This is the third article in a six-month series on Social Security and Medicare reform. This installment includes the explanation of a multi-faceted historical problem and the myths and smokescreens that surround it, as well as the proposal of a viable policy solution. It's not a quick skim.

As the president's bipartisan fiscal commission studies solutions to the nation's Social Security funding problems, one of the issues it must consider is the "state and local FICA loophole." The odds are mounting that ten FICA-exempt states and numerous municipalities that now enjoy a free ride at other taxpayers' expense will be pulled into the system one way or another.

History. To understand the free rider issue, we need to go back to 1935 when Social Security was founded. Back then, several states raised potential constitutional challenges to the authority of the U.S. government to tax their payrolls. Lawsuits were filed in the private sector challenging the FICA (Federal Insurance Contributions Act) tax for Social Security. To avoid battles on two fronts, President Franklin Roosevelt and Congress backed away from requiring the states to participate. Later, in the 1950s, states were allowed into the increasingly popular Social Security system as an option. Forty states have since enrolled.

In 1990, after several Supreme Court decisions on intergovernmental tax and labor-market sovereignty that upheld federal authority on such matters, Congress closed the door on further exemptions. Public employers participating in the system were locked in for good. Those outside of Social Security were required to maintain equivalent retirement systems for their employees.

A peculiar privilege. Ten states (and numerous localities in all 50 states) continue to exempt themselves from the Social Security system. The outlier states are Alaska, California, Colorado, Illinois, Louisiana, Maine, Massachusetts, Nevada, Ohio and Texas. They and more than 6 million employees representing 30 percent of the state and local workforce are required to pay Medicare taxes, but they remain exempt from Social Security taxation. Conversely, 80 percent of the states and 70 percent of state/local employees now participate in Social Security just like all other Americans.

To put this into perspective, the sub-population of public employees that legally evades FICA taxes is equivalent in size to the entire adult American workforce residing in Michigan, the 8th most populous state in the U.S.

This idiosyncratic exemption enjoys no constitutional entitlement. It's just a statutory loophole that allows privileged employers and employees to both avoid paying 5.3 percent payroll taxes for Old Age and Survivors Insurance (OASI) and 0.9 percent in taxes for Disability Insurance (DI). To paraphrase Abe Lincoln, it's a "peculiar" privilege.

Double-dipping. Employees in these outlier states and localities can still collect Social Security benefits for work they do outside their government service. So firefighters can collect Social Security credits for their side jobs as construction workers, plumbers or electricians. Even without moonlighting, the notorious "early-in-early-out" retirees who pull down full pensions from these systems at the ages of 50 or 55 can readily collect 10 years of Social Security credits in a second career, and double-dip the two systems. Occupations with earlier retirement options are heavily weighted in the FICA-exempt sub-group, so the second-career double-dip scenario is quite common. Typically, their public pensions exceed those of workers paying into Social Security: Because the employer and the employees don't have to pay FICA taxes, they can pay more into the pension plan. Then the double-dippers can add duplicative Social Security benefits and play the two systems against each other. They get their cake and eat it too.

Income redistribution. If Social Security taxes were only used to provide benefits similar to public pension plans, this might not be such a problem. But Social Security does not simply pay a multiplier times earnings times years of service like a public pension, where benefits are roughly commensurate with contributions. There is a hard ceiling on the maximum full-retirement Social Security benefit — with the average benefit now $1,100 monthly for those earning $40,000 today. OASI benefits are heavily skewed toward low-income retirees. Nationwide, workers earning more than the average salary must subsidize lower-income retirees, in addition to pre-funding their own personal benefits.

The Social Security system therefore has a strong component of income redistribution in its formulas. This allows lower-income Americans to receive a modest subsidized social insurance pension benefit that greatly exceeds their actual contributions. Those who earn more than average thus receive progressively less than what they would if the system simply used a pension multiplier. Workers earning the taxable maximum (now $106,800) or more for a decade or longer get back a much smaller fraction of their payroll tax dollars than those at low pay levels.

The free-rider problem. This internal subsidy and income redistribution feature lies at the heart of Social Security's governmental free-rider problem. States and their employees that stayed out of the system have exempted themselves from paying into the income redistribution kitty that everybody else pays into — including public employees in the other 40 states and thousands of local governments who dutifully pay their FICA taxes.

According to the latest survey data from the National Association of State Retirement Administrators (NASRA), the average public employee contribution to pension systems outside of Social Security is higher than the contributions that comparable public employees pay into their public pension plans where Social Security taxes are collected. That's what we'd expect. The exempt employees' pension benefits should be commensurately higher, and they are.

But here's the free-rider problem: This peculiar subpopulation of public employees consistently pockets about half of what they don't have to pay in FICA taxes. Only half the FICA taxes they evade are actually used to buy better benefits. These exempt public employees and their employers have thus been contributing significantly less overall from their earnings than those in comparable public plans. On average, they each laudably contribute an extra 3 percent of pay toward pensions, over and above the level of their peers in Social Security, which superficially sounds good to the uninformed (see NASRA survey, figures M and N). But they simultaneously evade the taxes of 5.3 percent on those same earnings for OASI under FICA. On average, that's a 2.3 percent of payroll windfall that these employees and employers each retain under this loophole — or a combined 4.6 percent of the payrolls of more than 6 million workers. The revenue loss to the Social Security system from this 4.6 percent free ride is about $12 billion annually. If we include the (1.8 percent combined) disability insurance taxes that most of these employers and their employees also evade, the free-rider problem exceeds $15 billion annually and is growing as the population expands and salaries increase.

To put those numbers into perspective, their actuarial equivalent is 500 new Bell, Calif., lifetime pension scandals erupting nationwide every year — forever. In programmatic, service-delivery terms, it's equal to the annual combined budgets for both the federal Head Start program and the entire Transportation Security Administration. Or, going back to the earlier Michigan analogy, just imagine the governmental crisis and union consternation if every working resident there declined to pay their 4.3 percent state income taxes.

When we add these employees' licenses to double-dip, by racking up Social Security earnings credits though second jobs and second careers, we have a clear inequity. Of course, nobody set out to create this problem deliberately. And to avoid overgeneralizations, I suspect that a rare handful of the involved parties do contribute their full FICA savings to their pension plans. Most of the exempt employees are oblivious to the amount of subsidy they receive. Aside from the labor lobbyists who know what they are doing, there are no sinister villains to attack here. But this glaring oversight obviously requires a timely remedy.

Windfall adjustments fall short. Congress tried to solve part of the problem with a so-called "windfall elimination" adjustment to Social Security payouts that reduces those benefits for retirees who receive a pension from an exempt state or local government employer. But the windfall adjustment fails to fully offset the undue benefits received by double dippers and needs to be bolstered as one part of the reform effort. If you study the math, it's not windfall elimination — it's merely a windfall reduction.

More importantly, however, the windfall adjustment does nothing to address the free-rider problem of those public employees who earn more than the national average but do not pay their fair share into the income redistribution kitty. That's where real reforms are most needed.

This is no longer a states' rights or public-purpose debate. If America's federalist history had left us with a system in which all state and local government employers and employees stand exempt from Social Security, their lobbyists might be able to argue that this free-rider benefit is "part of the package" of public-service compensation. But that story doesn't wash when 40 states and thousands of political subdivisions are paying into the system just like everybody in the private sector. What we unfortunately have now is a large herd of sacred cows that graze on prime pastures for free, whose lobbyists shroud their subsidy behind the false guise of "retirement security." While other workers all pay into Social Security for the benefit of our poorest American elders, these 6 million "special" employees keep collecting fatter pension and payroll checks. There is something dead wrong with these neo-feudal privileges.

Solutions that respect states and localities. Congress has two options to fix the problem. The simplistic solution is to universalize Social Security and make everybody pay into the system. For new employees hired in the future by state and local governments, that would be a crude and incomplete fix. That said, nobody should be surprised to see this idea included in the federal fiscal commission's recommendations. The problems are: (1) what to do with the incumbents, and (2) whether a mandatory universal approach is overkill.

It will be foolhardy to force all incumbent pubic employees into the conventional FICA system in mid-career while their employers also are legally bound — sometimes constitutionally — to maintain current pension benefit formulas for those employees. Alaska, California, Illinois and Massachusetts public employers face double-jeopardy. Those states have unwittingly painted themselves into a corner with their incumbents. Employees might come out OK under a universal mandate, by receiving extra Social Security benefits to compensate for their new FICA contributions. But the employers would be forced to contribute to a federal retirement system on top of their oft-irrevocable pension obligations. So, exempt public employers will instinctively oppose full, universal coverage for incumbent employees given their constraints under state law.

Here's a better solution, one that finesses the double-jeopardy issue and preserves the legacy claims of these states and localities to remain exempt from Social Security. It's a compromise between the hard-liners and the freeloaders.

Let's not forget that public employers can always join the Social Security system any time in the future. (Maine and Louisiana have recently considered this option). But if they don't, then:

a. The new employees pay their Social Security taxes, which include 5.3 percent for old-age pensions (OASI) and 0.9 percent for disability (DI), into the system. The non-participating governmental employers do not pay anything more for these workers. In return for their FICA contributions, the new employees qualify for one-half of the Social Security benefits they would otherwise receive if their employer participated. Their 50 percent of FICA taxes thus buys them 50 percent of FICA benefits. That's fair to everybody and should be non-controversial.

b. Incumbent employees pay a Social Security equalization (income-redistribution) tax of 5.3 percent for that portion of their individual earnings above the national average individual payroll earnings level of $40,000. This represents the affected employees' fair share of the "Robin Hood" tax burden that the rest of America now pays to provide benefits to low-income senior citizens. As with everybody else, the maximum earnings subject to this FICA-equalization tax would be the same as the earnings limit on all Social Security taxes, presently $106,800.

For example, a six-figure school superintendent who's now exempt would pay $3,500 annually and a building code inspector making $50,000 would pay $500 that year. Workers in this group who earn less than the national average would pay nothing more. Even the highest-paid incumbents would contribute no more than 53 percent of what comparable individual taxpayers pay in FICA taxes.

These employees need not participate in the disability system because their employers already provide such a benefit. In fact, we'd invite mischief with disability retirements if states and localities were allowed to now shift that burden to the federal government mid-career for those aging incumbents. After all, they have collected the contributions up front in the early-career service periods when disabilities are less frequent.

The FICA taxes these incumbent employees and their employers can still escape on the first $40,000 of their earnings will buy full-career public retirees a pension benefit substantially equal to everything they would have acquired under the Social Security system. These incumbents at all income levels lose nothing relative to their peers under this design.

All such employees would remain subject to the windfall adjustment factor to account for double-dipping, but those who are taxed hereafter will increasingly present a much smaller problem in each passing year. Only the high-income double-dippers nearing retirement will still need a deeper haircut than the current system requires.

Flexibility to adjust the pensions. Non-participating state and local governments would be free to make such adjustments to their pension plans as they may see fit. The employers will pay nothing more into the Social Security system, so they can still maintain their generous pension benefits if they wish. If the new employees complain about making large pension contributions in addition to paying Social Security taxes, then they can bargain to reduce the duplicative pension benefits in order to reduce their pension withholding. In most states, that will pass constitutional muster because it's a legitimate quid pro quo.

A balanced, bipartisan solution. Like many of today's issues in public pension reform, this compromise merits bipartisan support. Conservatives and Tea-Partiers will conclude that these particular public employees unfairly get a far better deal than the taxpayers who support them. Progressives will agree that everybody in America should pay their fair share toward income redistribution for our low-income elderly. Incumbent employees earning less than the national average would pay nothing more, so this approach is highly progressive as a matter of tax policy. Centrists and moderates in both parties would rather close tax loopholes than reduce Social Security benefits.

Under this compromise, the ten states and kindred localities would still escape paying their rightful $4 billion annual share of the Robin Hood tax. I can live with that vestige as an historical wart in a federalist system that respects the states as partners. Imposing FICA taxes on those governments for their incumbent employees would simply increase the burdens on local taxpayers and make their employees' pensions look outrageously generous to local voters. Most of them will need the money now to pay for unfunded liabilities for incumbent employees. If Congress decides to ultimately eliminate all inequities, it could apply the equalization tax on these employers for their higher-income new hires beginning in 2013. That would slowly migrate them into paying their fair share of the Robin Hood taxes that all other employers now bear, with very little immediate budgetary impact. Employers would lose their loophole profits on new hires but keep them for the incumbents. The public-employer associations may conclude that this path is the most respectable and sustainable permanent remedy.

This approach purposely avoids sweeping, costly universal mandates on the states and their subdivisions. It gives affected public employers time to adjust their pension plans. Incumbent employees retain vested pension rights, and there's no impact whatever on lower-income public employees in that group.

I've also sidestepped the federal disability insurance (DI) taxes evaded by these exempt employers and their incumbent employees. They probably should be subject to an equalization tax for DI as well; but that smaller piece of the puzzle is more complex and not worth fussing over. Knowing this workforce as I do, those employers will need every dollar they have socked away for disability benefits. They are sitting ducks for the abusive petitioners within their aging police, fire and transportation workforces who incessantly wangle for income-tax-free lifetime disability retirement benefits. That small, omnipresent minority of finaglers is the costliest faction of the FICA free riders.

This FICA loophole is a glaring inequity in the current system — albeit unintended. Several smart people at the president's fiscal commission already know that. Their Social Security working group, led by former Federal Reserve vice-chair and federal budget guru Alice Rivlin, has been informed about this problem. There is no public-policy argument against plugging this loophole. Only the self-interest of peculiarly privileged free riders stands in the way of a fair solution. They can't have their cake — for free — and eat it, too.

Especially in the aftermath of last month's public pay scandal in California, the free-lunch mentality fuels outrage and pension envy in the electorate, which will destroy any popular support that public pension plans have earned in the past century. The legitimate credibility of states and localities in Congress and back home will erode as this anomaly draws increasing, rightful criticism. There are FICA-exempt employees working for schools or local governments in almost every state in the nation. Major newspapers and watchdog groups can find a story right in their back yard, if they do the homework. Free riders pocketing the biggest windfalls will look worst to the folks at home as salary charts like this pop up nationwide, with spotlights on those who also escape paying FICA taxes. The easy targets are exempt school superintendents, state administrators, county CAOs, city managers, urban finance directors, public health professionals, police and fire chiefs and nearly a half-million other six-figure public employees, including public-safety "overtime Olympians" who escape FICA taxes.

Those who lobby for this constituency must explain to the rest of America what makes their 30 percent subset of the state and local workforce so special that they alone deserve a $12- to $15-billion-dollar free ride every year. Their lobbyists must re-evaluate the intellectual honesty of their position as remedied here. Public sympathy over police, firefighter and teacher layoffs in these states will evaporate as the FICA free rider story gains traction.

I value public service highly, and have immense respect for the important work these employees perform. But the current arrangement is indefensible. Reform here is necessary and unavoidable if we are to genuinely preserve retirement security and not perpetuate a tax sham. If the professional associations can proffer a better way for this unduly privileged sub-population to make the Social Security trust funds and American taxpayers whole, I'll happily showcase it here in a future column.

View the author's previous columns on Fixing Social Security and Medicare and Value-Added Taxes to fund these programs and stabilize the states.

Girard Miller's opinions presented here are entirely his own and do not reflect the positions or policies of any organization with which he is, or previously was, affiliated.