Is a fix for Social Security even worth discussing if it would only delay the system's inevitable shortfalls by six or seven years? Groups such as AARP think so and have proposed raising the payroll tax cap to make the wealthy pay their "fair share" for Social Security. But this would only patch the system's finances for a few years, rather than solving the problem for good. And that's not the worst of it. Raising the tax cap would raise taxes for many middle class families, impose a tremendous burden on small business, slow the economy, and cost jobs. In short, raising the payroll tax cap would make Social Security an even greater burden than it is today.
Currently, workers pay Social Security payroll taxes on only the first $90,000 of their annual income. This "wage cap" is indexed to the growth of real wages in the economy and increases every year. The wage cap serves to limits the amount of Social Security benefits that a well-off retiree will receive. Even though Bill Gates and Donald Trump earn millions of dollars a year, for the purpose of calculating Social Security benefits, they earned just $90,000 in 2004.
Using the message that "Those who have benefited from the growth in the economy should be asked to pay a little more to help secure Social Security," groups such as AARP call for raising the amount of income subject to Social Security payroll taxes from $90,000 to somewhere between $125,000 and $200,000. AARP, which favors a $140,000 cap, claims that this simple move would "solve" 43 percent of Social Security's projected shortfalls.
Polls show that raising the wage cap has some popular support. A February 10, 2005, Washington Post poll showed that 81 percent of those questioned supported raising the income cap. Respondents might be more skeptical, however, if more people knew what AARP isn't telling them: raising the wage cap is no fix. It would postpone Social Security's problems for only a few years.
A recent report from the Social Security Administration (SSA) examined the effects of not just raising the wage cap, but of eliminating it completely. Under this radical approach, Bill Gates and Donald Trump would pay Social Security taxes on every dollar that they earn. They would also receive benefits on those earnings. The scoring memo also examined a still more radical proposal: that people would pay Social Security taxes on all of their income but receive benefits only on income below $87,900, the wage cap that was used in the SSA study. This would be a major shift from the current policy that Social Security benefits are based on a worker's taxable income. Still, neither of these policies would improve Social Security's cash flow very much, and both are much more ambitious than AARP's plan.
SSA's actuarial study showed that that eliminating the payroll tax cap entirely would only delay the start of Social Security's annual deficits by six years, from 2018 to 2024. Eliminating the wage cap on payroll taxes while paying benefits on only the first $87,900 of earnings would delay the start of annual deficits by an additional year, to 2025.
As well, these policies would delay the onset of massive deficits by only a few years. As Social Security now stands, annual deficits will first reach $100 billion a year (in 2003 dollars) in 2022, according to the 2003 Social Security trustees report. Eliminating the wage cap delays $100-billion deficits until 2029, or only seven years. On the other hand, subjecting all earnings to payroll taxes but only paying benefits on income up to the current wage cap delays the start of those $100-billion deficits until 2031.
If completely eliminating the wage cap only delays deficits by six or seven years, how could just raising it to $140,000 solve a significant part of Social Security's financial problems?
Another problem with raising the wage cap is that for every taxpayer with an income of over $500,000 affected by raising the tax cap to $125,000, 27 taxpayers with lower incomes would pay higher taxes, too. In 2001, the majority of taxpayers earning more than $90,000 had incomes between $90,000 and $150,000. Only a very small number of the 130 million tax returns filed in 2001 (0.3 percent of taxpayers) showed income between $500,000 and $1 million, and an even smaller number (0.1 percent) showed incomes of over $1 million.
Raising the cap to $125,000 would directly increase taxes for 7 million middle-class families. Going to the $140,000 advocated by the AARP would cost many of these families even more. At up to an additional $2,650 in taxes per year, this change might not mean much to millionaires, but the families who would bear the brunt of this tax increase would surely suffer.
Perhaps the most significant impact of raising the wage tax cap would be on small-business owners and the self-employed. Small firms and individual entrepreneurs are the driving force of rapid innovation and economic growth in the United States. Small-business owners would have to pay higher taxes on behalf of all their workers were the wage tax increased, and they might have to spend more on salaries, too, to make up the drop in workers' take-home pay. The self-employed would face a direct tax hike twice as great as other workers because they pay both side of the payroll tax.
No surprise, a higher tax cap would sap economic growth and destroy job opportunities. A 2001 report from the Center for Data Analysis modeled the economic impact of eliminating the cap on wages subject to the payroll tax. The results of this small change-actually the largest tax increase ever-would be severe:
- Reduce the take-home pay of 10.4 million workers by thousands of dollars, decrease family savings by thousands of dollars, and reduce investment by hundreds of billions of dollars;
- Decrease the rate of economic growth significantly, shaving hundreds of billions of dollars from the U.S. GDP; and
- Reduce the number of job opportunities and increase unemployment.
In other words, lifting the wage cap would be quite expensive in terms of its effect on the economy and on millions of individual workers and families.
Raising the wage cap has been greatly oversold. It would directly increase taxes for millions of middle-class families who can ill afford to give up even more of their paychecks. It would increase benefits for the wealthy, who scarcely need the extra money. And it would harm the economy, slowing growth and job creation, as well as impacting millions of families' savings. Worst of all, for all these terrible effects, raising the wage cap would push Social Security's massive shortfalls only a few years into the future. Social Security is already a bad deal for most Americans and a burden for younger generations. Raising the wage cap would make it worse.
David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.