Wednesday, May 7, 2008

(Bad) Idea of the Day: Eliminate the Employer Social Security Payroll Tax Cap

The Center for American Progress puts forward a new idea for Social Security financing:

We propose eliminating the payroll tax cap on the employer side to make businesses pay Social Security taxes on all of the income of the highest paid employers, just like they do for those earning less than $97,500. This is the fairest way to help shore up the finances of Social Security. This change would impact the taxes that businesses pay for only the top 6.5 percent of earners (couples and individuals), yet would yield significant additional revenue to reduce the deficit and bring the Social Security system closer to solvency.

According to the Social Security and Medicare Board of Trustees, the long range, 75-year actuarial deficit is equal to 1.95 percent of taxable payroll. Eliminating the cap on both the employer and employee side would be more than enough to bring the system into long-range balance. Removing the cap on the employer side would thus go a long ways toward restoring solvency as well as help ensure greater progressivity and fairness in the payroll tax.

This idea seemingly has political merit, since it would ostensibly hit businesses (who don’t vote) rather than individuals (who do). But it’s worth thinking how this would play out in practice. To understand that, consider two things:

First, in a competitive economy an employee is compensated according to his contributions to the business (technically, the marginal product of his labor). If he is paid more than he contributes, the firm goes out of business; if he is paid less, he will be lured away by a competing firm. Second, the firm cares about the employee’s total compensation, not about how compensation is divided into salary, health benefits, pension contributions or payroll tax contributions on the employee’s behalf. The employee may care, but the employer focuses on the total amount.

Given these facts, what happens if the employer share of the payroll tax is increased? The employer simply reduces other parts of the employee’s compensation to make up for it. Let’s say a given employee receives $200,000 in salary, $20,000 in health and pension contributions, and $6,200 in Social Security payroll tax contributions, for a total of $226,200. If the $100,000 cap on payroll taxes is eliminated, the employer’s contribution will rise from $6,200 to $12,400. Our best guess is that the worker’s salary and benefits will be reduced by the amount of the tax increase, in order to maintain total compensation at $226,200. Why? Because that’s how much the employee is worth to the firm. Is this always true? Of course not, but it’s the best approximation of what would take place in practice.

For this reason, it’s the standard practice of government agencies such as CBO and SSA to attribute the employer share of the payroll tax to employees. So increasing the employer share has no merit different from increasing the employee share, and potentially less because of the lack of transparency involved.

However, raising the tax cap on employers would have one effect distinct from increasing the employee tax cap: it would tend to reduce non-Social Security tax revenues. Employees pay both state and federal income taxes on the wages that are taxed for Social Security purposes. However, if their wages are reduced by their employers to cover the employers’ increase payroll tax obligations, those wages would no longer be subject to state/federal income taxes. If the marginal tax rate for high earners is in the range of 35-40%, the total revenue raised by this plan could be substantially lower than the static projection based on Social Security taxes alone.

Overall, if the folks at the CAP want to increase the tax cap, they should probably focus on employees or both employees and employers; focusing on employers only isn't particularly good policy.

As an aside, there is one instance in which the cap on employer taxes has already been lifted: for individuals with multiple jobs. Individual wages subject to Social Security taxes are capped at $102,000; if an individual has multiple jobs, each earning under the cap, he may end up paying Social Security taxes on more than $102,000 in earnings. At the end of the year, however, he can claim these excess taxes back on his tax return. His employers, however, cannot do so.

3 comments:

Arne said...

While I actually agree with the conclusion I am not sure about the reasons.

I believe most people making over $200K do have significant control over their own salary.

But the real issue is that when you accept that SS is retirement insurance, you should also accept that at a certain level of income an earner does not really need an increasing level of insurance.

Brooks said...

Andrew,

Great post. Very well said, particularly:

"in a competitive economy an employee is compensated according to his contributions to the business (technically, the marginal product of his labor)...[W]hat happens if the employer share of the payroll tax is increased? The employer simply reduces other parts of the employee’s compensation to make up for it."

Perfectly logical and (one would think) intuitive.

And great additional point re: reducing non-Social Security tax revenues.

I don't usually comment on blogs just to praise the host (I'm much more likely to raise questions, challenge or outright disagree), but I've just discovered your blog and I just want to say thanks for a great post (the first one of yours that I've read).

Bruce Webb said...

The idea that wages are set by marginal productivity may be perfectly logical and (some would think) intuitive but it is both in a historic sense and in the modern day nonsense. Wages like other prices are set on the basis of 'what the market will bear' which in turn is affected by all kinds of variables external to productivity from marketing/advertising to state coercion.

For employers wages are a cost like any other to be paid at whatever price clears the market. In scarce or expensive (in terms of cost of living) labor markets the price will be higher, in crowded or cheap labor markets the price will be lower. The notion that overall labor costs are matched to an employers perceived calculation of how much that labor contributed to productivity may be theoretically useful but I think would leave most real world bosses and workers befuddled. You have price, you have cost, and you have profit. Employers will do what they can to control the first two in hopes of maximizing the latter. Clearly productivity is a cost factor but thinking it is determinative of actual wages could only be convincing to a freshman Econ 101 student who never in fact had a real job.
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That being said a cap increase on either the employer or employee side is an extremely stupid idea. Social Security is currently is surplus, simply increasing cash flow through it just adds to total debt in terms of future interest owed. If there was a proposal on the table to take these increased revenue flows and invest them in outside assets (my choice would be transportation bonds) this proposal would make marginal sense. As it is it simply seems to not understand the mechanics of Social Security finance as it exists in 2008 and is projected to exist until 2017. There is a fatal confusion of accounting and cash flow going on here.

It would also be helpful if they were using 2008 numbers (1.7%/$102,000) instead of 2007 numbers (1.95%/$97,500). The Reports are readily available in two electronic and one paper form, it is inexcusable to propose Social Security policy without checking the most recent data.