On Means Testing

The mysterious knzn makes a good point about means-testing entitlement programs for the elderly, such as Social Security and Medicare. He notes that from the standpoint of incentives, means-testing is equivalent to a tax increase. As a result, economists worried about the adverse incentive effects of taxes (like me) should be also worried about the adverse incentive effects of means-testing.

Knzn is exactly right about the equivalence. (I was once in a conversation about possible Medicare reforms, where a bunch of policy wonks were discussing the idea of making co-pays rise steeply as a function of income. I asked, "Aren't we in effect talking about an income tax surcharge levied only on old, sick people?") As a general matter, those of us who think the incentive effects of taxes are large should be careful before we endorse means-testing.

Beyond the general equivalence of taxation and means-testing, two further issues make means-testing of Social Security and Medicare even less attractive.

First, for seniors, a higher fraction of their income is capital income rather than labor income. If capital taxes are less efficient than labor taxes, as many economists believe, then means-testing would seem to be less efficient than an overall increase in income taxes. In other words, means-testing Social Security and Medicare would largely be a form of a capital taxation and, as such, could provide a huge disincentive for saving.

Second, seniors can easily hide capital. Medicaid covers nursing homes for poor seniors, and a significant problem is asset shedding--giving assets to children in order to claim eligibility. A whole industry of Medicaid lawyers helps seniors structure their finances to become eligible for government handouts. More extensive means-testing would encourage that industry to grow even larger.

Is there a solution to these problems that would make means-testing less distortionary? One possibility is to define "means" not as income or assets in old age but, instead, as average lifetime earnings. The Social Security Administration is already collecting the necessary data, so this solution is feasible. In this case, means-testing would be like a lifetime earnings tax, which is still distortionary but probably less so.

Under this plan, a person who earns a lot throughout his life and blows it, ending up penniless, would not be eligible for generous benefits. Some people might view this outcome as unfair. However, any option that is kinder to such a person will inevitably provide disincentives for people to prepare for their own retirement.