Thursday, June 18, 2009

Why we shouldn’t increase the Social Security tax cap

In the Senate Aging Committee hearing yesterday, there was considerable support expressed for increasing the Social Security taxable maximum wage – currently $106,800 – to cover 90 percent of total earnings as a means to increase revenues and improve the program's solvency. The following are thoughts that occurred to me as the lone witness who wasn't so hot on the idea.

  1. As the Economic Policy Institute's John Irons argued at the hearing, the payroll tax covers a smaller share of total earnings today than it did in the early 1980s. But if you look at the chart included in the addendum to my testimony, the current coverage level – around 85 percent, according to the 2009 Trustees Report – isn't out of line with the program's history. On average, the payroll tax cap has covered around 84 percent of total earnings, making today's level just about on par with past practice. Moreover, while the tax max covered 90 percent of total earnings in the early 1980s – not as a result of the 1983 reforms, but from changes made in the 1977 reforms – it's not at all clear that Congress explicitly targeted 90 percent. There is one after-the-fact reference in a committee document to 90 percent, but past discussions with the SSA historian Larry DeWitt indicate that this link is pretty hazy. The conclusion here is simply that we shouldn't assume, as some seem to, that 90 percent coverage by payroll taxes is a historical norm we must adhere to.
  2. Raising the current tax max of $106,800 to cover 90 percent of total wages would mean increasing it to around $172,000, according to the SSA actuaries. (Interestingly, this 2009 figure is much lower than it would have been under 2008 projections, due to significant shrinkage of earnings above the cap. Had the recession not occurred, the 90 percent coverage figure would have been around $214,000. I guess we've fixed the income inequality problem…) A single person earning $107,000 pays a marginal tax rate of 28 percent; if married, the effective marginal rate may be higher, since taxes are levied on the couple's earnings. The typical person also pays a state income tax of 6-7 percent, so we've got a current total marginal tax rate of around 35 percent. If we raise the tax max and pay extra benefits on those taxes, the effective marginal tax rate rises to a little over 45 percent. Because extra benefits are paid, the "net tax" is around 10.5 percent, rather than the full 12.4 percent statutory payroll tax. Nevertheless, the idea that a person earnings a little over $100,000 should pay nearly half their income to the government – and this, before we've even touched Medicare and Medicaid reform – just seems to high to me, from an economic standpoint, from the standpoint of fairness between different earnings levels, and from the standpoint of the relationship between a supposedly limited government and those who support it. For some earning more – say, near the new cap level of $172,000 – the marginal tax rate could exceed 50 percent. That's just too much.
  3. Lifting the tax max will tend to reduce work effort by those affected. It's a bit complex, since there are both income effects that can push them to work more – the tax reduces your income, and you may work harder to make up the loss – and substitution effects that will cause them to work less – that is, since the next dollar of earnings brings you less after-tax income, you won't work as hard. For someone right at $107,000, there's no income effect but a big substitution effect; in that area, people will work less. From $107,000 to the new cap, it will be a mix, although I'd wager that the substitution effects will generally dominate. At earnings levels above the new cap there's no substitution effect, so people may work more. How much more, we don't know, and in any case this is a very small number of people. The alternative, reducing future benefits, will almost surely increase labor force participation and personal saving, as people try to make up the difference. Given that almost all reform plans will protect true low earners, it seems to me we should opt for one that would help the economy rather than hurt it, particularly given all the other economic challenges we face.
  4. Even assuming the decline in the tax cap from 90 percent to 85 percent of total earnings matters, that decline was driven almost entirely by increased earnings at the very high end – not of people making $170,000, but $1.7 million or $17 million. Essentially, the person making $107,000 to $172,000 is paying the tab for something that really has nothing to do with him. I'm not so keen on President Obama's proposals for a surtax on earnings above $250,000, but it at least targets the source of rising inequality.
  5. $107,000 is a good salary, but for people in a place like New York City it's hardly upper class – for comparison, it provides the same standard of living as a person earning around $53,000 in Milwaukee. Good, sure, but this is hardly the realm of private jets, or even private schools. A lot of these high earners will be clustered in high costs cities. I have no special favor for New York City, but we shouldn't be confused that these are folks in limousines.
  6. Finally, this proposal is a bit out of character from the traditional structure of social security as designed by President Roosevelt. Roosevelt was strict in saying that Social Security should not resemble "welfare," that it should be like a private pension plan. Social Security taxes were to resemble pension contributions, so there would be no stigma on people who received benefits and no resentment from higher earners for the taxes they paid. Roosevelt wanted people to feel ownership in their benefits by virtue them being paid for by workers' own contributions. It's worth mentioning that when Roosevelt's Committee on Economic Security first drafted a social security plan, high earners wouldn't even have been included in the system – there would have been no redistribution from very high earners to everyone else. So to pin the whole burden of restoring solvency on higher earners seems out of step with how the program has functioned over time.

13 comments:

James said...

I'm not so keen on President Obama's proposals for a surtax on earnings above $250,000, but it at least targets the source of rising inequality.

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On the other hand, this was a campaign promise made in keeping with his pledge NOT TO RAISE taxes on the middle class. The administration will increasingly find this promise, made time and again during the campaign, hard to keep.

One clear downside to raising the maximum taxable wage, at least to my thinking, is that the immediate effect is to increase the surplus and extend the period before this becomes a deficit. Those extra funds will merely encourage additional spending or discourage placing a brake on expensive new programs. The end result may very likely be a considerably larger trust fund that citizens will be on the hook for down the road, in the form of higher taxes or reduced spending elsewhere in the budget. And, of course, none of this is happening in a vacuum. As should be very clear by now, there will be intense competition for US taxpayer dollars from a variety of sources in the decade ahead.

Andrew G. Biggs said...

James -- I agree with you on the danger of 'putting more cookies in the cookie jar.' I think Obama's folks are at least aware of this problem: they didn't schedule their surtax to kick in until around 2017, in which case it would mostly just cover annual deficits rather than building up a big trust fund.

shoffy22 said...

Good points to think about in regards to raising the tax max Andrew! I think points #3 and #4, especially, show that perhaps a different increase of the tax max than raising the cap to cover 90% of earnings could have better economic effects. I'm intrigued by the idea of taxing all wages above the current law cap of $107,000 at half the current rate, so that employees and employers each pay 3.1% on all wages above $107K. I think this change would raise about as much money as raising the cap to cover 90% of eanings. It would also be a much smaller increase to marginal tax rates so should mitigate the substitution effects. And it would spread this new burden across all high wage earners, instead of putting all the burden on those making between 107K and 172K. This is important since as you point out most of the increase in earnings inequality is coming from the growth in income for super high earners.

Andrew G. Biggs said...

Shoffy,
Thanks for the thoughts. My very rough guess is that if around 15 percent of total wages are above the cap and we tax them at a 6.2% rate, that would produce about as much as if we raised the ordinary payroll tax by around 1.1%, which is a bit more than raising the tax max to 90% gets but definitely in the neighborhood.
But I guess the philosophical question is why high earners should pay the bill? If Social Security is a shared program, shouldn't we share the cost of solvency?

Bruce Webb said...

Andrew maybe the confusion is just in my head but there seems to be some blurring between 'earnings' and 'wages'. I find it hard to believe that $172,000 is the 90% mark of wages if by that we mean the kind of earnings exposed to FICA. Because if so it suggests that the bonus culture is way out of hand. I understand that between college football coaches, university presidents, movie stars and CEOs of 'non-profit' foundations there are plenty of people earning more than $172k in base salary but I hardly think 10% of the working population fits into that category.

Andrew G. Biggs said...

Bruce,
$172,000 is the level that covers 90% of earnings subject to FICA. I believe income such as bonuses are counted as earned income and thus are subject to payroll taxes, while capital gains and other investment (i.e., non-earned) income are not. Around 6 percent of workers have earnings above the cap in any given year, although obviously it's not the same 6% each and every year.

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