Cutting the payroll tax on older workers: a tax cut that could pay for itself?

Following is an op-ed I had in the Wall Street Journal last week looking at the possibility of cutting the Social Security payroll tax for older workers. I make three main points: first, Social Security provides a very poor return on contributions for workers nearing retirement; second, these near-retirees are far more sensitive to such incentives than middle aged workers; and third, due to this sensitivity, lowering payroll tax rates on older workers could spur labor force participation such that extra collections from non-Social Security taxes could offset much or all of the loss to Social Security’s revenues.

A Payroll Tax Cut Could Help Social Security

The annual Social Security Trustees Report, released on Monday, confirms that the program is significantly underfunded. After decades of delay, Congress and the next president will need to take steps to restore Social Security's finances and improve Americans' retirement income security. Although it might seem counterintuitive, one positive step toward achieving both goals is to cut the 12.4% payroll tax for workers nearing retirement, say, at age 62.

The reason is that the current system encourages too many individuals to retire early, forgoing the extra savings they could have by extending their work lives.

It is true that, in the aftermath of the Great Recession, more people are postponing retirement to rebuild their battered 401(k)s. Nevertheless, Americans on average still retire more than two years earlier than they did in 1960, despite less strenuous jobs and significantly longer life spans. The typical worker will spend one-third of his adult life in retirement, financed by entitlement programs that cannot bear the strain.

There are many reasons Americans retire young, but Social Security benefit rules unquestionably play a role. A 2009 study I coauthored with David Weaver and Gayle Reznik of the Social Security Administration (for the SSA's Office of Retirement and Disability Policy) found that for each dollar of additional payroll taxes a near-retiree pays into the system, he or she receives only around 2.5 cents in extra lifetime benefits.

The returns are meager because Social Security benefits are based upon an individual's highest 35 years of earnings—an additional year of work is unlikely to boost benefits. Second, most female retirees receive a spousal benefit based upon their husbands' earnings, and the spousal benefit is not increased by any additional taxes she may pay. Third, once individuals reach the full retirement age they are ineligible for Social Security disability benefits, but they must nevertheless continue to pay the 1.8% disability payroll tax.

Unlike other taxes, the work incentives presented by Social Security are a function of the tax workers pay in a given year minus the future benefits those taxes entitle them to. For younger or low-income workers, this "net tax rate" is low or even negative. For near-retirees, however, little or any new benefits are earned in exchange for taxes paid, making Social Security a clear disincentive to work.

How sensitive are near-retirees to changes in after-tax earnings? A 2005 study by Eric French of the Chicago Federal Reserve found that a 10% increase in wages as of age 62 would increase this cohort's labor supply by 18%, and the overall labor supply by 1.1%. In a 2009 study that relied on differences in state income-tax rates, Lucie Schmidt of Williams College and Purvi Sevak of Hunter College found that a 10% increase in after-tax earnings would increase labor force participation by 7.5% among men and 11.4% among women. And in forthcoming research, John Laitner and Dan Silverman of the University of Michigan find that eliminating the payroll tax at age 59 would cause individuals to delay retirement by an average of 1.1 years.

Obviously, reducing or even eliminating the payroll tax for older workers would lower Social Security revenues. But increased labor-force participation would raise non-Social Security tax collections. The budgetary question is how these balance out.

Using the standard Social Security models developed by the Policy Stimulation Group, I estimate that eliminating the 12.4% payroll tax for workers at age 62 would reduce annual Social Security revenues by roughly 2.2%, or about $16.2 billion in 2012 tax collections.

Using Eric French's parameters, it would increase the overall labor supply by around 1.4%. The average 62-year-old working full time in 2010 earned around $58,800, implying a federal income-tax rate of about 15%. Adding the 2.9% Medicare tax and a 4.4% average state income-tax rate, total non-Social Security revenues would rise by around $18.3 billion, of which the federal government would collect about $14.7 billion. Thus higher non-Social Security revenues compensate for much of the payroll tax cut. (Higher benefits earned by later retirements have no significant impact on these estimations.)

Meanwhile, the gains to individuals and the economy could be substantial. Working one additional year would boost average private pension income by almost 5%. And all Americans would benefit from the extra goods and services that older workers could provide.

Cutting the payroll tax on older workers won't pay for itself. But the fact that it would come so close to doing so illustrates the losses we suffer under current policy and the potential gains to individual welfare and the economy.

Mr. Biggs is a resident scholar at the American Enterprise Institute and a former principal deputy commissioner of the Social Security Administration.