April 19, 2005
By Norbert J. Michel, Ph.D., J. Scott Moody and Ralph A. Rector, Ph.D.
Groups such as the
American Association of Retired Persons (AARP) have proposed to
"fix" Social Security by raising the $90,000 cap on the amounts of
salaries and wages that are subject to the Social Security payroll
tax. Even if the 12.4 percent payroll tax rate remains untouched,
raising the payroll tax cap would affect 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
Workers now pay Social
Security payroll taxes on the first $90,000 of annual income. This
cap on the payroll tax is indexed to the growth of real wages in
the economy and changes every year. For example, the payroll
tax cap was $87,000 in 2003 and 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 (OASDI) programs.
and Indirect Effects
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 raising taxes on others would
not affect them. 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 on 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. However, 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 to expand
and grow in general.
on the Economy
The following are a few
examples of the impact that raising or eliminating the payroll tax
cap would have in 2005.
Small Businesses Would
These figures 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 report positive net business income to
the IRS on the Schedule C form.
These figures do not
include small-business owners who report a net loss on their
Schedule C forms, even though some earn more than $90,000 in wage
and salaries. This group numbers about 1 million, bringing the
total number of the affected small-business owners to about 4
The composite index
presented in this section can be used to gauge which states'
small-business owners will suffer the most economic hardship if the
Social Security wage cap is raised. The principle is
straightforward: The higher the index score, the more susceptible
that state's small-business owners are to any economic effects
caused by higher taxes.
owners will bear the brunt of raising the Social Security wage cap,
and the index attempts to identify where those business owners
live. Because Social Security taxes are not levied in a vacuum, the
index also reflects states' overall tax burden.
New York is the state most
vulnerable to this potential tax hike, for two reasons. First, it
is above the national average in terms of the number of business
owners earning salary and wage incomes greater than the Social
Security wage cap. Second, it has the second highest overall tax
burden-adding another tax hike on top of that tax burden would
only further erode New York's economic competitiveness. The next
four most vulnerable states are Connecticut, Montana, the District
of Columbia, and Wyoming.
Delaware, on the other
hand, is the least vulnerable to this potential tax hike
because it has a low overall tax burden and a below average
percentage of business owners earning salaries and wages greater
than the Social Security wage cap. The next four least vulnerable
states are Pennsylvania, Alaska, Alabama, and Nevada.
Raising the Social
Security wage cap would 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 the small-business sector
would have $242 billion less to hire and pay workers, to purchase
equipment, and to expand businesses.
However, raising or
eliminating the payroll tax cap would ultimately affect many more
people, such as small-business owners' families, employees,
and customers. Policymakers should keep this fact in mind when
proponents of raising or eliminating the payroll tax cap say
that it would just make the rich pay their "fair share" for Social
Security. In reality, it would affect far more Americans of
all economic classes.
Norbert J. Michel,
Ph.D., is a Policy Analyst, J. Scott Moody is a
Senior Policy Analyst, and Ralph A. Rector,
Ph.D., is a Research Fellow and Project Manager in the
Center for Data Analysis at The Heritage Foundation.
Methodology for Business Statistics
The estimates in this
paper were calculated using The Heritage Foundation's
microsimulation tax model. To estimate the year-to-year change in
federal payroll tax revenue, the model simulates the effect of
tax law changes on a representative sample of taxpayers. Data for
these taxpayers were extrapolated or "aged" to reflect
detailed taxpayer characteristics through 2014. The data were
aged so that they were consistent with the August 2004
Congressional Budget Office baseline forecast and extensions
of President George W. Bush's tax cuts. For purposes of
this analysis, the microsimulation produced conventional revenue
The starting point for the
estimates was small-business owners that file a Schedule C form
with the Internal Revenue Service and report net business
incomes greater than zero. Heritage Foundation 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. The 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 a Schedule
C, Schedule E, or Schedule F with a net positive
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
For the taxpayers that
file Schedule Cs and report net business incomes greater than zero,
the microsimulation model was used to project interest expense,
depreciation expense, and wage and salaries expense. For each
category, the analysts then calculated 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 Schedule 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 Global
Insight's U.S. Macroeconomic Model to forecast the
economic effects of the tax cut extensions. The growth rates were
applied as follows: The projected GNP growth rate was used for wage
expense and interest expense, and the projected corporate
investment growth rate was used for depreciation expense and net
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 Statistics
of Income (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. For S corporations' wages, analysts did not include
the item "other deductions," which includes salaries and wages that
are not listed separately.
Methodology for Vulnerability Index
The composite index ranks
states on a scale of one to five, with five representing the worst
projected tax situation in 2005. Each state's composite index
score is the mean of the two components: the wage cap component and
the tax burden component. The wage cap component reflects the
projected percentage of a state's small-business owners whose
salary and wage incomes are greater than the Social Security wage
cap. The second component uses the
Tax Foundation's estimated state-by-state total tax burden as a
percent of income.
Each of the components is
calculated beginning with the national mean. For each state, the
squared difference from the mean is calculated. The squared
differences are then summed and divided into five equal increments.
Each state is then assigned a ranking based on where it fits in
these increments. The mean of a state's two component indices is
the state's composite index score.
The wage cap component is
the number of business owners with salary and wage incomes
greater than $90,000 divided by the number of taxpayers within the
state. National estimates for both the business owners (individuals
who reported income on Schedule C, Schedule E, or Schedule F) and
total taxpayers were estimated with The Heritage Foundation's
for Schedule C and Schedule F filers are made using data from the
IRS master tax file as published in the spring editions of the
Statistics of Income Bulletin. Projections for the
state-by-state allocations to 2005 are based on a trendline
estimate using historical data from 1991-2002.
State-by-state allocations for Schedule E
filers are imputed using the national ratio of Schedule E filers to
Schedule C filers. Projections for the Schedule E filer ratio to
2005 is based on a trendline estimate using historical data from
The tax burden component
was created using 2005 estimates generated by the Tax Foundation
for its annual Tax Freedom Day report. The data reflect projections
of net national product and all taxes paid on the federal, state,
and local levels as defined by the National Income and Product
Accounts from the Bureau of Economic Analysis.
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
Foundation analysts project that eliminating the cap will raise
$484 billion (in nominal dollars) over five years. For the
methodology, see Appendix A.
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. However, it is not
uncommon for "regular" small businesses to incur a loss, and 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 earned a profit.
purposes of this comparison, the District of Columbia is treated as
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," Heritage
Foundation Center for Data Analysis Report No. 04-09,
September 20, 2004, at www.heritage.org/
Insurance Contributions Act.
estimates do not include any farms that do not file both a Schedule
E and a Schedule F.
Beach et al.,"The Candidates' Tax Plans."
2005, the wage cap is $90,000. Any income earned over this amount
is not subject to the 12.4 percent OASDI payroll tax. The tax rate
includes the employee and employer portion and also applies to
those individuals who are self-employed.
Curtis S. Dubay, Sumeet Sagoo, and Scott A. Hodge, "America
Celebrates Tax Freedom Day," Tax Foundation Special Report
No. 134, April 2005, at www.taxfoundation.org/sr134.pdf
(April 12, 2005).
Revenue Service, Statistics of Income Bulletin, various
years, Table 2 in "Selected Historical and Other Data"
Raising the Social Security wage cap would not fix SocialSecurity's finances, but it would directly increase taxes for 3million small-business owners by as much as $242 billion over thenext five years, leaving the small-business sector with $242billion less to hire and pay workers, to purchase equipment, and toexpand businesses.
Norbert J. Michel, Ph.D.
Research Fellow in Financial Regulations
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Ralph A. Rector, Ph.D.
Senior Research Fellow
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