Raising the Cap on Payroll Taxes Doesn't Solve the Social Security ProblemJeff Lemieux
November 17, 2003
Social Security's actuaries have released a new memo estimating the impact of raising the cap on annual earnings subject to the payroll tax ($87,000 in 2003). Raising the tax cap would simply defer Social Security's cash-flow problem by a few years -- it isn't a permanent solution. Social Security reformers could consider raising the cap as a financing device, but not as a long-term solution in itself.
Outline:
Measuring Social Security's Budgetary Problem
Raising the Tax Cap
Cash-Flow and Trust Fund Accounting
There are many reasons to pursue Social Security reform: creating opportunities for low-wage workers to build financial wealth, improving benefits for low-income workers and widows, making benefits fairer for working spouses, and so on.
But the main reason for reform is budgetary. Is there a way to reform Social Security so that its benefits remain adequate while preventing burdensome tax increases on future workers as the large baby boom generation retires?
Measuring Social Security's Budgetary Problem: Figure 1 (below) shows one method of illustrating Social Security's budgetary problem. Social Security's dedicated tax revenues, which include payroll taxes and transfers linked to the income taxation of Social Security benefits, are projected to be roughly flat over time. Yet Social Security benefit costs will grow by over 2 percent of GDP over the next 30 years as the huge baby boom generation retires and joins the rolls.
Figure 1.
The gap between dedicated revenues and costs is shown in Figure 2. When dedicated revenues are greater than benefit costs, the gap is positive and the program can be said to be in surplus. When revenues fall below costs, the gap is negative and the program is in deficit. Under current law, Social Security is projected to run cash surpluses until 2018.
Figure 2.
Raising the Tax Cap: Currently, the maximum amount of annual payroll income subject to the Social Security tax is $87,000. Nationwide, that caps the amount of payrolls subject to the tax at roughly 85 percent of total wages earned.
To increase the program's revenues, some proposals would raise the cap to cover 90 percent of total wages; other proposals would eliminate the cap entirely.
There are two main policy issues with raising the cap: (1) Will the extra taxes count toward additional benefits for those paying them? (2) Will raising the cap too far (or eliminating it completely) cause high-wage workers to switch their compensation from taxable payroll to non-taxable benefits (such as private pension contributions) or dividends and capital gains?
There is one additional consideration. The tax cap has gradually declined from about 90 percent of payroll in the early 1980s because the indexing rate has not kept up with the growth of wages and salaries received by high-income workers. Therefore, allowing the tax cap to rise back toward 90 percent would have a certain political logic.
Here are 4 potential ways to raise the tax cap, ranging from the most politically acceptable to the most difficult politically.
1. Raise the tax cap to cover roughly 90 percent of total payroll (roughly $141,000 in 2003 dollars) and allow the extra taxes to accrue or count toward taxpayers' benefits.
2. Raise the tax cap to roughly 90 percent of total payroll ($141,000 in 2003 dollars), but do not allow the extra taxes to count toward taxpayers' benefits.
3. Eliminate the tax cap (so that all wages and salaries are taxed), but allow the extra taxes to count toward benefits.
4. Eliminate the tax cap, but do not allow the extra taxes to count toward benefits.
The first option, raising the tax max to roughly $141,000 and allowing the extra revenues to count toward benefits, does not greatly change Social Security's long-term budget outlook (see Figure 3).
However, this action would not be too difficult politically, because it could be said to restore payrolls subject to the tax to the 90 percent threshold, and because the tax increase would be accompanied by higher future benefits for those affected. While this policy would not reduce Social Security deficits by nearly enough to be considered a long-term solution, it could be an important financing component of a larger Social Security reform proposal.
Figure 3.
The second option, raising the tax cap to 90 percent, but not paying extra benefits, saves more money (see Figure 4). However, because it would not allow the extra taxes collected by raising the tax cap to $141,000 to count toward additional benefits, it would be more difficult to impose politically, except perhaps in the context of a larger Social Security reform. (In a larger reform package, workers with incomes above the current tax cap of $87,000 might benefit from other elements of the package, such as personal accounts. That could make the extra taxes they would face more palatable.)
Figure 4.
Eliminating the tax cap altogether would improve the long-term Social Security cash-flow deficit by a considerable amount, but it would not come close to reducing the future deficit to zero. The deficit under this policy would still be almost 2 percent of GDP by the end of the 75-year projection period (see Figure 5).
However, eliminating the cap would be politically difficult, even if taxpayers were allowed to accrue benefits from the additional tax payments. By placing a new tax of 12.4 percent (including both the employee and employer share) on all earnings above $87,000, it would create a strong incentive for affluent workers to shift income from earnings to forms of income that are taxed at lower rates, such as capital gains or dividends.
The Social Security actuaries' memo makes a small adjustment for this sort of income switching. However, over time the impact of such switching could be substantially larger than the actuaries assumed. If so, the revenues collected from removing the tax cap would be less than projected.
Figure 5.
Figure 6 shows the impact of eliminating the tax cap, and not allowing the extra tax payments to count toward additional benefits. This sort of tax increase would face especially steep political hurdles. Even then, the improvement in the Social Security surplus over the next 15 or 20 years, and the reduction in the deficit thereafter, would not come close the bringing Social Security cash revenues and costs into permanent balance.
Figure 6.
(It is important to note that while the calculations in Figures 3 through 6 are derived from the Social Security actuaries' memo, they should not be attributed to the Social Security Administration or its Office of the Actuary. Centrists.Org is responsible for these calculations and any errors they might contain.)
Cash-Flow and Trust Fund Accounting. The Social Security cash surplus or deficit gives a fairly realistic picture of the budgetary impact of the program. But it is not a perfect measure.
For example, Social Security is currently in cash-flow surplus. That could give the public the idea that current surpluses will counterbalance at least some of the future projected deficits. After all, Social Security has a trust fund, to store surpluses until they are needed, right?
Not really. The Social Security trust fund has proven to be a very unreliable storage location for the program's surpluses. This is because Congress and the public don't behave as if the trust fund's balances were truly out-of-reach or off-limits. Instead we make spending and tax decisions reckoning that the Social Security program is just another part of the government. This makes sense, because Social Security taxes and spending really are just parts of the government, and economists will always be most concerned about the overall or "unified" budget, not the various pieces or subcomponent systems.
There was a political effort in the late 1990s to convince the public to subtract out Social Security from its notion of what really comprised the overall budget. This was the notorious "lockbox" debate. But that effort didn't prove durable in public opinion. Social Security surpluses remained part of legislators' implicit and explicit calculations of overall budget surpluses, and were essentially disbursed via non-Social Security tax cuts and spending increases.
Therefore, the insolvency date of the Social Security trust fund is an especially unhelpful measure of the program's budgetary impact.
The bottom line is that Social Security costs will rise when the baby boom generation retires, and the nation will have to figure out how to pay the added bill. We could certainly raise taxes, including the tax cap as shown here.
However, we would need a much more reliable storage location for surplus funds if our goal was to pre-fund the program's future costs in some way.
This is why Social Security reform advocates are interested in personal accounts. If workers had accounts they truly owned, and federal funds were disbursed to those accounts, then those funds would not remain part of the federal budget, explicitly or implicitly.
Successful pre-funding of Social Security's inevitable cost increases via personal accounts would reduce future tax burdens faced by the next generation's workers and would limit or offset the impact of benefit cuts imposed on future retirees.
Links:
Social Security Administration Office of the Actuary Memo on Eliminating the Tax Cap (October 20, 2003)
Centrists.Org Issue Summary: Wealth Building (Basics)
Centrists.Org Issue Summary: Social Security
