Pay as You Go Taxes

Pay as You Go Taxes

Taxes

Pay as you go system is a concept, where all current revenues are used to pay current benefits leaving very little cushion for trust fund. This is the most basic structural factors effecting social security financial problems. This system is highly vulnerable to effect developments in any of the many social and economic factors. Recession, inflation, fertility and mortality are few of these social and economic factors. As and when the pay-as-you go system reaches its mature age, these vulnerabilities are reflected by themselves. When a pay-as-you-go system starts up, a complete generation of tax payers contributes by way of paying taxes to the system without any beneficiaries entitled for benefits based on past tax payment. On the contrary in a fully funded investment, the initial tax payments are saved and invested to cover the expenses of future benefits of current workers. However in a pay-as-you-go system there is no investment of initial tax collections, instead the taxes of the next generation of workers will pay for the current workers benefits. In this system since there is no requirement for substantial financial needs in the start up phase, there is no difficulty to pay for unpaid for, unexpected or windfall benefits to the first batch of retirees from the initial tax funds. This increases temporarily the popularity of the system. The financial background changes significantly as the plan grows older with many liabilities getting accrued with an obligation of providing benefits to an entire generation. (Ferrara, 1985)

In a pay-as-you-go system, which is financed by taxes on payroll, the contribution or the income does not get pooled in a fund or against any workers individual account as it is in the case of a private savings retirement pension plan. On the contrary all income or contribution from current payroll taxes is straight away paid to retired employees who are currently drawing pension since what is due to each current retired employee as pension is to some extent based on the prior taxes paid by them in to the system. Both, insurance and transfer elements are curiously mixed in an U.S. social security system, where the insurance is loosely approximated by the relation between pensions earned once retired and taxes contributed while employed and the transfer element is a direct transfer from the payroll tax contributed from employed employees to retired employees. (Rosa; Institute for Contemporary Studies, 1982)

There were quite a few misleading statements over the years from the social security administration in terms of relation between contribution or taxes and the reserves. In America people know that reserves are meant for emergency or contingency to be used for balancing temporary deficit between contribution and outgo in a similar way where an individual maintains a reserve pool in his checking account to adjust in the event of any differences in his receipts and expenditure account. The pay-as-you-go system of social security is quite different in terms of person's rights when compared with rights under private pension fund scheme. In the later scheme though some companies makes it mandatory to participate in pension plan, the private pension fund scheme provides much wider elements of voluntary choice. There is lot of differences among different employers and there is scope to contribute more even to any particular scheme based on associated premium and risks. (Rosa; Institute for Contemporary Studies, 1982)

In a private insurance the contribution of an employee is invested by the private insurance provider on behalf the employee to fund the pension payments of the employee when he retires. This is not the case with Social Security taxes paid by the employees. In social security there is no investment or fund to yield return to employee's contribution. Social Security is a vast intergeneration transfer system where in, relatively younger employees contribute to pay pension to older network. The political system is the main culprit for the current status of pay-as-you-go system. The system allows politicians to frequently add interesting and attracting features, by continuously postponing the costs for future time. (Davies, 1986)

The distinctive features of items to be placed in a capital budget are stream of returns that extends in to the future. In general these items should be financed by borrowings. The items which are of ordinary nature which are expensed out currently should be funded by annual taxes on a pay-as-you-go basis. Items which are used for a substantial future time should be funded by pay-as-you-use basis. The borrowing terms should correspond with the life of the capital item. Only the charges equal to interest and amortization should be carried by the current budget, paying off the principal of the debt as the benefits. Intergenerational equity can be provided only by financing public durable goods through loans. If the service yield from a project is spread over many years, then the people should pay according to their use to make sure that younger generation pays more to a new project than the older generation. This concept is ideal in the case of municipal finance where the people belonging to a municipality keeps moving or changing quite often as sated by Richard a Musgrave. (Aronson; Hilley; Maxwell, 1986)

In the event of an older resident moving to a locality where the locality incurs a huge expenditure on durable item that is finance by pay-a-you-go basis, then it is unfair treatment for the older resident. Case of items of expenditure that are large in amount and not regular in time is another justification of loan finance. In a case where a small district is in need of a school, if the entire cost is funded by increase in taxes for just one or two years, there will be an unnecessary distribution of effects. One of the substitutes to overcome this problem is to have reserves which could be used for such expenses or to go for borrowings to meet the cost of school construction, and raising annual taxes only to the extent of covering interest and amortization. However the loan finance irregularity argument can be stressed here. A large or a moderate size government's expenditure on each type of public work is generally irregular. However the yearly total expenditure in general is close to constant or can be made close to constant. (Aronson; Hilley; Maxwell, 1986)

In general the old age security systems are publicly managed. Pay pensions are directly linked to the workers earnings and are funded by taxes on a pay-as-you-go basis. This means that the taxes on people who currently earn salary are to cover pension costs of people who have already retired. Problems of similar nature happen again and again in many industrialized and developed countries. This indicates that these problems are not occurring unexpectedly; instead they prevail and are a continuing essential constituent in the political economy system. This is politician's efforts to enjoy current benefits with a large future cost. There is need for a new system which is not obliged to these dangerous. Small contributions from a large number of employees are possible when the population is young to contribute to generous benefits to the pensioners. Once the population age and the system grow, this system should change to tax higher to maintain the same benefit to the increasing number of retirees. (Prieto, 1997)

Egypt, Hungary, Russia, Brazil, Italy and Kyrgyzstan charge payroll taxes for pension at a rate of above 25%. If the pay-as-you-go systems have to be retained when the population age in the next 30 years, tax rates in all these regions have to be increased substantially. Lower take home pay or unemployment results with higher payroll taxes without having the same related benefits if there is not well structured pension plan in place. If the system of high payroll taxes is not tied to corresponding benefits, the system gives rise to tax evasion. This scenario is much higher in the case of developing countries with restricted enforcement mechanism. Eastern Europe's informal sector is growing at a very fast rate and to avoid payroll taxes over 40% of the labor force are in informal sector. More than 50% of workers were tax evaders in terms of their contribution to pension system in Argentina. This evasion of contribution to pension system is a critical problem for the system to pay pension. This will result in further hike in rate of contribution to pension system which in turn affects the economy since the people who works for informal sectors are less productive over people who works for formal sectors. (Prieto, 1997)

In Hungary, while the average retirement age is 54, with a payroll tax of 31%, more than 25% of the total population comes under the category of pensioners. In Turkey people retire at the age of 50 and in some cases even at 40, but still gets generous pension. In many countries, the average age of retirement for public sector employees is 55 or earlier. In the past two decades there is reduction in the rate of male employees over the age of 55 in every DECD countries. The people who opt for early retirement stop staring contribution to pension system where as they start getting the benefits of pension system. (Prieto, 1997)

The traditional unfunded social security system is facing lot of problems in the United States and other developing countries with the increasing life expectancy of the people. The cost of providing any level of service is directly linked to the percentage of people who are employed against people who have already retired and enjoying pension in a pay-as-you-go system. The problem is continuing and increasing with people's move towards early retirement which is encouraged in many countries social security system. Even in the event of retirement being stabilized, the steep increase in the ratio of the aged against that of working age is contributing to the substantial raise in the cost of pay-as-you-go system. The United States estimators, who work for social security system, forecast an increase from current 12% of covered payroll taxes to 17% for cost of providing the benefits covered under the social security system. This is estimated to be 20% by 2070. (Campbell; Feldstein, 2001)

In pay-as-you-go system, taxpayers pay high cost to obtain any given benefit which demonstrates the comparative low rate of return the contributors earn on taxes paid by them in an unfunded system. Only the growth in the base tax rate is the implied rate of return on taxes payers' contribution in an unfunded system as shown in 1958 by Paul Samuelson in one of his famous papers. In U.S. system the tax is based on the cash wages which is the mode of finance and the future total growth in cash wages is the factor which determines the rate of return. The assumption that the future reduction in population growth rate will limit the implied real rate of return to less than 2% per annum is the only factor based on which the social security estimators estimate the future required tax rate increase. In spite of U.S. social security system being a pay-as-you-go module, where in the every current year, the total tax collection is used for paying benefits of retirees who are already enjoying retirement benefits; there is still an investment in government bonds in the form of a trust fund. (Campbell; Feldstein, 2001)

The overall rate of return the contributors get on the taxes they contribute and the funds available to pay the annual benefits is affected by the rate of return on the trust fund invested in government bonds. But since these interests are just a transfer within two government accounts this has no substantial economic contribution, though they can contribute to raise the return on payroll tax payment at the expense of income tax payments. Overall rate of return that participants get on their social taxes are very little influenced by the overall return on trust fund since the trust fund is very small, comprising just two years worth of benefits and not even up to 10% of current total obligations under the social security system. The actual rate of return is determined by the growth and in effect the system effectively operates on a pay-as-you-go basis. (Campbell; Feldstein, 2001)

The pay-as-you-go system costs are increasing and there are three simple ways to control these increase in costs under this system which are reduction in benefits, increase in taxes and pre-funding. These methods can be used together or individually to control the increasing costs under pay-as-you-go system. Some experts are of the opinion that by cutting the future benefits, the raise in future tax can be controlled. The changes should be to the existing structure of social security benefits with a move towards more fundamental shifts from the existing structure of social security system to a uniform benefit structure such as increase in retirement age and modification to the post retirement inflation adjustment. Some other experts are of the view to continue with the same benefit by increasing the tax rate significantly in the future. (Campbell; Feldstein, 2001)

However since both these measures of large tax rate increase or major reduction in benefits does not go well with politicians, the idea of pre-funding future benefits by keeping aside resources now and investing those set aside funds together or on individual accounts is not encouraged. The common feature of pre-funding is that of increase in national saving resulting in increase in national capital stock though the pre-funding proposals have many variations. Future retirement consumptions are financed by the increased national capital stock resulted from additional national income which makes possible to maintain benefit without raising taxes. However the pre-funding concept was not accepted well by people since long because of the problem of transition generation ending up with paying twice. The transition generation has to pay the pay-as-you-go taxes to finance the benefit of those who have already retired and enjoying retirement benefits but at the same time saving for their own retirement. With the current rate of over 12% on wage income, this method will be a double burden with the transition generation ending up with paying above 24% tax on wage income. (Campbell; Feldstein, 2001)

Considering this the concept of pre-funding is not accepted since it is unfair on transitional generation and/or politically impossible to introduce. Actually the additional cost on transitional generation is smaller than that of what is highlighted by the critics since with the pay-as-you-go system; the implicit rate of interest is much lesser than the rate of interest on real saving. The actual savings required to finance any future benefits is lesser than the related pay-as-you-go tax rate. The extent of pay-as-you-go benefits can be gradually reduced because of retirees receiving some benefits from the funded part of system during the transition phase. Despite the increased aging population, without increasing the combined amounts of pay-as-you-go taxes and the compulsory savings by 2% of wage income, that is from the current 12.4% payroll taxes to a maximum of 14.4% and also without any changes in the current or future benefits a transition from pay-as-you-go system to a funded defined contribution system could be achieved as shown by Feldstein and Samwick. (Campbell; Feldstein, 2001)

The sum of OASI trust fund receipts i.e. The interest on the trust fund balance and the revenue transfer to trust fund on the basis of taxing the benefits of high income retirees and the total of OASI portion of the payroll tax is projected to cross the OASI benefits only by 2021 under the current law. Beyond 2021, public borrowings through sale of government bonds held under social security trust fund should temporarily help to continue payment of benefits. Pay-as-you-go benefits have to be cut or the tax rates have to be raised once the trust fund bonds gets exhausted in 2040. Keeping the trust fund always positive in the future without increasing the taxes, with the projected mixture of PRA annuities and the pay-as-you-go benefits for each group of retirees exceeding the pay-as-you-go benefits, that are projected in the current law is one of the main advantage of a mixed system. (Poterba, 2002)

To make this possible, the pay-as-you-go part of aggregate retirement benefits should be reduced from the extent projected in current law to the extent that can be funded but that are nevertheless high enough for combined benefits to exceed pay-as-you-go benefits projected in current law. There are many ways that a pay-as-you-go benefits can be reduced to equivalent to the extent projected in current law. Simple methods can reduce, pay-as-you-go benefits by 0.3% for each year an individual participates in a PRA system during the first five years of the program from 2003 to 2007 and 0.6% for each year in the next six years from 2008 to 2013 and 0.9% per year after 2014. (Poterba, 2002)

As far as taxes are concerned, there is no need for employees to worry much since most or all of the taxes related to their paycheck is withheld and directly paid to the IRS and state tax department by the employer. The employer does all the relevant calculations and the employee's obligation is just to file the annual tax returns with the IRS and state tax departments. But when an employees starts his own business, the tax life changes dramatically where there won't be any employer to calculate, withhold and pay taxes, instead the self-employed have to do on his own. This requires period tax calculation and filing with the IRS and state tax department which an employee may not be used to while he was an employee and not self-employed. (Fishman, 2006)

To file periodic tax calculation and filing with the IRS and state tax department, one has to maintain records of actual income and expenditure. Also the process of tax calculation and filing of tax returns gets complicated each year. When one becomes self-employed, the federal government is the one which has the biggest bite in taxes paid by a self-employed which includes income tax, self-employment tax, estimated tax and employment tax. Federal income tax and self-employment taxes are pay-as-you-go taxes. All those who earn more than a stipulated ceiling have to pay income tax. Unless a self-employed person is part of a group of self-employed people who have formed a corporation, one has to pay personal income tax on the profits the business earnings. But there is scope for deduction of various business related expenses which is allowed as per law to decrease ones taxable income in the case if self-employment. Self-employed people are entitled for social security and medical benefits when they retire just like any other non-self-employed employees. (Fishman, 2006)