Commentary | Retirement

Raising cap on social security tax best way to fix shortfall

Thank you Chairman Kohl, Ranking Member Martinez, and other members of the committee for inviting me to testify today.

The Social Security system has been the bedrock of retirement security for Americans for over half a century. Over the years, the system has evolved in response to changing conditions. As is well known, program outlays are expected to outpace revenue so that the system faces a shortfall over the next 75 years. Responsible stewardship of the program would necessitate making feasible adjustments to move us towards sustainability.

Long-run balance within the system can be achieved in one or a combination of three ways: by reducing total benefits, by increasing payroll tax revenue currently dedicated to Social Security, or by transferring general revenue to Social Security.

My testimony today will focus on the second of these options – that is, increasing payroll tax revenue. Specifically, I want to suggest that any policy to increase overall revenue through the payroll tax should include an increase in the cap on earnings subject to the tax.

As you know, Social Security taxes are levied on earnings up to a maximum level that is adjusted each year to keep pace with average wages. In 2009, this payroll tax cap is set at $106,800 dollars, and roughly 6 percent of the population has earnings above the cap.

Due to growing income inequality, the share of earnings above the cap has risen from 10 percent in 1982 to over 16 percent in 2006. This is because incomes have grown strongly at the top while middle incomes have stagnated.

This trend is expected to continue, meaning that a growing share of earnings will remain outside the tax base.

The cap also means that higher-income individuals pay a smaller share of their income in Social Security taxes than middle-class employees. Including the employee and employer shares of Social Security and Medicare taxes, earners in the middle fifth of the income distribution pay an average effective payroll tax of about 11 percent. In contrast, the top 1 percent of earners pay just 1.5 percent on average.
Let me turn now to different options for making adjustments to the cap.

According to the Social Security Administration, fully eliminating the cap on taxable earnings would be sufficient to fully close the projected shortfall. If newly-taxed earnings above the taxable maximum were credited toward benefits, eliminating the cap would close most, but not all, of the gap.

Short of that, raising and indexing the cap to capture 90 percent of earnings, as it did when the system was last in long-term balance, would reduce the shortfall by slightly less than half, assuming benefit adjustments.

A third option would be to split the difference: eliminate the cap on earnings for employer contributions, and raise the cap to cover 90 percent of earnings for employee contributions. With earnings up to the employee cap credited for benefit purposes, this change would reduce the long-term shortfall by about three-fourths.

There are several advantages to this last approach. It would eliminate most of the long-term shortfall, while maintaining a link between contributions and benefits. It would not lead to extremely large benefits for millionaires, which could be a concern if all earnings were credited for benefit calculations. Finally, self-employed taxpayers, who are responsible for both the employer and employee contributions, would not face as large an increase in payroll taxes as a full elimination of the cap.

Further, this option would have a modest impact on the standard of living of upper-income taxpayers. On the employee side, this would mean an increase in tax payments of, at most, 2.6 percent of income. If income growth for the top 5% of households continues as it has for the past twenty years, and assuming that all 6.2 percent of the employer tax were passed on to employees in the form of lower wages, this additional tax obligation would be recouped by these households in less than 4 years. Affected taxpayers would also recoup some of these higher taxes in the form of higher benefits.

Some will argue that an increase in the cap will create inefficiencies and cost jobs. Indeed, all else equal, I too would prefer to live in a world without taxes, but all else is not equal. If revenue is not generated by lifting the cap, it must be raised from other sources, or benefits must be cut.

While no one likes to raise taxes, raising the cap on taxable earnings would, in my opinion, be a better option than raising tax rates across the board; thus, any policy to increase overall revenue through the payroll tax should have a higher cap as part of the equation.

In particular, raising the cap to cover 90 percent of all earnings and eliminating the cap on the employer side of the tax would close about 3/4 of the projected 75-year shortfall. This higher cap would affect just 6% of employees. In contrast, an across the board hike would affect everyone, with a disproportional impact on low- and moderate-income workers. For most of those who would face a higher tax obligation, the impact would be minimal relative to their incomes, and would likely be more than offset by wage growth in just a few years.

Thank you for the opportunity to speak with you today. I look forward to answering any questions you may have.

Irons’ full written testimony can be read here

EPI’s Alexander Hertel-Fernandez’ testimony on young adults’ stake in a stronger social security system can be read here.

See related work on Retirement | Social Security