March 17, 2005 | WebMemo on Social Security
Groups such as AARP propose to "fix" Social Security by raising the $90,000 cap on the amount of salaries and wages that are subject to Social Security's payroll tax. Even if the 12.4 percent payroll tax rate remains untouched, raising the payroll tax cap would impact millions of small business owners, slow economic activity, and cost jobs. That is a high price to pay for a proposal that would not even fix Social Security's finances.
Workers now pay Social Security payroll taxes on the first $90,000 of their annual income. That cap on this payroll tax is indexed to the growth of real wages in the economy and increases every year. For example, the payroll tax cap in 2003 was $87,000, and it rose to $87,900 in 2004 and $90,000 in 2005. Any income earned over this amount is not subject to the 12.4 percent payroll tax that funds Social Security's Old Age and Survivors and Disability Insurance programs (OASDI).
Proponents of raising the payroll tax cap point out that most workers would not face a tax increase. But that is not to say that they would unaffected by the economic impact of raising taxes on others. After all, when people pay higher taxes, they have less to spend on goods and services, which translates into fewer jobs and lower wages across the economy. These indirect effects are especially apparent when those paying higher taxes own businesses and employ workers.
Eliminating the Social Security wage cap would directly raise taxes for 3 million small business owners by as much as $242 billion over the next five years. It is easy to see this direct effect - more of small business owners' wages would be exposed to the payroll tax. But what is not so obvious is that their businesses would have $242 billion less to spend on wages, to invest in new buildings, to purchase new computers, and, generally, to expand and grow.
Here are a few examples of the impact that raising or eliminating the payroll tax cap would have in 2005:
The figures above are conservative in that they do not include all small business owners who would be directly affected by raising or eliminating the payroll tax cap. The figures include only small business owners who earn at least $90,000 in wages, salaries, and self-employment income and also report positive net business income to the IRS on the Schedule C form.
The figures above do not include small business owners who report a net loss on the Schedule C form, even though some earn more than $90,000 in wage and salaries. Altogether, this group numbers about 1 million small business owners, bringing the total number of small business owners who would be affected by raising or eliminating the payroll tax cap to about 4 million.
Raising the Social Security wage cap will directly increase taxes for 3 million small business owners by as much as $242 billion over the next five years, from 2005 to 2009. This means that there would be $242 billion less in the small business sector to hire and pay workers, purchase equipment, and expand businesses.
But all that is just the tip of the iceberg. Many more would ultimately be affected by raising or lifting the payroll tax cap, such as small business owners' families, their employees, and their customers. Policymakers should keep this fact in mind when proponents of raising or lifting the payroll tax cap say that it would just make the rich pay their "fair share" for Social Security. In reality, far more Americans, of all economic classes, would be impacted.
Norbert Michel, Ph.D., is Policy Analyst, and J. Scott Moody is Senior Policy Analyst, in the Center for Data Analysis at The Heritage Foundation.
The above estimates were calculated using The Heritage Foundation's micro-simulation tax model. To estimate the change in year-to-year federal payroll tax revenue, the model simulates the effect of tax law changes for a representative sample of taxpayers. Data for these taxpayers are extrapolated or "aged" to reflect detailed taxpayer characteristics through 2014. The data were aged so that they are consistent with the August 2004 CBO baseline forecast and extensions of President Bush's tax cuts. For purposes of this analysis, the micro-simulation produced conventional revenue estimates.
The starting point for the estimates are small business owners that file an IRS Schedule C form and report business net income greater than zero. Analysts calculated the percentages of these Schedule C filers' interest expense, depreciation expense, and wage and salaries expense accounted for by Schedule C filers that report salaries, wages, and self-employment income greater than $90,000. Analysts assumed that the percentages of Schedule C interest, depreciation, and employee costs accounted for by this group of tax filers were similar to the corresponding proportions for other small business entities. As a result, the overall category of "small business owners" includes all taxpayers that file either a Schedule C, E, or F with net positive income to the IRS.
Payroll tax revenue includes the employee and employer portions of the FICA tax on salaries and wages as well as the SECA tax on self-employment income (Schedule C).
For the taxpayers that file an IRS Schedule C and report business net income greater than zero, the microsimulation model was used to project interest expense, depreciation expense, and wage and salaries expense. Analysts then calculated, for each category, the percentage of the totals that were attributed to the "above the cap" tax returns. These ratios were used to estimate the corresponding percentages for small business owners that organize as S corporations and partnerships (and therefore file Schedule E or F).
Analysts applied the percentages calculated for "above the cap" Schedule C filers to projections of aggregate totals based on 2001 S corporation and 2001 partnership data. The economic assumptions used to derive revenue projections for 2005 S corporation and partnership aggregates were based on a macroeconomic analysis of President Bush's 2005 fiscal year budget proposals. Analysts used the Global Insight (GI) U.S. Macroeconomic Model to forecast the economic effects of the tax cut extensions. The growth rates are applied as follows: the projected GNP growth rate is used for wage expense and interest expense; the projected corporate investment growth rate is used for depreciation expense and net capital assets.
For all entities, "net capital assets" is defined as "depreciable assets" less "accumulated depreciation." To derive net capital assets for Schedule C filers, analysts applied the ratio of "net capital assets to depreciation expense" as reported in the 2001 SOI data for S corporations. For S corporations, wages are defined as "compensation of officers," which includes salaries, wages, stock bonuses, bonds, and other forms of compensation. Also, for S corporations' wages, analysts did not include the item "other deductions," which includes salaries and wages that are not listed separately.
 See Rea Hederman, Jr., and Tracy Foertsch, "AARP's Social Security Plan Would Raise Taxes for AARP Members Without Fixing Social Security," Heritage Foundation WebMemo No. 678, March 7, 2005, at http://www.heritage.org/Research/SocialSecurity/wm678.cfm.
 Heritage Foundation analysts project that eliminating the cap will raise some $483.5 billion (in nominal dollars) over five years. See the methodology section below.
 Critics may argue that including these "loss" firms overstates the number of true business owners and merely includes individuals who use "shell" businesses to offset their income. But it is not uncommon for "regular" small businesses to incur a loss. Also, some business owners may own more than one business and report a net loss for all of the companies on a combined Schedule C, even though one or more of the companies earns a profit.
 For specifics on the forecasted tax cut extensions, see William W. Beach, Ralph A. Rector, Rea S. Hederman, Alfredo B. Goyburu, and Tim Kane. "The Candidates' Tax Plans: Comparing the Economic and Fiscal Effects of the Bush and Kerry Tax Proposals by," Center for Data Analysis Report No. 04-09, September 20, 2004, at http://www.heritage.org/Research/Taxes/cda04-09.cfm .
 Our estimates do not include any farms that do not file both a Schedule E and F.
 See Beach et al. (2004).