The earnings test was originally imposed for a reason that now makes no economic sense. Its purpose was to get workers out of the labor force during the Great Depression in order to open up jobs for younger workers.2 Today, however, one of the biggest problems facing the country is not a lack of jobs, but a lack of workers. The earnings test is not only depriving American businesses of labor they desperately need, but is keeping out of the labor force some of our best educated and most experienced workers.3 As a nation we cannot afford to keep doing this.

Keeping older workers out of the labor force is also harmful to them. When they are forced into idleness by retirement, it often impacts negatively on their health and self-esteem.4 And the notion that older workers are not healthy enough to continue working is simply no longer valid. Rising life expectancy and improved medicine mean that today's average 65-year-old is probably in better physical shape than a 40-year-old worker was before World War II.5 Of course, no retiree should be forced to work if they prefer leisure, but actively penalizing those who want to work and are able to work is harmful both to them and the economy.

According to the Social Security Administration, 3.5 million people between the ages of 62 and 69, about 37 percent of all retirees under the age of 70, have some earned income.6 As Figure I shows:

• In 1995, 743,000 workers ages 65 to 70, or 8.5 percent of all retired worker beneficiaries, had their Social Security benefits reduced because their earnings exceeded the allowed amount.

• About 214,000 or 29 percent of those losing benefits received no Social Security benefits at all that year.

The total amount of benefits lost was $4.3 billion and the median benefits lost per recipient was $3,596.7

It should be noted that the earnings test also creates a kind of marriage penalty, because earnings by the primary Social Security recipient above the threshold can also reduce the benefits of auxiliary recipients. In 1995, secondary recipients losing benefits were primarily female. Only 2,000 males receiving secondary benefits lost benefits, while 62,000 females did.

Inclusion of secondary beneficiaries raises the number of those losing benefits in 1995 to 806,000. And because 154,000 other family members - nonworking spouses and children - are also affected by the reduction in benefits, the total number of people harmed by the earnings test rises to 960,000. But even this number understates the impact of the earnings test, because about 152,000 additional workers did not apply for benefits because their earnings were above the threshold.8

The withholding of benefits acts like an additional tax on earnings.

• For retirees between the ages of 65 and 69 it is a 33 percent tax rate.

• For those between the ages of 62 and 64 it is a 50 percent tax rate.9

These implicit tax rates come on top of explicit taxes such as federal and state income taxes, including taxes on Social Security benefits for those whose incomes are high enough. Of course, older workers continue to pay Social Security taxes as well. For those in the 15 percent federal income tax bracket, even before state taxes this can raise the marginal tax rate as high as 63 percent for those ages 65-69 and 80 percent for those ages 62-64, as Figure II shows. The marginal tax rate is higher still for those in the 28 percent bracket, who may also be taxed on part of their Social Security benefits. One study found that the marginal tax bite, both explicit and implicit, can reach more than 100 percent in some cases.10 Another study put the top rate at 96 percent just at the federal level.11 And the incidence of high de facto marginal tax rates is not limited to just a few of the elderly. One study found that 30 percent of the single elderly and 12 percent of married elderly faced marginal tax rates exceeding 60 percent.12

These high effective tax rates have a major impact on the employment status of older workers. [See Figure III.]

• In 1999 only 16.9 percent of men over age 65 were in the labor force, either by working or seeking work.13

• Fifty years ago, 47 percent of such men were still in the labor force.

• At the turn of the century the figure was better than 60 percent.14

This sharp decline is all the more remarkable given the significant rise in life expectancy over this period.15

The earnings test should be scrapped in its entirety. Either people have earned their benefits or they haven't, and singling out those who continue to work after retirement age is a violation of that principle. The only possible justification for keeping the earnings test is budgetary.16 Obviously, elimination of the test would lead to the payment of benefits that are now not paid, increasing federal outlays for Social Security. However, this cost is often grossly overestimated because estimates do not take into account the impact of the delayed retirement credit (DRC).

The DRC raises benefits for retirees when they put off drawing Social Security benefits, even though they are eligible for them. Workers turning 65 this year will receive a 6 percent increase in their Social Security benefits for each year they delay drawing benefits. Thus, if their work history entitled them to $1,000 per month in benefits at age 65, but they did not begin drawing benefits until age 66, they would get $1,060 per month.17

The idea of the credit is to encourage workers to stay in the labor force and not retire the minute they become eligible for benefits. But many workers are under the mistaken belief that any benefits they fail to draw simply are lost. Hence, many workers are retiring too soon for their own good. A recent study from the National Bureau of Economic Research says that most workers would be better off by delaying their first Social Security benefit check by up to three years.18

In future years, the gain will increase. That is because the delayed retirement credit will rise to 8 percent in the year 2008 (for workers born in 1943).19 This means that someone waiting until age 70 before drawing benefits would get 40 percent more than if they started at age 65. (After age 70 there is no further increase in benefits and also no earnings test.20) At that point, the Social Security actuaries estimate that the lifetime benefits people receive from Social Security will be about the same in the aggregate regardless of whether they retire at age 65 or age 70.

The DRC is extremely important in calculating the long term budgetary impact of eliminating the earnings test. Those people who now lose benefits because of the earnings test receive higher future benefits. They also receive higher benefits because earnings past age 65 can cause their benefits to be recomputed. That is because Social Security uses a 35-year earnings history to calculate benefits. If post-65 annual earnings are greater than the lowest of these years, they can lead to higher benefits.

Because the DRC is supposed to cause lifetime benefits to be the same regardless of when people begin to draw benefits, the long term cost of eliminating the earnings test should in theory be zero. Higher benefits paid out in the short-run to people who would otherwise lose benefits because of the earnings test will be offset by lower future benefits because they will no longer claim the DRC.21

Another problem is that estimates of the net cost of eliminating the earnings test sometimes look only at increased payroll taxes that will result from expanded labor supply, as those now forced out of the labor market by the test remain in it or reenter.22 These estimates tend to overlook higher income tax revenues and reduced outlays for Medicare due to older workers having employer-provided health benefits. One study that did take all of the relevant factors into account found that after about eight years, the net increase in federal outlays is just $1 billion per year.23

I believe that all arguments against abolishing the earnings limit are spurious. In fact, my suspicion is that the true barrier to doing so is simply class envy. Those who would benefit most in the short run from abolition of the earnings test are relatively high income earners. But in the longer run, especially given the rise in life expectancy, I would expect to see many more moderate income workers stay in the labor force if the earnings test were repealed.24

This is not a partisan issue. President Clinton proposed eliminating the earnings test in his State of the Union Address in 1999, and has reiterated his desire to do so again this year.25

Bruce Bartlett, Senior Fellow

This Backgrounder is adapted from testimony before the Subcommittee on Social Security of the U.S. House Ways and Means Committee on February 15, 2000.

NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.