Get Ready For "Unearned Entitlements" To Enter Your Lexicon

The coming debate over deficit reduction will not require advanced mathematics or powerful super-computers. It will evidently require something much more basic — a new lexicon. In particular, we will need to become familiar with a new term — “unearned entitlements.”

This new term is a composite of two terms most of us are already familiar with — “entitlement” and “unearned income.” Anyone who has filled out a tax return is familiar with the concept of earned income — the technical tax term for wages, salaries, and other income from personal services. It is typically contrasted with income from investments, like interest, dividends, royalties, rents, and capital gains. The 1969 Tax Reform Act was famous for creating a maximum tax rate of 50 per cent for earned income, even as investment income continued to be taxed at rates as high as 70 per cent.

My research indicates that the earliest use of the term “unearned income” came in 1971. Back then, it referred to the income a dependent child might receive on the child’s investments, which typically resulted from a parental gift in trust made to take advantage of the child’s lower tax rate. In that context the implication — that the income was not really attributable to the child’s own efforts — was understandable. Outside of that context, however, the tax code generally did not refer to investment income — such as the investment income of an adult — as being “unearned” in any sense. To the contrary, although it was not “earned income” there was no suggestion that it did not result from entirely legitimate and desirable investment activity of the taxpayer.

That appears to have changed with the enactment of Obamacare. Section 1411 of the Code — which imposes a Medicare tax for the first time on investment income — expressly uses the term “unearned income” to refer to this investment income. The implication appears to be intentional that this investment income is “unearned” in the sense of being a windfall, and perhaps as being illicit or ill-gotten gain. Perhaps that implication was necessary to get over the longstanding historical precedent that “entitlements” like social security and Medicare are properly funded only by taxes on the earned income (i.e., income from personal services) of those who will later receive the benefits of such programs. Whatever the cause, with the tax code now formally referring to investment income as “unearned” — implying if not stating that such amounts do not really belong to the taxpayer — perhaps it is time to begin referring to a comparable difference between what could be called “earned” and “unearned” entitlements.

What is the difference between an “earned” and “unearned” entitlement? And why is that difference important to the coming policy debates?

For most of us, social security retirement benefits are “earned entitlements.” Since 1983, the social security system has mostly been a forced savings program. Pretty much, in the aggregate, we receive what we put in, plus a slight return on our investment.

Why is that important? For one thing, it suggests that raising the retirement age would appear to be justified only if actuarially computed life expectancies, in the aggregate, began to dramatically increase, turning this “earned” entitlement into a partial windfall. That might be the case, for example, if science suddenly discovered (or was reasonably expected to discover) a miraculous cure for ageing that dramatically lengthened life expectancies. Barring that, to the extent an increase in the retirement age is imposed arbitrarily just to make the system more solvent, such an increase would arguably be more of a tax, and quite possibly an unfair tax. Because our social security entitlements were paid for with wages withheld from our earned income they are truly “earned” entitlements and reducing them constitutes a tax — a cost that is really being imposed to pay for some other government program.

Medicaid, in contrast, is obviously wholly unrelated to any work performed by the recipient, or any of the recipient’s earned income. While it may be an entitlement in a legal sense, it is entirely an “unearned” entitlement. That is not to cast aspersions on the fairness or propriety of the program. But we should not lose sight of the fact that it is a welfare program, not an insurance program like social security.

Medicare is a mixed bag. Medicare is funded — prior to Obamacare — mostly by taxes imposed on the beneficiaries during their working lives and insurance premiums after retirement. So far so good. But a careful analysis of the program reveals that the actuarial value of the insurance benefits actually provided by Medicare is far more than the aggregate premiums and taxes actually paid by the beneficiaries over their lifetimes. Thus Medicare — to a significant degree — is also an “unearned entitlement” or welfare program. That is, it requires contributions from taxpayers other than beneficiaries, to pay for the benefits promised to beneficiaries.

Only when we can agree and accept that a large portion of Medicare is a welfare program — because it is not fully paid for, in the aggregate, out of the taxes and premiums incurred by its beneficiaries — can we hope to address the deficit problems this and other health care programs create. That does not mean that Medicare (and Medicaid) should not be continued. But it does mean that the costs of these programs should not be treated as if the beneficiaries, in the aggregate, had actually paid anything close to the real cost of the benefits currently promised to them. To the contrary, unlike social security benefits, a significant portion of current Medicare benefits are truly “unearned” — in both the technical and colloquial meanings of that word.

Donald B. Susswein is a Washington lawyer who practices and writes in the areas of taxation, tax and fiscal policy, and financial institutions and products. He served as an advisor on these issues to the Committee on Finance of the United States Senate. He writes a weekly column for Benzinga every Tuesday.

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