama.  The Pew Research Center released on November 19 a report with careful estimates of the number of unauthorized immigrants from Mexico residing in the US.  The report brings up to date figures the Pew Center had released previously for earlier years.

The chart at the top of this post is a replication of the chart presented as Figure 5 in Chapter 1 of their report, with figures on the estimated total number of unauthorized Mexican immigrants resident in the US by year.  The second chart is then simply the net annual flows as calculated from the numbers on the totals in the first chart (the change from one year to the next).  It should be noted that Pew Center presented estimates only for 1995, 2000, and 2005, before going to annual figures.  Hence the figures on net flows for 1996 to 2000 and 2001 to 2005 assume equal annual changes.

The Pew Center estimates that the number of unauthorized Mexican immigrants resident in the US reached a peak in 2007, and has since fallen substantially.  The falls in 2008 and 2009 can probably be attributed mostly to the severe downturn in the US in those years, when jobs were scarce and more Mexicans immigrants chose to return to Mexico than come to the US.  However, it is significant that as the US labor market has strengthened since 2009, with the unemployment rate hitting just 5.0% recently, the net outflow of Mexican immigrants continued.  In each and every year of the Obama administration there has either been a net outflow, or no net change, in the number of unauthorized Mexican immigrants in the US.

There are many reasons for this, including stepped up and more effective border enforcement as well as more deportations.  The Pew Report provides a good review of the factors, and I will not go into them all.  But one fact to note is that in FY2013, with Obama as president, the number of deportations reached a record high of 315,000, an increase of 86% from the level in 2005.

One may debate what the appropriate policy should be.  In my view, while immigration has been controversial throughout US history, the US has always also always benefited from it. Recall the discrimination against Catholic immigrants from Ireland in the early and mid-1800s, and yet how such immigration developed into an important part of what made the US what it is now.  There is little reason to believe that this time is different.

But regardless of whatever one’s policy views are, one should start with the facts.  And it is clear that the Republican candidates for president do not have these straight.

The Problems in Congress Come Not from Gridlock, But from Roadblocks

Republican Party Now.png

 

Gridlock, as originally defined, refers to a severe traffic jam in a grid of intersecting streets, where cars backed up on the intersecting roads block each other from moving.  No individual car is to blame, but rather all of them together are to blame.  The term is now also commonly used to refer to the inability of Congress to get things done.

But the problem in the US Congress is not really gridlock.  As will be clear from several examples discussed below, a majority in Congress exists for moving important legislation forward.  The problem, rather, is that congressional leaders, who decide what will be voted on and when, have acted to keep such legislation from coming to a vote.  But this is not gridlock.  Rather, it is deliberately placed roadblocks.

Events over the last month show what might be done when such roadblocks are removed. The resignation of John Boehner as Speaker of the House in late September created a narrow window when he could call up legislation for a vote while not being threatened by a minority of just 30 Republican congressmen on a motion to remove him from the Speakership.  He had already removed himself.  As discussed in the previous post on this blog, the traditional practice of straight party line votes for the position of Speaker means that a small group in the majority party (equal to just 30 in the current Congress) could deny the majority party candidate of this post.  A small group of the Republicans in Congress threatened to use this against Boehner should he move legislation forward that they opposed.

Boehner struggled to lead his party under such constraints, and eventually gave up and resigned.  But with that resignation, he was able to negotiate and push through to passage, with strong bipartisan support, a bill that addressed the immediate threat of default on the US debt (current borrowing authority limits would have been reached on about November 2), provided an overall budget framework for fiscal years 2016 and 2017 (with the sequester restrictions eased by $50 billion in FY16 and $30 billion in FY17, equal to a total of just 0.2% of GDP over the two years), and addressed immediate issues arising on Social Security Disability Insurance and on Medicare premiums.

The bill was approved 266 to 167 when put to a vote.  All Democrats voting approved, as did about a third of the Republicans:

Budget and Debt Ceiling Bill – House

Yes

No

Not Voting

Republicans

79

167

1

Democrats

187

0

1

Total

266

167

2

 

The bill then went to the Senate, where it was also approved by a strong majority (again with all Democrats in favor and about a third of the Republicans):

Budget and Debt Ceiling Bill – Senate

Yes

No

Not Voting

Republicans

18

35

1

Democrats

46

0

0

Total

64

35

1

 

In perhaps an even more surprising example of what can be done to get around the roadblocks being imposed, the House membership used a discharge petition to force a vote on renewing the US Ex-Im Bank charter.  Successful discharge petitions are rare: Only three times in recent history (since 1985) have they been approved and then led to new legislation.  They require the public signature of 218 congressional members (half of the chamber), and thus require the support of at least some in the majority party even if all of the minority party are willing to sign.  Such maneuvering to force a vote against the wishes of the congressional leadership can and does lead to retaliation by the leadership against the members.  The petition was filed on September 30, with the support of 176 Democrats and 42 Republicans.

The Ex-Im Bank’s charter authority lapsed on July 1.  Reauthorization is required periodically, and never before in its 81 year history has Congress failed to approve this.  A strong majority voted in favor in the Senate in a vote on July 27, with bipartisan support:

Ex-Im Bank Reauthorization – Senate

Yes

No

Not Voting

Republicans

22

28

4

Democrats

42

1

3

Total

64

29

7

 

Once the vote in the House was forced (it took place on October 27), a strong majority came out in favor, including not only almost all Democrats, but a majority of the Republicans as well:

Ex-Im Bank Reauthorization – House

Yes

No

Not Voting

Republicans

127

117

2

Democrats

186

1

1

Total

313

118

3

The bill, however, is not yet fully passed.  The Senate will now need to reconsider the bill, and despite the earlier strong vote in favor, it is not clear a vote will be held now. Republican Senator Mitch McConnell, the Majority Leader, has said he will not allow a vote to take place, at least on the stand-alone bill passed by the House.  And by attaching the Ex-Im legislation to some other bill McConnell would force it to be returned to the House again, where the leadership could again try to block any vote from being held.

Paul Ryan has now been elected to be Speaker of the House, succeeding John Boehner. Despite these examples of legislation that can move forward in the current congress with bipartisan support provided votes are held, the prospects that Ryan will act differently from Boehner are slim.  Ryan still faces the challenge that just 30 members of his party can choose not to vote for him in future votes for the Speakership, and he would then lose the office.  Indeed, nine members of his party voted for another candidate in the October 29 vote.  And while Ryan at first said that as a condition of becoming a candidate for the Speakership, he wanted agreement to change the House rules so that no future such votes on the Speakership could be held until the start of the next Congress in January 2017, he was not able to secure such a commitment from those who had brought Boehner down, and Ryan then backed down from this demand.

An example where important reform would probably pass with bipartisan support if a vote were held is immigration reform.  The Senate passed a bill on immigration reform (written in part by Senator Marco Rubio, who later denounced his own bill following conservative criticism) by a 68 to 32 majority (with 14 Republicans voting in favor) in June 2013.  But with the conservative criticism, Speaker Boehner refused to bring it up for a vote in the House.  And while it is now more than two years later, with the 2014 elections in between, it is likely that a majority of members in both chambers would still be in favor of immigration reform along the lines of the bill passed in the Senate in 2013.

However, Paul Ryan has publicly announced that he will not allow any such bill to come up for a vote.  And he insists it is Obama’s fault!  In an interview Sunday on CBS’s “Face the Nation”, Ryan said it would be “a ridiculous notion” to work with President Obama on the issue, because Obama is someone they “cannot trust”.  But there is no basis for such a charge.  Obama’s executive orders on immigration have been no different in nature from orders issued by Reagan and the first Bush when they were president.  And no such accusations were leveled against Reagan and Bush then.

But regardless of what one concludes on that issue, why such actions should preclude a vote in the legislative chamber is not at all clear.  Rather, the basic disrespect of the presidential office by Ryan appears to signal that Ryan intends to follow the same path as his predecessor, and allow a minority of about 40 congressmen to dictate what legislation will be brought to a vote, and what will be blocked.  As noted before, the problem is deliberately placed roadblocks, not gridlock.

Jon Huntsman for Speaker of the House!

Jon Huntsman.001

 

Congress should elect Jon Huntsman for its next Speaker.  Well, perhaps not Jon Huntsman specifically, but some moderate Republican (there are a few) who would appeal not only to those in the Republican Party who want to get things done in Washington, but also to most Democrats, who also want to get things done.  Perhaps Ray LaHood, a former Republican congressman who served as Secretary of Transportation under President Obama, would be a good choice, or even former New York Mayor Michael Bloomberg.  But we are getting ahead of ourselves.  First, we need to discuss why this has come up.

Under pressure from the far right in his party, Speaker of the House John Boehner announced on September 25 that he would resign as Speaker effective the end of October.  Boehner still clearly enjoyed the support of a substantial majority of his party’s members in the House.  But to understand why he ultimately decided he would need to resign or face an embarrassing vote that would remove him, one must understand the rules and customs followed in the House.

Traditionally, the congressional members of each party (Democrats and Republicans) vote in a unified fashion for whomever has been elected the leader of their respective party in the House.  The election of party leader might well be subject to a competitive election among the party members.  But once a party leader is chosen, 100% of the congressional members from that party have traditionally then voted for that leader in the election for the Speaker position.  Thus whichever party has a majority in the House, will elect its leader to the Speaker post.

But there is no rule that one must follow this tradition.  Members of a party can vote for someone else as leader.  And that has become increasingly common in recent years.  Ten Republicans did not vote for Boehner as Speaker in January 2013, and 25 did not in January 2015.  While those numbers seem small, and indeed are small, not many are necessary.  By House rules, the person to be voted Speaker must receive an absolute majority of the “votes cast for a person by name” (thus excluding those absent, as well as excluding those voting “present”).  If the majority party in the House has a majority of only a relatively small number of seats, then a few renegades who decide not to vote for their party’s chosen leader can deny that person the Speakership.

In the current 114th Congress, which was elected in November 2014 and took office in January 2015, Republicans enjoy a quite substantial majority, with 247 seats vs. 188 seats for the Democrats, or a majority of 30 seats.  This is indeed the largest Republican majority in Congress since 1929, when Herbert Hoover was elected president.  But had just 30 Republican members decided not to vote for their party leader (Boehner) to become the Speaker, then he would have been denied the position (assuming all House members are present and vote for a person).

Thus the revolt that led to 24 Republican members to vote for someone other than Boehner (plus one voting “present”) in the January 2015 vote for the Speakership, was significant.  It was, and was clearly intended to be, a warning to Boehner that the minority of the Republican members on the far right of the party were willing to vote against their own leader, if that leader did not act as they wished.

Following up on this threat, Representative Mark Meadows of North Carolina (one of the Republicans who voted for someone other than Boehner) introduced a motion on July 28 to “vacate the chair”.  This could have acted as a vehicle to force a vote on Boehner as Speaker.

Faced with this, Boehner faced the choice of either caving into the demands of the extreme right in his party, or gotten critical legislation passed to allow the government to continue to function from October 1.  Failure to pass such legislation would have been an embarrassment.  The legislation was necessary so that government departments could continue to spend funds with the start of the new fiscal year (as the Congress has not yet passed a budget for the year – a common occurrence).  Democrats supported keeping the government open, as did a substantial share of the Republican majority.  Together they could pass such a bill.  But they are only allowed to vote on measures in Congress that the Speaker chooses to bring up for a vote.  This is what makes the Speakership such a powerful position.  But if Boehner brought up such a bill, members on the extreme right wing of his party made clear that they would vote against Boehner in a vote on the Speakership.  With only 30 such votes necessary for Boehner to lose such a vote (amounting to just 12% of the 247 Republican held seats in the Congress), Boehner was in a bind.  He was being held hostage by a small minority within his party.

Boehner has of course faced this dilemma before.  So far he has chosen to try to work with the extreme right wing.  But as this became more and more difficult, as their demands became more extreme and as their criticism of Boehner grew, ultimately Boehner decided all he could do was resign.  Losing such a vote for the Speakership would be terribly embarrassing.  Better to resign first, and at least go out on your own terms.

Following his resignation, Boehner did indeed bring to a vote a bill to fund the government for almost two and a half months (until December 11).  And it passed easily, by a majority of 277 in favor and 151 opposed.  It received 186 votes in favor from the Democrats (all Democrats who voted) and 91 votes in favor from the Republicans (with 151 opposed).

It appears now that the current Majority Leader Kevin McCarthy will succeed Boehner, through the traditional process.  McCarthy appears in most respects to be similar to Boehner in his approach, although somewhat closer to the right-wing of his party than Boehner was.  But Boehner’s resignation and the expected selection of McCarthy to the Speakership changes little if anything.  There will be the need to pass a budget to fund the government by December 11, or we will once again be in the same situation as this past week.  The extreme right of the Republican members have made clear that they still want what they want, and that if that means shutting down the government, then that is a price they are willing to pay.

Even before December 11, it appears that the government will hit the debt ceiling. Congress sets the debt ceiling, and Treasury Secretary Lew stated in a letter to Congressional leaders on October 1 that they now expect to hit the current ceiling on or about November 5.  Unless Congress acts by then, the US would be forced to default on its financial obligations.  Once again, a broad majority in the Congress, made up of Republicans and Democrats together, would certainly vote in favor of a bill to address this. But they can vote on such a bill only if the Speaker allows a vote on it, and the extreme right wing of the Republican members see this as leverage to get what they want.  By threatening to vote out the Speaker if he does bring up such a bill, they can hold the Speaker hostage to their demands.

Thus there is every reason to expect gridlock to continue, despite Boehner’s resignation and the election of a new speaker such as McCarthy.  Can anything be done?

Yes, the members of congress have it within their power to address this.  Platitudes (such as we will all work together, or will work harder together) will not suffice.  Rather, one needs to address the traditional practices of the current system that empower a small minority within the majority party to hold hostage the Speaker to their demands.

This can be done by going outside the traditional system in the choice for Speaker. There is nothing in the Constitution that requires the Speaker to be a member of Congress.   While the Speaker has historically always been a member, the Constitution does not require this.  All the Constitution says on the institution is in one line at the end of Article I, Section 2, where it states the “House shall choose their Speaker and their Officers”. Anyone can be so chosen.

To change the dynamics, one needs a Speaker who will draw support from the large majority of members who do not represent the extremes of either party.  The Speaker role would change from highly partisan party leader, to a more balanced mediator who seeks a consensus that may well cross party lines to move needed legislation forward.  With Republicans in the majority, the person chosen should be a Republican.  But he or she should be someone who can work with both sides to try to reach a consensus that spans the broad middle ground, thus ending the current system that allows a small minority to hold the Speaker hostage to their demands.

Jon Huntsman might be such a candidate.  He might in particular be appropriate given his recent work as Co-Chair of “No Labels”, a bipartisan group that has proposed a set of process reforms not only to get congress to work, but also the presidency and government more broadly.  I would not necessarily endorse all of these proposals (and some are pretty broad and vague), but thinking along such lines will be necessary if we are to see an end to gridlock in Washington.

The new role of the Speaker would be to seek a broad consensus on issues, crossing party lines, and bringing to the floor measures that will be endorsed by a majority rather than voted up or down on strict party lines.  Voting solely on party lines is a characteristic of parliamentary systems, such as that of the UK.  Such a system works fine to move an agenda forward when the chief executive (the Prime Minister in a parliamentary system) is the head of the majority party in the parliament (or of a coalition that constitutes a majority). But the US Constitution did not establish a parliamentary system.  Rather, it established a system with a separately elected chief executive (the president), who runs the executive branch of government and where the government is made up of three equal and separate branches:  the executive, the legislature, and the judiciary.

Voting solely along party lines, as has become common in recent years in the Congress, works fine in a parliamentary system but not in the system of government established by the US Constitution.  This will not change as long as the Speaker sees his role as primarily that of a partisan leader of his party, rather than as a mediator seeking to produce a consensus on needed legislation with this then passed by a majority of members from both parties representing the middle rather than the extremes.  As long as an extreme can hold the Speaker hostage, he or she will not be able to act as such a mediator spanning the parties.

With such a change to this new type of Speaker, one can foresee a large set of measures passing soon, as a majority in the Congress have been in support.  These include not only necessary upcoming legislation such as for the budget and a bill to raise the debt ceiling, but other items as well.  For example, the previous federal highway funding bill expired in 2009, but since then Congress has not been able to pass any long term extension. Rather, Congress has passed 34 different short term extensions to keep road funding going, and with just these numerous short term extensions, states and localities could not plan in any reasonable way.  The Senate finally passed a longer term (six year) reauthorization this past summer, but the House has yet to act.  There is also a broad consensus on the need for immigration reform, and the Senate passed such a bill in 2013. And if one aimed at achieving a consensus in the middle, rather than appealing solely to one side or the other, one could envisage progress on bills that would address the underfunding and poor management of the VA health system.  One could even see measures to address the high cost of health care (instead of seeking to score political points by calling Obamacare an abomination despite its success in extending insurance cover).

None of this is realistic, of course.  I have no expectation that Washington will change. The point, rather, is that gridlock is not a necessary outcome of the system, but rather a choice that has been made.  Members of Congress have it within their power to change how their Speaker is chosen, and thus ensure the Speaker will abide by the interests of a majority in the Congress rather than a minority in one party.