Fire up the Seniors: The Push to Exempt Social Security

Problematic in principle but politically opportunistic, the justifications for exempting all Social Security income from state taxation conflict with policy, economic and demographic realities.

Back in 2017 with considerable bipartisan support, Minnesota enacted senior tax relief with a Social Security subtraction that departed from federal tax treatment of these benefits.   The subtraction was subsequently increased in the 2019 session.   For republican lawmakers these back-to-back legislative accomplishments have not “addressed the concern” but rather “stoked the fires” to have Minnesota go even further and join the 37 -- and soon to be 38 -- other states (seven of which do not have state income taxes) in totally exempting Social Security income.  In interviews previewing the 2020 legislative session, Senate Majority Leader Gazelka has said this is the centerpiece of GOP’s tax policy to do list. 

From a budget standpoint, this proposal is not cheap. According to the Department of Revenue a full exemption effective in 2020 would cost the state $435 million in FY 21 and would only go up from there (although past proposals have called for multi-year phase outs to mitigate budgetary impacts).   From a tax principle standpoint, it is a Superfund site of horizontal equity problems -- “treating equals unequally” simply based on where income comes from.   But from a political standpoint, it’s shrewd and the reason why the majority of states with state income taxes exempt this income.  The entertainingly-blunt tax author and scholar David Brunori once summed the overall situation thusly: "Tax breaks for old people are silly from a tax policy perspective.  Under no theory of taxation should a person who turns 62 (or whatever age we pick) magically be exempt from taxation.  Let's face it, states offer tax relief to old folks because those folks vote more than anyone else."

Good tax policy principles seldom serve as the north star for navigation in state tax policy debates.  So instead it’s worth evaluating the merits of the three primary arguments that will be used to justify this proposal.

Stop “Double Taxation” – Proponents argue since individuals have already paid social security taxes all through their working careers, taxing it again at retirement amounts to double taxation.  However, the federal government’s exclusion, first enacted based on the recommendations in 1983 from the National Commission on Social Security Reform appointed by President Reagan, was designed to address that specific issue.     

Social Security is treated as an earned benefit by the federal government and therefore its taxation is modeled on the taxation of private pensions – paying income tax to the full extent that benefits exceed their contributions.  As a 2019 Congressional Research Service report on Social Security taxation notes:

“In 1993, the Social Security Administration’s Office of the Actuary estimated that, if pension tax rules were applied to Social Security, the ratio of total employee Social Security payroll taxes to expected benefits for current recipients (in 1993) would be approximately 4% or 5%.  The actuarial estimates were that for workers just entering the workforce, the ratio would be, on average, about 7%. Because Social Security benefits replaced a higher proportion of earnings of workers who were lower paid and had dependents, and because women had longer life expectancies, the workers with the highest ratio of taxes to benefits would be single, highly paid males. The estimated ratio for these workers (highly paid males) entering the workforce in 1993 was 15% ... Taxing no more than 85% of Social Security benefits (the estimated portion not based on contributions by a recipient, including highly paid males) would ensure that no one would have a higher percentage of Social Security benefits subject to tax than if the tax treatment of private and civil service pensions were actually applied.”[1]

In other words, the current “85% taxable cap” established by the federal government on Social Security income exists because actuaries determined that no Social Security beneficiary had paid through Social Security withholding for more than 15% of his or her own benefits.  Since most beneficiaries are not “single highly paid males” (who have the highest ratio of taxes to benefits), the existing treatment of Social Security is not double taxation but, in reality, a more favorable tax treatment than private pension income.

Seniors are on fixed incomes and are more economically vulnerable – It’s true that younger working households may generally have more income generating opportunities than senior households with the same incomes.  It’s also true that over the last nearly 50 years, as the accompanying graphic shows, seniors are the undisputed heavyweight champion in improving their income status.

As Pew notes, “The biggest winners overall are people ages 65 and older.  They are most likely to have moved up the income ladder since both 1971 and 2001. They are less likely to be lower income and more likely to be upper income than they used to be.  Other age groups gained only slightly or lost ground.”[2]   Pew also notes this change in the economic status of older adults may actually be understated since only income is included and not wealth.   Another study found while the average married elderly household had total income equal to 64% of non-elderly households in 1990, by 2013 that percentage had grown to 101%.[3]  These significant gains have been achieved with the federal government taxing Social Security benefits at much higher marginal rates than states for over 35 years.  

Most importantly, the progressive structure of Social Security benefit taxation insulates seniors whose economic welfare is most affected by its continued taxation.   Moreover, the 2017 Minnesota income subtraction (which is phased out at higher incomes) significantly expanded protections to households with higher Social Security incomes.     According to the Minnesota Department of Revenue, the number of households with taxable Minnesota Social Security income fell by 94.3% in the state’s 4th income decile (household incomes from $33,700 to $44,700); 55% in the 5th decile ($44,700 - $57,700); and 24% in the 6th decile ($57,700 - $74,200).    These declines do not include the effects of the 2019 subtraction enhancements.

Keep more Minnesota seniors in Minnesota -- Taxes, seniors, and mobility is a complicated relationship. Seniors, of course, move for a lot of different reasons besides taxes.    Taxes, of course, also pay for services and amenities seniors need and care about.   Even among any seniors whose moves are solely motivated by lower taxes, all forms of taxation will likely be taken into consideration, not just one part of the system.  For example, the influential retirement resource Kiplinger labels Texas a “not tax friendly state” for seniors despite having no income tax because of its high sales and property taxes.  

The correlation versus causation issue has long made efforts to determine the role of taxes generally, and income taxes specifically, in relocation decisions difficult.  However, data does offer two worthwhile insights on this topic.

First, tax policy changes don’t seem to be necessary to retain most retirees.  Research has found elderly populations are actually a very stable demographic to begin with.  Less than one percent of the population age 65 and over moves across state lines in a given year – an estimate which has been quite steady over the last few decades and “has been declining, if anything.”[4]  

Second, the relationship between state social security exemptions and senior outmigration rates is inconclusive at best and non-existent at worst.  According to the State Demographer’s office, over the 5-year period from 2013-2017, Minnesota’s average annual net outmigration rate of -0.13% for seniors 65 and over ranked 15th highest in the nation.  Ten of the states[5] with higher outmigration rates fully exempt Social Security income.    (Interestingly, the state that had highest net outmigration rate among the 48 contiguous states over this period is South Dakota, which has no income tax at all).   Conversely, 7 of the 13 states that fully or partially tax Social Security income had positive net migration rates for seniors.

One subset of seniors may be more at risk -- the relatively affluent seniors with higher incomes, greater mobility, greater tax exposure, and the ability to retire/relocate earlier (which the 65+ mobility analysis above does not capture).  In addition, the state and local tax deductibility cap in the TCJA has now made state income taxes much more economically relevant than ever before.

The key question regarding the behavior of these seniors is to what extent exempting Social Security would actually influence their decision-making.  Affluent seniors receive a much smaller proportion of their income from Social Security benefits.   A study examining how income changes in transitioning from work to retirement found the top 40% of senior income earners received one-third or less of their income from Social Security – the top 5% less than 15%.[6]    This relative share may, in fact, be significantly overstated.  A 2017 research study by U.S. Census Bureau linking survey responses with administrative records from the IRS and other agencies found that the median household income of seniors aged 65 and over was 30% higher than what the Census reported, “mainly attributable to underreporting of retirement income from defined benefit pensions and retirement account withdrawals.”[7] 

For higher income seniors, any relocation decision-making based exclusively on income taxes (rather than all aspects of the Minnesota tax system) will be far more influenced by the existence of Minnesota’s income tax structure --  its marginal tax rates and brackets combined with state tax treatment of much larger amounts of other retirement income such as pensions and retirement withdrawals.  Whether an exemption of what is often a relatively small fraction of their income could make an appreciable dent in the calculus, or “tip the scales” in favor of staying in the state seems very doubtful.   

Even if a full exemption is successful at keeping more seniors as residents, the price tag of this policy deserves consideration.  According to the latest information from the State Demographer, there are an estimated 890,000 seniors 65 years and older living in Minnesota.  If we apply the national 1% rate of state out-migration to this population, that translates into a “retention price tag” of $49,000 per potential senior migrant to keep them here in FY 21 ($435 million / 8,900).     If we very generously assume that one quarter of these individuals would decide to remain in the state because we exempt their Social Security benefits, that translates into $195,000 per retained senior.   These “staying put” seniors (and any new ones “recruited” by our now more favorable senior tax policy) would have to generate over four times the size of the state’s median 65+ household income in economic benefits to have this tax break pay for itself. 

The Wisdom of the Crowd?

Unfortunately, a vicious cycle may be at work, with legislated favors leading seniors to greater involvement in politics and legislated burdens leading the young to greater apathy. It cannot bode well for America's future when the rising generation thinks there's no such thing as a level playing field. Let's be clear: The Concord Coalition does not believe that Americans ought to pay heavy taxes. What we do believe is that in a democracy, once the total cost has been determined, the burden should be fairly shared. Right now, the burden is not-and rolling back the Social Security benefit tax will only make matters worse.

“Taxes on Seniors--How Low Can We Go?”   Concord Coalition

According to the State Demographer, the number of Minnesotans turning 65 in this decade will be greater than the past four decades combined.  This year, Minnesota's 65+ population is expected to eclipse the 5-17 year-old K-12 population for the first time in history.   The total number of older adults (65+) is anticipated to double between 2010 and 2030.   By then, more than 1 in 5 Minnesotans will be an older adult, including all the Baby Boomers.   Within this demographic shift will likely be a rising number of seniors introducing public finance burdens due to long term care and health care costs -- a tab picked up by younger taxpayers adding equity insult to equity injury.

With the current make-up of the legislature and the executive branch, the odds of passing a full Social Security exemption this year are zero.  However, these demographic figures and projections guarantee the topic will be a recurring and high-profile feature of state tax debates for many years to come.   For anyone looking to cut any taxes, anytime, anywhere, for any reason, just on principle, not taking advantage of this golden demographic environment would amount to electoral malpractice.

Proponents have the apparent wisdom of 37 (and soon to be 38 [8]) other states behind the cause.  However, Minnesota should reject the wisdom of the crowds.   There is an important reason why Minnesota has been a national outlier on this issue for a long time.  That reason is reflected in the powerful long-term budget, spending, and tax fairness implications arising out of those very same State Demographer figures and projections.


[1] Social Security: Taxation of Benefits, Congressional Research Service, November 2019

[2] The American Middle Class is Losing Ground, Pew Research Center, December 2015

[3] “Protecting the Vulnerable or Ripe for Reform?  State Income Tax Breaks for the Elderly - Then and Now” Brewer, Conway and Rork, Public Finance Review, September 2016

[4] “How has Elderly Migration Changed in the 21st Century? – What the Data Can and Cannot Tell Us”  Smith Conway and Rork, Demography, August, 2016

[5] Includes D.C.

[6] “Using Panel Tax Data to Examine the Transition to Retirement” Brady, Bass, Holland, Pierce, SSRN.#2928375 March 6, 2017

[7] “Do Older Americans Have More Income Than We Think?” Bee and Mitchell, U.S. Census Bureau, SESHD Working Paper #2017-39, July 2017

[8] West Virginia will have fully phased out their taxation of Social Security benefits in 2022.