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© National Tax Association. Reprinted with permission.

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Introduction

One way of relieving the economic pressures created by an aging population would be to encourage workers to delay retirement. As society grows older, there is increasing concern about the ability of workers to pay enough taxes to support future retirees and other government functions. Over the next 50 years, for example, the number of Social Security beneficiaries per 100 workers will rise from 30 to 50, assuming current employment patterns persist (Board of Trustees 2005). Older Americans could limit the impact of these demographic trends by working longer. People who work an extra year produce goods and services that can support their own current consumption and help cover the costs of retirement programs and other government efforts.

Enticing workers to delay retirement depends crucially on the individual returns to work at older ages. As work pays more, in terms of current after-tax earnings and increments to future retirement benefits, people may become increasingly willing to sacrifice leisure and remain at work to obtain richer consumption opportunities both today and later in retirement.¹ Rising tax rates can discourage work by reducing the share of output that workers take home. Earnings at older ages can be taxed in the traditional way, with payments to the Internal Revenue Service (IRS), or they can be "taxed" through reductions in future Social Security and other retirement benefits.

The complex interaction between wages, benefits, and taxes determine how much work pays at older ages. Working an additional year will generally increase future Social Security benefits, for example, but the relationship between work history and Social Security is complex, and sometimes depends on the spouse's employment. Those who have earned much less over their lifetimes than their spouses might not gain any Social Security benefits from an additional year of work, because they receive benefits based solely on their spouses' earnings. In addition, many traditional defined benefit (DB) plans penalize those who continue on the job after they qualify for full retirement benefits, reducing the lifetime benefits they receive from the plan. Many workers receive valuable health benefits from their employers, and the loss of these benefits when they retire can provide strong incentives to remain on the job before they qualify for Medicare benefits at age 65.

This article describes the combined impact of Social Security, Medicare, employee benefits, and the tax system on the financial incentive to work for representative adults age 55 and older. We compute the implicit tax rate on work, broadly defined to include standard income and payroll taxes as well as changes in future Social Security benefits, employer-provided pension benefits, and health benefits associated with an additional year of employment. We measure how work incentives vary by life expectancy, Social Security take-up age, pension plan type and contributions, earnings level, access to employer-sponsored health insurance and retiree health benefits, health status, and marital status. We also examine how selected policy reforms, such as eliminating the payroll tax and the taxation of Social Security benefits, could improve work incentives at older ages. Although previous research has examined how Social Security, employer pensions, employer health benefits, and taxes individually discourage work at older ages, this article is the first effort to measure the combined impact of these various disincentives and to express them as a tax rate. For example, most studies of how Social Security and pensions affect retirement decisions have ignored the role of taxes and Medicare (e.g. Coile and Gruber 2004; Friedberg and Webb 2005; Samwick 1998).

Notes from this section of the report

1. By increasing income, however, higher after-tax compensation can lead people to consume more goods and services as well as more leisure, reducing hours of work. But higher returns to work will raise work hours and delay retirement as long as the impact of the increased price of leisure (the substitution effect) outweighs this income effect. Studies show that workers generally retire if they would lose future pension or Social Security benefits by remaining at work (Lumsdaine and Mitchell 1999).

Note: This report is available in its entirety in the Portable Document Format (PDF).

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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