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WebMemo #639 on Social Security

January 13, 2005

The Unacceptable Costs of Raising Payroll Taxes to "Save" Social Security

By , and

President Bush proposes to solve the problem of Social Security's unfunded liabilities by enacting a reform plan that includes personal retirement accounts (PRAs). Proponents of PRAs argue that this sort of reform would increase national savings, bolster employment, and improve economic growth, all while closing Social Security's funding gap. Opponents, such as Representative Charles Rangel (D-NY), argue that "There is no crisis" in Social Security's funding that demands wholesale reform and that Social Security's shortfall is only a "challenge" that can be addressed by making small changes to the current program.

 

One such change that has been proposed would be to raise payroll taxes enough to render Social Security solvent. Opponents of real reform are right that raising payroll taxes could close a portion of Social Security's funding gap, but they are wrong in saying that doing so would require only a small change. Raising payroll taxes would make Social Security a worse deal for millions of working Americans, harm the economy, and cost thousands of jobs, and still would not fix Social Security.

 

Social Security faces an unfunded liability of $27 trillion in 2003 dollars over the next 75 years. This number represents the amount that the system, despite having promised the money to America's workers, will be unable to pay. Short of major reforms, raising taxes or cutting benefits are the only ways to close this funding gap.

 

Right now, workers pay a 6.2 percent tax on their wages up to $90,000 to fund Social Security. Employers pay an additional 6.2 percent tax. This division in the payroll tax is artificial, however, as employers regard their part of the payroll tax as an expense of hiring, just like wages and other benefits: In other words, it is money that the employer is willing to spend on his workers. Though workers see only a 6.2 percent deduction on their pay stubs for Social Security, they really pay the whole 12.4 percent tax in terms of foregone wages.

 

Social Security's Trustees estimate in their most recent annual report that increasing the payroll tax by 1.89 percentage points, to 14.29 percent in total, would be sufficient to make Social Security's Old Age, Survivors, and Disability programs solvent.[1] This is the sort of "small change" that opponents of reform paint as a reasonable solution to Social Security's developing crisis.

 

The average worker might disagree. If payroll taxes were increased by 1.89 percentage points, a worker earning $35,000 would forego an additional $662 in pay every year. Raising payroll taxes by 1.89 percentage points would cost this worker, on average:

 

  • As much as he spends on gasoline over three months;
  • As much as he spends in two and a half months on clothing;
  • As much as he spends in one month on food for consumption at home; or
  • As much as he spends in two months on food outside of the home.[2]

In other words, this "small change" in the payroll tax would have a major impact on most workers' household budgets.

 

Using the Global Insight U.S. Macroeconomic Model, economists at The Heritage Foundation's Center for Data Analysis simulated a 1.89 percentage point increase in the payroll tax.[3]

 

It should be no surprise that a tax increase of this magnitude would increase the cost of labor in the economy and thereby have an impact on jobs. The CDA study found that a 1.89 percentage point increase in the payroll tax would reduce potential employment by 277,000 jobs per year, on average, over the next 10 years relative to the baseline.

 

There are spillover effects on economic growth as well. Increasing the payroll tax would reduce U.S. gross domestic product (GDP), a broad measure of economic activity, by $34.6 billion per year, on average, over the next 10 years.

 

Overall, raising the payroll tax would have a major impact on U.S. households. On average, every American would have $302 less in disposable income per year for each of the next 10 years, amounting to over $1,200 per year for a family of four. Personal savings would also decline in the aggregate by $46.9 billion per year, on average, over the next 10 years. Ironically, this decline in savings would make worse the very problem that Social Security is intended to fix-workers retiring with insufficient savings.

 

But the problem is even more fundamental: Social Security's very structure is such that even all this sacrifice would not be enough to save it. Currently, the system is in a cash-flow surplus, which means that it takes in every year more money in taxes than it pays out. But these extra funds don't really accumulate. Instead, the government spends them and issues the Social Security Trust Fund special bonds, which are really just IOUs to pay back the money at a later date.

 

According to Social Security's Trustees, the system is set to have a negative cash flow beginning in 2018. To pay out promised benefits, it will have to cash in the government's IOUs, and the money to pay them will have to come from somewhere-either higher general revenue taxes (e.g., income taxes), lower government spending, or, ironically, more government debt. Because of the way the Trust Fund operates, raising payroll taxes would only delay the date when Social Security's cash flow goes negative. Future tax increases or benefit cuts would still be on the table.

 

Opponents of real Social Security reform are right, but also deeply misleading, when they say that the current system can be saved by making only small changes: The changes may indeed be small, but the numbers involved are enormous. Raising the payroll tax enough to fully fund Social Security would put a damper on savings, jobs, and economic growth to the great detriment of working Americans. And raising taxes enough to take Social Security's cash-flow problem off the table would require even more sacrifice.

 

Opponents of the President's plan to reform Social Security with personal retirement accounts should come clean when they say that the current system can be fixed: Their medicine may be just as bad as the disease itself.

 

Rea S. Hederman, Jr., is Manager of Operations and a Senior Policy Analyst in, and William W. Beach is John M. Olin Fellow in Economics and Director of, the Center for Data Analysis at The Heritage Foundation. Andrew Grossman is Senior Writer at The Heritage Foundation.



[1] The Trustees base this estimate on a 75-year time horizon.

[2] Data taken from U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditure Survey.

[3] These estimates are preliminary and subject to change. CDA used the Global Insight, Inc., U.S. Macroeconomic Model to conduct this analysis. The methodologies, assumptions, conclusions, and opinions in this report are entirely the work of Heritage Foundation analysts. They have not been endorsed by and do not necessarily reflect the views of the owners of the model.

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