Background

Since a pair of 1938 Treasury Department Tax Rulings, and another in 1941, Social Security benefits have been explicitly excluded from federal income taxation. (A revision was issued in 1970, but it made no changes in the existing policy.) This changed for the first time with the passage of the 1983 Amendments to the Social Security Act. Beginning in 1984, a portion of Social Security benefits have been subject to federal income taxes.

The three Treasury Rulings (see below) established as tax policy the principle that Social Security benefits were not subject to federal income taxes. This was special treatment for Social Security benefits since most private pensions are partly taxable. In most private pensions, an amount of the pension equal to the contributions made by the worker are tax-free. The amount of such private pensions which exceeds the amount of the worker's contributions, is usually subject to federal income taxes.

A slightly different, and more complicated, way of saying essentially the same thing is that the portion of pension benefits not subject to taxation is that on "after-tax income." For a worker, his entire pay is subject to federal income taxes, including that part that is subject to Social Security payroll taxes, and so, in the sometimes confusing parlance of tax policy, this is said to all be "after-tax income." His employer, however, is allowed to deduct his portion of the Social Security payroll tax from his taxable income. So Social Security payments made by the employer are considered "before-tax income" (and hence, not taxable). So the value of the "before-tax income" received by the beneficiary (i.e., the employer's contribution) is potentially taxable. Or to say it the other way, only that portion of the worker's "after-tax income" on which he paid payroll taxes, is not taxable.

Yet another way of describing this idea is to use "exclusion ratios," which is how the Treasury Department defines the taxable portion of a pension benefit. In all of these ways of describing it, the basic idea is the same: the pension recepient is generally liable for taxes on that portion of his benefits that he did not himself contribute.

Treasury's underlying rationale for not taxing Social Security benefits was that the benefits under the Act could be considered as "gratuities," and since gifts or gratuities were not generally taxable, Social Security benefits were not taxable. It is likely that Treasury took this view owing to the structure of the 1935 Act in which the taxing provisions and the benefit provisions were in separate Titles of the law. Because of this structure, one could argue that the taxes were just a form of revenue-raising, unrelated to the benefits. The benefits themselves could then be seen as a "gratuity" that the federal government paid to certain classes of citizens. Although this was clearly not true in a political and moral sense, it could be construed this way in a legal sense. In the context of public policy, most people would hold the view that the tax contributions created an "earned right" to subsequent benefits. Notwithstanding this common view, the Treasury Department ruled that there was no such necessary connection and hence that Social Security benefits were not taxable.

On the other hand, the fact of the matter is that Social Security beneficiaries do not fully fund their benefits through their payroll taxes. Benefits are funded from three sources: the employee's payroll tax, the employer's matching payroll tax, and interest earned by the Trust Funds. Only one part of this funding could be said to have been directly paid by the beneficiary. Also, technically speaking, benefits are computed based on the workers' earnings, not on the amount of taxes they pay.

So the beneficiary's own contributions do not account for the employer's matching contribution or the interest earned on both. Nor does it account for the benefits received in excess of total contributions. That is, due to the fact that the Social Security program operates in part on the insurance principle, most beneficiaries receive far more in benefits than either they and/or their employers contributed to the system.

If a rigorous effort is made to identify how much of the average beneficiary's benefit was directly paid for by the beneficiary, the general answer is about 15%. Or to say it the other way, about 85% of the average Social Security benefit represents an amount in excess of that contributed to the program by the average worker.


The 1979 Advisory Council and the Greenspan Commission

The 1979 Advisory Council was charged with studying the financing and benefit provisions of the Social Security program. The Council wrote extensively on the issue of taxation of Social Security benefits:

"The present tax treatment of social security was established at a time when both social security benefits and income tax rates were low. In 1941 the Bureau of Internal Revenue ruled that social security benefits were not taxable, most probably because they were viewed as a form of income similar to a gift or gratuity.
The council believes that this ruling was wrong when made and is wrong today. The right to social security benefits is derived from earnings in covered employment just as is the case with private pensions.
The council believes that the current tax treatment of private pensions is a more appropriate model for the tax treatment of social security, Pension benefits from contributory private pension plans (including those for government employees) are now taxed to the extent that the benefits exceed the employee's accumulated contributions to the plan. Cumulative retirement benefits up to the employee's own total contributions are not taxed because the income from which the contributions were paid was taxable. That part of the benefit representing the employer's contribution and interest income on both the employee's and the employer's contributions is taxed when received.
Estimates by the Office of the Actuary of the Social Security Administration indicate that workers now entering covered employment in aggregate will make payroll tax payments totaling no more than 17 percent of the benefits that they can expect to receive. The self-employed will pay no more than 26 percent on average. Therefore, if social security benefits were accorded the same tax treatment as private pensions, only 17 percent of the benefit would be exempt from tax when received, and 83 percent would be taxable. . . Rough Justice would be done, however, if half the benefit (the part commonly if somewhat inaccurately attributed to the employer contribution) were made taxable."

This recommendation by the Advisory Council encountered widespread resistance in the Congress. In an effort to make the idea more palatable, it was suggested that exclusionary thresholds could be added so that beneficiaries of low to moderate incomes would not be affected. This was similar to the procedure in use for the taxation of unemployment compensation benefits, which began in 1978.

Thus, the proposal as it emerged was for 50% of Social Security benefits to be subject to federal income tax, with threshold exclusions set at the same levels as those used for Unemployment Compensation (U.C.).

Following the 1979 Advisory Council, the National Commission on Social Security Reform (informally known as the Greenspan Commission after its Chairman) was appointed by the Congress and the President in 1981 to study and make recommendations regarding the short-term financing crisis that Social Security faced at that time. Estimates were that the Old-Age and Survivors Insurance Trust Fund would run out of money, possibly as early as August 1983. This bipartisan Commission was to make recommendations to Congress on how to solve the problems facing Social Security. Their report, issued in January 1983, was the basis for Congress' consideration of the Social Security reform proposals which ultimately resulted in the 1983 Social Security Amendments.

In its Report, the Commission recommended that Social Security benefits be taxable: "The National Commission recommends that, beginning with 1984, 50% of OASDI benefits should be considered as taxable income for income-tax purposes for persons with Adjusted Gross Income (before including therein any OASDI benefits) of $20,000 if single and $25,000 if married. The proceeds from such taxation, as estimated by the Treasury Department, would be credited to the OASDI Trust Funds under a permanent appropriation."

This was essentially the Advisory Council recommendation as it had come to be modified in subsequent debate. (With the change that the thresholds are computed before adding in the Social Security benefit--the opposite of the way it was done in U.C.)

The Commission estimated that its proposals would effect only about 10% of Social Security beneficiaries and that it would result in $30 billion in revenue to the Trust Funds in the first seven years.

1983 Amendments

Congress passed and President Reagan signed into law the 1983 Amendments. Under the '83 Amendments, up to one-half of the value of the Social Security benefit was made potentially taxable income. The specific rules adopted in 1983 were:

When considering the 1983 Amendments, the Report by the House Ways & Means Committee argued as follows: "Your Committee believes that social security benefits are in the nature of benefits received under other retirement systems, which are subject to taxation to the extent they exceed a worker's after-tax contributions and that taxing a portion of social security benefits will improve tax equity by treating more nearly equally all forms of retirement and other income that are designed to replace lost wages. . ."

The Senate Finance Committee Report offered these additional observations: ". . . by taxing social security benefits and appropriating these revenues to the appropriate trust funds, the financial solvency of the social security trust funds will be strengthened. . . . By taxing only a portion of social security and railroad retirement benefits (that is, up to one-half of benefits in excess of a certain base amount), the Committee's bill assures that lower-income individuals . . . will not be taxed on their benefits. The maximum proportion of benefits taxed is one-half in recognition of the fact that social security benefits are partially financed by after-tax employee contributions."

The Senate Report thus acknowledged that one motivating factor in introducing this change was to raise revenue for the Trust Funds. This was part of a much larger package of program changes designed to address the financial solvency of the program. One might fairly say that cutting benefits and raising revenues was the purpose of the 1983 Amendments, and the adoption of Social Security benefit taxation was simply one provision among many to facilitate these aims. It is also important to note that funds raised under this provision do not go into the General Fund of the Treasury but into the Social Security Trust Funds. This emphasizes again that the purpose of introducting this provision was to raise revenue to help restore Social Security's financial solvency. (The Committees estimated the six-year savings from this provision at $26.6 billion, and estimated that this provision would supply almost 30% of the total additional long-range funding provided by the Amendments.)

We should also take note of the rationale for the exclusionary thresholds in the law. The Congress intended that the taxation provisions should not affect "lower-income individuals." The $25,000 and $32,000 thresholds were included to accomplish this. So the thresholds are not based on any feature of the Social Security program--they are pure tax policy. Since the thresholds in the 1983 law were intentionally not indexed, over time, they would lose some of their threshold effect as increases in real income or in inflation would tend to pull more and more people into tax liability. Indeed, by the time the law was first amended in 1993, about 18% of Social Security beneficiaries had some tax liability (compared to about 10% when the law was originally enacted).

The idea that only one-half of the benefits would be subject to taxation did have some basis in the Social Security program. It was based on the simple notion that the employee had made only one-half the contributions used to fund his benefit (the other half having been paid by the employer). Since in private pensions, benefits in excess of the employee's own contributions are taxable, one could argue that 50% of Social Security benefits should be subject to taxation. As Ways and Means Committee member Wyche Fowler (D-GA) explained the provision on the House floor: " . . . although employees pay income taxes on their income subject to the payroll tax, employers do not because they can claim a business expense deduction for their payroll tax payments. Therefore, it is argued that requiring Social Security beneficiaries to pay taxes on their benefits--the part provided by employer contributions--is appropriate at the time of receipt."

Even so, this rough-approximation did not really give Social Security benefits the same tax treatment as private pensions--because the real "non-contributed" portion is about 85% of the average benefit, not 50%. During consideration of the bill in the two houses some unsuccessful amendments were advanced to make the Social Security provision more precisely like those governing private pensions, but ultimately the idea of a 50% portion prevailed.

The idea of taxing benefits, like many of the individual features of the omnibus bill, was not universally popular. Some complained that it introduced a form of "means test" in that beneficiaries of lower incomes were not subject to the provision (due to the thresholds). It was also argued that this introduced General Revenue financing into the system, and that it watered-down the equity of those beneficiaries who had to pay taxes.

Ultimately, the 1983 Amendments were passed in the House on the evening of March 9, 1983 by a vote of 282 to 148. On the evening of March 23rd, the Senate passed its version of the bill by a vote of 88 to 9. Both bills contained virtually identical provisions for the taxation of benefits, with only one change in the Senate bill: requiring that tax-free interest income be used in the computation to determine if the thresholds were exceeded. In the Conference, which took place on March 24th, the House accepted the Senate provision. Immediately following the conclusion of the Conference, at 10:25 p.m. that night, the Congress reconvened to consider the Conference Report. The House quickly adopted the Conference Report by a vote of 243 to 102. In the Senate, the debate went on through the night and finally, in the early morning hours of March 25th, the Senate voted 58-14 for final passage. (See detailed Summary of the 1983 Amendments.)

1993 Changes in the Law:

In 1993, as part of Omnibus Budget Reconciliation Act, the Social Security taxation provision was modified to add a secondary set of thresholds and a higher taxable percentage for beneficiaries who exceeded the secondary thresholds. Specifically, the 1993 did the following:

Note that these were secondary thresholds and taxable percentages. Thus they did not increase the number of beneficiaries subject to taxation. Rather, they raised the potential tax liability for a subset of those already subject to the tax (those with higher earnings). Prior to this change, 81.8% of Social Security beneficiaries had no potential tax liability for their Social Security benefits. This was not changed, in any way, by the 1993 law. However, of the 18.2% already subject to potential taxation, 10.6% saw their potential tax liability increase, while the remaing 7.6% suffered no change.

The changes introduced by the 1993 amendments were designed to make the treatment of Social Security benefits more closely approximate private pensions--albeit, only for higher-income beneficiaries. To this end, the taxable percentage was set at 85% for these higher-income beneficiaries. New thresholds were added, but only to differentiate those subject to the higher percentage from those still subject to the 50% figure.

In explaining the rationale for these changes, the House Budget Report stated:

"The committee desires to more closely conform the income tax treatment of Social Security benefits and private pension benefits by increasing the maximum amount of Social Security benefits included in gross income for certain higher-income beneficiaries. Reducing the exclusion for Social Security benefits for these beneficiaries will enhance both the horizontal and vertical equity of the individual income tax system by treating all income in a more similar manner."

Under the House version of the bill, however, the increased revenues from the new percentage taxable was to go to the General Fund of the Treasury. Under the Senate version, the increased revenues were to go into the Medicare HI Trust Fund. The Senate position prevailed.

Under the House bill, there were no changes in the existing thresholds--everyone with countable income over the 1983 thresholds would be subject to the 85% rate. Under the Senate version, new secondary thresholds were proposed at $32,000 and $40,000--with the old rules applying for those over the old thresholds but under these secondary thresholds. For those over the new thresholds, the 85% figure would come into play. The Senate version prevailed here as well, except that the Conference agreed to boost the secondary thresholds to $34,000 and $44,000.

Thus, under present law, almost all Social Security beneficiaries still enjoy more favorable tax treatment of their benefits than is the case for recipients of private pensions.

Early Treasury Rulings on Taxation of Social Security Benefits

Larry DeWitt
SSA Historian's Office
February 2001