The Social Security system continues to face an
immense financial crisis. In 16 years, it
will begin taking in less money than it needs to pay the benefits
it has promised to participants. In order to
maintain the benefit payments from the Old-Age and Survivors
Insurance (OASI) program, in 2017, Congress will either have to
raise taxes or begin to borrow substantial sums from the public.
Without reform, the Social Security retirement program will run an
annual deficit of $594 billion (in 2001 inflation-adjusted dollars)
by 2075.
In
light of these projections, some policymakers have begun to call
for an increase in Social Security taxes--which means raising
either the OASI payroll tax rate or the maximum amount of wages
subject to the tax, or both. Some lawmakers also
have proposed increasing the taxable wage cap, while some policy
analysts are calling for its complete elimination.
To
answer the questions of whether it is possible to save the OASI
program by changing the maximum amount of wages subject to the OASI
payroll tax and what effect higher taxes would have on the economy,
Heritage analysts used Social Security Administration (SSA) data
and a leading econometric model of the U.S. economy. Specifically, they
examined the effect of changing the taxable wage cap in order to
raise the largest amount of revenue, and thus have the best
likelihood of restoring the system to full solvency. That change
involves eliminating the taxable wage cap and subjecting all labor
income to the OASI payroll tax.
Based on SSA's own projections, Heritage
analysts found, however, that eliminating the cap on wages subject
to the OASI payroll tax would generate only enough revenue to delay
the date of the system's insolvency by a few years. Moreover, by
2035, the OASI program would have enough revenue on hand to pay
only 87 cents on every promised dollar in benefits.
Yet
the cost of this change would be substantial. It would require the
largest tax increase in U.S. history, subjecting
millions of American families to a massive hike in their payroll
taxes and further reducing an already dismal rate of return. This change would
harm America's economic prospects by slowing economic growth and
reducing employment opportunities.
Specifically, eliminating the cap on
taxable wages would:
-
Result in the largest tax increase in the history
of the United States to raise $505 billion (in nominal dollars)
over five years and almost $1.2 trillion over 10 years.
-
Fail to save Social Security from ;
the system's insolvency date would be pushed back only seven years,
from 2017 to 2024. (See Chart 1.)
-
Increase the top effective federal marginal tax
rate on labor income to almost 52.5 percent, its highest level
since the 1970s.
-
Reduce the take-home pay of 10.4 million
workers by an average of $4,907 in the first year alone after
the cap is removed.
-
Weaken the economy by reducing the number of job
opportunities and savings ; in fiscal year (FY) 2011, the
decline in job opportunities would exceed 1.1 million, and the loss
in personal savings (adjusted for inflation) would amount to $39.5
billion.
THE CAP ON TAXABLE WAGES
The
OASI program is currently funded by a payroll tax of 10.6 percent
on labor income (wages, salaries, and self-employment income), with
a cap on earnings subject to the OASI tax. In 2001, the maximum
taxable amount (the cap) is $80,400. This amount is indexed to
change annually by the rate of growth in the average wage.
Social Security benefits are calculated on
the basis of a worker's earnings over his or her career. However,
only the worker's earnings under the maximum taxable amount (and
subject to the payroll tax) are used to compute those benefits.
A
cap on taxable earnings has existed since the inception of the
Social Security system in 1937. The maximum taxable amount reflects
the original purpose of the OASI program: to provide workers with a
"safety net" of retirement income. Social Security was created as a
pay-related retirement system, not as a welfare program that
redistributes money from workers to those in need regardless of
whether or not its recipients had paid into the system. The
benefits that retirees received were linked to the taxes they had
paid when they were in the workforce. Social Security was intended
to supplement rather than replace private sources of retirement
income by providing only a basic, government-guaranteed source of
income.
Maximum Level of Benefits and Maximum
Taxable Wages
Within this context, Congress determined
that it was appropriate to set an upper limit on the amount of
income Americans would receive from the Social Security program. A
limit on benefits, combined with the principle that workers'
benefits should relate to the amount of money they paid into the
system, made an upper limit on the taxes that workers would pay
appropriate.
In
1939, Congress set the maximum Social Security benefit at $494 per
year ($6,326 in 2001 dollars), with the cap on taxable labor income
set at $3,000 ($38,417 in 2001 dollars). In 2001, the
maximum benefit payable to a single participant retiring at age 65
totals $18,456, while the maximum taxable amount of labor income
subject to the payroll tax is $80,400.
Since 1945, the maximum OASI benefit as a
percent of maximum taxable earnings has ranged from 17.3 percent to
32.9 percent. (See Chart 2.) In
2001, the maximum OASI benefit was just 23 percent of maximum
taxable earnings, well below the post-World War II average of 25.3
percent.
If
the tax cap is removed, the percentage will fall to less than 10
percent. For example, raising the cap on taxable wages to the mean
income for families in the top 5 percent of the income distribution
($272,354 in 2000) without increasing the maximum benefit would
dramatically drop the maximum OASI benefit to just 6.8 percent of
maximum taxable earnings.
Since 1939, Congress has raised both the
maximum taxable amount and the Social Security payroll tax rate on
many occasions, exposing an ever-higher percentage of workers'
income to taxation. Contrary to the assertions made by a number of
commentators today, the proportion of covered earnings below the
maximum taxable amount is not now at an historic low. In fact, it
is above the average for the entire post-1945 period. (See Chart
3.)
Proportion of Wages
From
1945 to 1965, the proportion of wages subject to the Social
Security payroll tax declined from 87.9 percent to 71.3 percent.
From 1965 to 1983, this trend reversed as additional revenue was
needed to pay for the Great Society's expansion of benefits,
climbing to an all-time high of 90 percent. Since then, the
percentage of total payroll subject to Social Security taxes has
declined slowly to 83.8 percent. This proportion is projected to
fall slightly to just over 83.2 percent of total earnings by
2011--still above the post-World War II average of 82.9 percent.
The Tax Rate
Not
only is the total proportion of payroll subject to Social Security
taxes above historic levels, but the successive increases in the
payroll tax rate mean that the proportion of total labor income
consumed by OASI taxes is close to an all-time high. As Chart 4
shows, since 1945, the proportion of all covered wages (including
those that lie above the maximum taxable amount) consumed by OASI
taxes has increased to 9.1 percent. Removing the maximum cap on
taxable payroll would increase this tax burden to 10.6 percent of
all covered labor income. This would boost payroll taxes as a share
of all covered wages, salaries, and self-employment income to their
highest level ever.
THE BIGGEST TAX INCREASE IN U.S.
history
As
noted above, eliminating the Social Security taxable wage cap would
result in the largest tax increase in U.S. history--amounting to
$505 billion over five years ($461 billion in 2001
inflation-adjusted dollars). The increase would dwarf the size of
each of the last three tax increases (passed in 1993, 1990, and
1982), regardless of whether they were measured in nominal or
inflation-adjusted dollars. Even after the
enormous tax increase, Social Security would still have to borrow
an average of $203 billion per year (adjusted for inflation) from
2035 to 2075 in order to maintain benefits.
Removing the cap on taxable wages also
would result in a massive 10.6 percentage point hike in the top
marginal tax rate for millions of workers--bringing the top rate to
almost 52.5 percent, the highest rate since the 1970s. Should Social
Security's tax cap be removed, many workers would immediately find
that federal taxes consume over 52 cents of every additional dollar
they earn from employment.
An
increase in the marginal tax rate on labor income would damage the
economy by reducing the incentive to work. The fact that the Social
Security tax increase would fall on wage, salary, and
self-employment income would lead many workers (especially the
self-employed and small-business owners) to find ways to avoid this
tax, perhaps by taking employment income in the form of non-taxable
"profits" or fringe benefits.
WHO WOULD PAY ADDITIONAL OASI taxes?
Heritage analysts, using data from the
U.S. Bureau of the Census, estimate that eliminating the Social
Security taxable wage cap would subject 10.4 million workers to a
$1.2 trillion tax increase from FY 2002 to FY 2011. Almost 5.7 million
of these workers are heads of families, and 2.8 million are
spouses. Another 1.5 million single workers also would see their
paychecks decline. On average, these 10.4 million workers would see
their taxes increase by $4,907 in the first year after the tax cap
is removed.
Of
the 10.4 million workers who would be directly affected by tax
increases,
-
8.5 million (82 percent) are men ; two-thirds,
or 5.7 million, of these men are aged 35 to 54; another 1.7 million
are over the age of 54 and nearing or eligible for retirement.
-
On average, these 10.4 million workers work 49
hours per week year-round.
-
8.2 million (79 percent) are married.
-
4.5 million (43 percent) are married with
children.
-
7.3 million (67 percent) have college degrees
; 1.2 million (11.4 percent) are high school graduates or less.
-
Over 50 percent (5.5 million workers) live in
eight states: California (1.5 million), New York (859,000),
Texas (754,000), Illinois (519,000), New Jersey (503,000), Florida
(495,000), Pennsylvania (430,000), and Michigan (429,000).
-
Most (6.1 million, or 58 percent) live in the
suburbs. Another 2.3 million, or 22 percent, live in central
cities.
-
Over two-thirds (7.2 million) are private-sector
wage-and-salary workers; 2.1 million (20.5 percent) are
self-employed.
-
Nearly 10 percent (816,000) are union
members.
-
Nearly 5 percent (485,000) are not U.S.
citizens.
-
Over two-thirds (7.1 million) are in executive,
managerial, and professional specialty occupations , but not
all are doctors, lawyers, or CEOs.
-
Over 1.2 million of the affected workers are
teachers, nurses, truck drivers, computer analysts, construction
workers, farmers, police officers and firemen, mechanics,
repairers, and retail sales workers.
-
Two-thirds (6.6 million) work in six major
industries: manufacturing (1.9 million); finance, insurance,
and real estate (1.2 million); other professional services (1.1
million); business and repair services (940,000); medical services
(660,000); and retail trade (728,000).
These Americans work long and hard to
provide for their families and save for their retirement years. The
record size of the tax increase and its focused impact may induce
many of the 583,000 workers aged 62 and above to retire early
rather than pay additional taxes. Others may decide to shift some
of their compensation from wages and salaries to benefits that are
not subject to payroll taxes. Still others may reduce spending
and/or saving as their disposable income declines. The most likely
impact of an increase in payroll taxes would be some combination of
these three responses.
HOW REMOVING THE CAP WOULD AFFECT RETIREMENT
SAVINGS
Data
from the U.S. Department of Labor show that families earning more
than $90,000 a year (many of the same families who would be
affected by the tax increase) use a disproportionate share of their
income to pay Social Security taxes and invest in pension funds. This spending is
made with discretionary income that is left over after purchasing
such necessities as food and clothing. Eliminating the Social Security tax cap on labor income would reduce the discretionary
income that these families have for such activities and likely lead
to a decrease in private retirement savings.
This
effect also would be amplified by an expectation of higher Social
Security benefits in the future, making these families even less
inclined to set aside funds for their own retirement. In 1998-1999,
these families devoted almost $1 of every $7 in their budgets to
Social Security and private pensions. Significantly
increasing federally mandated taxes for retirement would
substantially decrease take-home pay and likely reduce the amount
saved for retirement rather than the amount spent on food and
shelter.
Increasing the OASI taxable wage cap is
also likely to alter the support Social Security receives from
high-wage workers. These high earners are currently projected to
receive very low or even negative rates of return on the OASI
payroll taxes they pay in the future. Any tax increase
that focuses on these workers would cause their rate of return to
fall so low that their perception of Social Security would likely
change from that of a retirement system to just another welfare
program that consumes 10.6 percent of their labor income with no
benefit to themselves. Such a change in perception of Social
Security is likely to reduce public support for the program.
HOW REMOVING THE CAP WOULD AFFECT THE
economy
Removing the Social Security taxable wage
cap would reduce job creation and economic growth while
substantially increasing payroll taxes for American workers. A
slowdown in the growth of compensation and a significant decrease
in the savings rate would further squeeze family budgets.
To
analyze the economic effects that removing the taxable wage cap
would have on jobs and economic growth, Heritage economists
employed the WEFA U.S. Macroeconomic Model to conduct a
dynamic simulation of the proposal. They reconstructed WEFA's July
2001 long-term model to embody (1) the economic and budgetary
assumptions published by the Congressional Budget Office (CBO) in
August 2001, (2) the recent increases in federal spending, and (3)
the latest Blue Chip forecast for economic growth following the
September 11 terrorist attacks. This specifically
adapted model uses CBO budget assumptions to produce dynamic
simulations of proposed policy changes. (For a description of how
removing the taxable wage cap was incorporated into this version of
the WEFA U.S. Macroeconomic Model, see Appendix A.)
The
Heritage dynamic analysis shows that removing the taxable wage cap
would:
-
Decrease economic growth . Higher OASI payroll
taxes would decrease the rate of economic growth by 0.3 percentage
point in FY 2002 and 0.5 percentage point in FY 2003. (See Appendix
B.) By the end of FY 2011, gross domestic product (GDP), adjusted
for inflation, would be $136 billion lower than the baseline
forecast without the tax policy change.
-
Reduce the number of job opportunities . Over
1.1 million fewer Americans would be working at the end of FY 2011,
compared with the baseline forecast. Moreover, the unemployment
rate would average 5.6 percent instead of 5.2 percent from FY 2002
to FY 2011.
-
Decrease family income . By the end of FY
2011, real disposable personal income (income after taxes, adjusted
for inflation) for a family of four would fall by $2,736. In
response to this decrease in family budgets, consumer spending
would drop by $160 billion, or $2,100 for each family of four.
-
Decrease family savings . By the end of FY
2011, a family of four would be able to save $520 less (adjusted
for inflation) than the baseline forecast. The already low savings
rate would decline by an average of 0.7 percentage point from FY
2002 to FY 2011, from 0.8 percent to just 0.1 percent.
-
Reduce investment . Investment (adjusted for
inflation) would decrease by an average of $36 billion per year
from FY 2002 to FY 2011. By the end of FY 2011, the net capital
stock would be $180 billion lower.
Eliminating the Social Security tax cap
would increase the unified budget surplus over the FY 2002 to FY
2011 period from $3.239 trillion to $3.789 trillion, but the
off-budget and on-budget surpluses move in opposite directions. The
tax increase raises the off-budget (Social Security) surplus by
$672 billion from FY 2002 to FY 2011, while the on-budget surplus
declines by $122 billion because of slower economic growth and
personal income tax revenue.
CONCLUSION
Since the inception of the Social Security
program in 1937, Social Security taxes have been raised at least 24
times, an average of once every two years. Yet the system
continues to slide toward bankruptcy. Although the Tax Equity and
Fiscal Responsibility Act of 1982 was supposed to restore the
Social Security system to permanent solvency, a mere 17 years
later, the system is once again confronted with the specter of
bankruptcy.
Eliminating the cap on the maximum taxable
amount of labor income subject to Social Security taxes would
represent the largest tax increase in the history of the United
States. It would raise taxes on millions of hard-working Americans
and their families, reduce savings, slow economic growth, and
eliminate employment opportunities. It likely would also have the
unintended consequence of undermining one of the most vital
activities that American families undertake: privately saving for
retirement.
Despite the massive hike in the tax
burden, eliminating the cap on taxable earnings would not save the
Social Security system; it would only extend its solvency by a mere
seven years from 2017 to 2024. Even after implementing this tax
increase, the OASI program in 2035 would have enough revenue on
hand to pay only 87 cents on every promised dollar in benefits.
Either payroll tax rates would have to be raised, money would have
to be borrowed from the public, or promised benefits would have to
be cut.
In
short, eliminating the Social Security maximum taxable wage cap
will do little good and too much economic harm.
D. Mark Wilson is a former Research
Fellow in the Thomas A. Roe Institute for Economic Policy Studies
at The Heritage Foundation.
Appendix A:
Methodology
Heritage Foundation economists follow a
two-step procedure in analyzing the economic and budgetary effects
of proposed policy changes.
First , using published forecasts of total
earnings and taxable earnings from the Social Security
Administration (SSA), preliminary static payroll tax revenue
estimates stemming from eliminating the Social Security payroll tax
cap were estimated. These static estimates are based on a
Methodology that does not account for the macroeconomic effects
that would result from an increase in tax rates. These effects
include changes in gross domestic product (GDP), interest rates,
employment, personal income, and inflation that can significantly
affect tax revenues. Therefore, the static estimates provide a very
limited analysis of the economic and budgetary impact of any policy
change. To forecast the change in federal tax revenue, spending,
and the economy more accurately, a dynamic model must be used.
Second , the static revenue changes were
introduced into the WEFA U.S. Macroeconomic Model. The WEFA model
is a dynamic model of the U.S. economy designed to estimate how the
general economy is reshaped by policy reforms, such as tax law and
spending changes. Heritage economists developed a revised WEFA
model for Heritage work that embodies the economic and budgetary
assumptions published by the Congressional Budget Office (CBO) in
August 2001, the recent increases in federal spending, and the
latest Blue Chip forecast for economic growth following the
September 11 terrorist attacks. This specifically
adapted WEFA model produces dynamic responses from the CBO baseline
as a result of the proposed policy changes.
THE SIMULATION
The
WEFA model contains a number of variables that are used to simulate
proposed policy changes. The following sections describe how the
CDA static estimates were introduced into the WEFA model to
estimate the dynamic economic and budget results.
Payroll Taxes.
The WEFA model contains a variable that measures the total amount
of OASDI (Old-Age, Survivors, and Disability Insurance) payroll
taxes as a percentage of wage and salary income. Heritage
economists increased this effective tax rate for each of the
forecast years to reflect the increase in static payroll tax
revenue estimates.
labor Force Participation.
Small adjustments were made in the model's exogenous labor force
participation rate to account for the dynamic effects of increasing
payroll tax rates on the supply of labor.
Monetary Policy.
The model assumes that the Federal Reserve Board will react to this
policy change as it has historically. This assumption was embodied
in the Heritage model simulation by including the stochastic
equation in the WEFA model for monetary reserves.
Appendix B
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