March 17, 2005
By Norbert J. Michel, Ph.D. and J. Scott Moody
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
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
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.
Ph.D., is Policy Analyst, and J. Scott Moody is Senior
Policy Analyst, in the Center for Data Analysis at The Heritage
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
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.
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).
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
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
 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
 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.
Raising the payroll tax cap would impact millions of smallbusinesses, slow economic activity, and cost jobs.
Norbert J. Michel, Ph.D.
Research Fellow in Financial Regulations
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