Should We Exempt Retiree Income from Tax?

March 8, 2022

By David Brunori, research professor of public policy at The George Washington University and Senior Director at RSM US LLP

Politicians love older people. Some of that love stems from the fact that nearly everyone – even politicians – have had grandmothers, grandfathers, great aunts and uncles. But elected officials have another reason to care about these men and women, many of whom have retired from active work. Older people vote.

According to the U.S. Census Bureau, in the 2020 election, “Voter turnout was highest among those age ages 65 to 74 at 76.0% while the percentage was lowest among those ages 18 to 24 at 51.4%.

Recently, there has been a spate of state proposals to give substantial tax breaks to retirees. In at least seven states, governors have made serious budget proposals to eliminate some or all income taxation on retiree income. The proposals have come in blue, red, and purple states.

Giving tax breaks to older Americans is not a new phenomenon. States have been giving property tax breaks to them for a half century. Some twenty-one states exempt military pensions (though my home state of Virginia only exempts pensions given to Medal of Honor winners, a rather rarified group).  Twelve states do not subject social security income to tax. Fourteen states exempt defined pension income from tax. And three currently exempt all retirement income including that from 401(k) plans and IRAs.

These exclusions from income taxes don’t come without a cost. Many people receive retirement checks of one kind or another and exempting their income is an expensive proposition. Still, every year the list of states granting exemptions grows. Besides affection for people of advanced years and their votes, elected officials are also motivated by the fear that when people find themselves on fixed incomes, there’s a strong attraction to  move to Florida, beyond the weather. That state doesn’t have an income tax for anyone, regardless of age.

While it’s easy to understand the reasons why elected officials would want to give tax breaks to retirees, in my view they are very bad tax policy.

Indeed, in most states the exemption violates all of the principles of sound tax policy. One such principle is neutrality, which is to say that all people should be treated equally well, or badly, by the revenue departments. But the exemptions in place and those proposed explicitly pick winners (older people) and losers (everyone else) in society.

Moreover, for two centuries, public finance experts have lived by the adage that a sound tax system is built on a broad base and low rates. Exempting retirement income in a nation with a growing number of people over 65 steadily narrows the base and keeps rates higher on everyone else.

Blanket exemptions for all retirement income can also violate precepts of fairness. Similarly situated taxpayers are supposed to be taxed similarly. It’s hard to find a good economic reason for taxing $40,000 of a 30-year-old’s income but exempting $40,000 of a 70-year-old’s income.

One often hears politicians justify these exemptions by saying that they protect older Americans who are living in poverty.  And for the record, I do not want to see anyone’s grandmother (or for that matter anyone at all) living on the street.

But a blanket exemption means that wealthy older people escape tax. Is there really any reason to exempt Warren Buffett’s social security income from state income tax? I know retired high-ranking military officers who are very highly paid consultants. Should we exempt their military pensions?  Worse, there are thousands of retired partners of law and accounting firms and corporate executives whose retirement income alone place them in the top one-half percent of Americans.

If we must exempt retirement income, and it seems like we must, I suggest that we make it a means tested exemption. The income tax is particularly well suited to providing tax relief to the poor. To the extent that there’s a valid concern for retired people who are living from social security check to security check, then we should target the relief to people who genuinely need it.

I propose exempting retirement income based on the amount of nonretirement income a senior receives. There are many ways to design an exemption that helps the retired poor without breaking the bank.

Admittedly, that may not help elected officials get more votes when it comes to election day. But it is better tax policy.

The contents of this blog post reflect those of the author, and not necessarily those of the GFRC.