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Why Raising Social Security’s Tax Cap Wouldn’t Eliminate Its Shortfall

Charles Blahous | 04/12/2011
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If one surveys left-of-center commentators about how to solve Social Security’s financing shortfall, one suggestion is heard more frequently than all others: increase the amount of worker wages subject to the Social Security payroll tax. The rationale is usually presented much like this:

  1. Social Security taxes are currently only applied to the first $106,800 (indexed) of wages. This cap is said to shield high-wage workers, and thus to be regressive and unfair.
  2. The current cap was set in 1983 to expose 90% of total national wages to the Social Security tax. Because of inequality in income growth since then (the rich growing richer), the amount of wages escaping such taxation has grown from 10% to about 15%. It is said that if we raise the tax, we will return to historical intent and also address the erosion of income equality since 1983.
  3. If we raise the cap on taxable wages, it is said, we would only affect a very small number of workers, the very richest Americans.
  4. If we raise the cap on taxable wages, it is said, we will make significant headway in reducing the Social Security shortfall.

All of the statements above are at the worst untrue, and at the very best so imprecise as to be misleading. The purpose of this piece is to clear up some of these points of common confusion, and to explain why raising the cap on Social Security taxable wages would actually leave most of the program’s financing shortfall in place.

One preliminary note: for concision and focus, this piece will steer almost entirely clear of the economic arguments against raising the cap on taxable wages. Exposing much more wage income to the payroll tax would likely have substantial adverse effects upon job creation, economic growth, and marginal returns on work. Those are all extremely important issues, but this piece is not about any of them. This piece is very narrowly about Social Security finances, and why raising the cap on taxable wages doesn’t come close to fixing them.

 

Point #1: The more wages that Social Security taxes, the more it owes in benefits. Social Security benefits are calculated as a function of wages subject to the payroll tax. The benefit formula is progressive – returns are higher for low-wage workers than for high-wage workers – but Social Security is not a pure welfare program: all taxable wages count towards benefits, even for high-income earners.

This means that raising the cap on taxable wages produces a Hobson’s choice for which proponents have yet to produce an answer. The first option would be to retain Social Security’s historical link between contributions and benefits. Under this option, raising the cap on taxable wages would be very inefficient; it would actually result in additional benefit outlays, paid to those who need them least. There would still be some small fiscal improvement for the system because high-wage earners earn a much lower return on their taxes (in contrast with the picture painted by references to a “regressive” payroll tax). But the fact remains that raising the tax max would increase system expenses on higher-income individuals – hardly an efficient policy choice in a safety-net program facing a multi-trillion-dollar deficit.

The other option, of course, is simply to sever the contribution-benefit connection for anyone affected by a wage cap increase. This, however, would be a radical change in Social Security. Once it is established that some Social Security taxes must be paid without any accompanying benefit credits, the program would lose its critical distinction from welfare. Perhaps at first only some would be required to subsidize Social Security in this way without benefits to themselves. Given the program’s continuing shortfalls, however, one shouldn’t expect that the number of such people would never increase.

Once Social Security’s contribution-benefit connection is abandoned, it is probably abandoned for good and never to be restored. That is certainly a policy choice we could make, but it would be intensely controversial. Proponents of raising the cap have yet to fully confront this issue.

 

Point #2: Even raising the cap by a lot would do very little to close financing shortfalls. To understand this, let’s first look at those shortfalls under current law.

As shown above, after the 1983 reforms – Social Security ran substantial cash surpluses for several years. Last year in 2010, it began to run a cash deficit. Those deficits will grow enormously over the next couple of decades even though technically Social Security would be “solvent” until 2037.

There is not space here to explain fully why this is happening. The short story is that in 1983, negotiators relied upon a superficial measure of aggregate long-range actuarial balance and did not realize until too late in the process that the legislation would result in large annual imbalances. Such a pattern can produce effective financing only if there is a mechanism in place to ensure that earlier surpluses are saved to enable the financing of later deficits. The 1983 negotiators – again, not realizing that this pattern would emerge – failed to establish such a mechanism, allowing program surpluses to be spent.

Since 1983, one bipartisan technical panel after another has come forward to urge that this mistake not be repeated. Such panels agreed that actuarial balance over long spans of time was a necessary but not sufficient standard for credible financing. And so for over a decade now, Social Security’s scorekeepers have routinely evaluated every reform proposal to determine not only whether it achieves a generic summarized actuarial balance over the long range, but also whether it ultimately eliminates shortfalls of annual tax income relative to annual expenditures. This is why the proposal of President Obama’s fiscal commission looks like this:

As the graph above shows, Simpson-Bowles would not only eliminate Social Security’s aggregate shortfall averaged crudely over all time, but it would return the program to a position in which its annual income is sufficient to finance its annual outgo.

Raising the cap on taxable wages, by contrast, would do little to establish practical financing. For example, consider the oft-floated proposal to raise the cap (to the equivalent of roughly $180,000) so that it covers 90% of all wages nationally. This would produce a flow of income and costs as in the graph below – reproduced exactly from the Social Security Chief Actuary’s web page:

As is evident by looking at the above picture, this proposal would leave almost the entirety of current-law annual shortfalls in place – roughly 86% of them in the out-years.

Even if the cap on taxable wages were entirely eliminated – that is, a new 12.4% payroll tax were applied on all wages from $106,800 to infinity – most of the annual shortfalls (62% of them over the long term) would still remain.

Finally, even if we took the most radical steps of all – both totally eliminating the cap and entirely severing the contribution-benefit link for all wages newly subject to tax – Social Security would still face substantial and rising shortfalls, as seen below.

What’s interesting about the current Social Security debate has been how proponents of raising the cap have largely ignored these fiscal realities. Many statements asserting the gains of raising the cap have just cited the one (insufficient) measure of actuarial balance while ignoring the equally (if not more) important metric of practicable annual cash flows that has been in wide use for several years. But if raising the cap ever truly received serious legislative consideration, it would no longer be possible to simply ignore this information.

 

Point #3: About one-fifth of workers would be affected by an increase in the cap. It’s often said that only the very richest Americans – roughly 6% – would be affected if the cap were raised. This sounds very attractive to those in favor of taxing the other guy, especially if he’s “rich.”

In the real world, however, wages fluctuate. If the cap on taxable wages were raised, it would affect everyone with at least some years of earnings above the cap. This is about 20% of workers.

It’s very important to avoid confusing annual wages with lifetime wages here. Social Security benefits are calculated based on lifetime average wages, a figure that further excludes any income above the cap. If instead we only discuss tax measures in terms of annual wages, it will always (wrongly) appear as though raising taxes affects few people, whereas benefit reductions would affect many.

For perspective, consider this: raising the cap on taxable wages from its current $106,800 would actually hit more workers than would a benefit change affecting workers with AIMEs (lifetime average indexed earnings) of $70,000 or above.

 

Point #4: Taxing 90% of national wages represents neither a historic average nor a policy intent of the 1983 reforms. It is true that the tax cap in 1983 was at a place where it captured roughly 90% of all national wages. But the 1983 reforms themselves did not change the level of the cap. (The cap had been raised in a series of ad hoc steps in the 1977 Social Security amendments. The 90% level it had reached by 1982 was actually a relatively high point historically. Prior to 1982, it hadn’t been 90% since the early 1940s. The cap has actually spent much more of its history below 80% than it has at or above 90%.)

 

Point #5: Raising the cap fails the equity test in that it would not actually hit those individuals who benefited from an increase in income inequality since 1983. “Restoring equity” by raising the cap on taxable wages reflects a fundamental analytical mistake: that future taxpayers are the same group of people that they were from 1983-2010. Raising the cap now would affect future taxpaying workers: in the 2010s, 2020s, 2030s and beyond. It would not principally affect those whose incomes grew fastest in the 1980s, 1990s and 2000s. Those former taxpayers are instead far more likely to be beneficiaries going forward. If one were serious about recovering the money from individuals who benefited the most from this increasing income inequality, one would have to focus on the benefit side of Social Security rather than on the tax side.

 

Point #6: Raising the cap fails the equity test, part 2: even if intergenerational effects were ignored, raising the cap would still hit the wrong people –it would hit those who have already paid more because of rising income inequality. To understand this, consider how increases in the cap affect different workers. Raising the cap doesn’t affect those who are always below it. Depending on how high it is raised, it would only marginally affect the richest of the rich. The people it hits the hardest are those with incomes just above the previous-law tax level.

As it turns out, those are exactly the groups that have been hit hardest by growth in the cap over the last few decades. As a fascinating recent Mark Warshawsky paper in Tax Notes shows, the proportion of income above the cap has grown disproportionately, but the number of taxpayers above the cap has not. This disconnect reflects disproportionate income growth by the extremely wealthy. Under current indexing methods, what happens in such a scenario is this: whenever there is rapid income growth on the very top end, the cap rises faster than it otherwise would have. Meanwhile, the fraction of total national income subject to the cap drops.

Who are the people hit hardest by this combination of events? People with incomes at or just above the cap on taxable wages – precisely those who would be hit hardest by a further cap increase.

 

Conclusion: It is certainly reasonable to propose raising the cap on taxable wages, especially if it is combined with corrective off-setting measures. The Simpson-Bowles commission, while including a cap increase in its reform plan, was careful to combine it with a substantial decrease in the benefit schedule for high-income earners so that it would not result in higher expenditures.

Serious discussion of raising the cap, however, needs to recognize the substantial policy problems associated with the idea, and most especially as a provision offered in isolation. It would adversely affect a substantial number of workers, and it would not at all address the equity issues usually invoked in its support. Raising the cap would also produce a nettlesome choice between severing Social Security’s time-honored contribution-benefit connection vs. obligating more benefits to those who need them least. Finally, and perhaps most importantly, even a large and economically painful cap increase would only modestly reduce Social Security’s future financial shortfalls.

Charles Blahous is a research fellow with the Hoover Institution and the author of Social Security: The Unfinished Work.


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