Posted by Jeffrey Brown on Jul 18, 2011
Filed Under (Retirement Policy, U.S. Fiscal Policy)
The political climate in Washington has finally shifted to one in which long-term deficit reduction has become a priority. This is definitely a good thing, given that our long term fiscal path is unsustainable and that any changes we enact will have to be much more painful the longer we wait to enact them.
While Social Security is only one piece of the federal budget, it is a topic that merits attention. As part of the debate, one idea that seems to be gaining traction (at least among Democrats) is the idea of raising the amount of income subject to the 12.4% Social Security payroll tax. Currently, this tax is applied to the first $106,800 of income. Consistent with this, only income up to $106,800 is counted in the computation of Social Security benefits. This cap is indexed over time so that it rises with average wage growth.
It has been pointed out by many scholars and analysts that the share of the overall payroll in the U.S. that is above this “taxable maximum” has grown over the decades, a consequence of rising income inequality. As such, many are calling for this cap to be gradually raised so that it covers a fraction of total payroll that is consistent with decades past. A common benchmark is to raise contributions by an additional increment – such as an additional 2% per year – until 90 percent of all earnings are covered. Social Security Actuaries have estimated that, at this rate, it would take about four decades to reach the new, higher taxable maximum, which would be equivalent to about $215,000 today (so roughly a doubling of the income subject to the tax).
Many have argued for this in terms of “fairness.” Basically, the argument goes, why should the rich not have to pay these taxes on the income above the cap? The usual argument against raising the cap is that this is essentially 12.4% increase in marginal tax rates on mid/high level earners, and that this level of a tax hike would reduce labor supply incentives and lead to loss of efficiency and reduced economic growth. In short, it is a classic example of “equity versus efficiency.” Or so it seems …
In some very good testimony before the House Ways and Means Committee a few weeks ago, Dr. Mark Warshawsky presented some additional arguments against raising the cap. [Full disclosure – Mark and I are former co-authors, and we also served on the Social Security Advisory Board together for two years.] In his testimony, Mark raises four additional points that have are often missed, some of which call into question the argument that raising this tax is “fair.” These four points are:
- “It unfairly targets a specific segment of the population that has not seen particularly large gains in earnings.” Mark gives a great explanation of this, showing that the vast majority of the increase in earnings for the top 20 percent of the income distribution is actually concentrated in the top 1 percent (in other words, there is growing income inequality even at the top). Raising the cap from $106,800 to $215,000 would be slamming those who have experienced only moderate earnings growth.
- “It is an extra burden in addition to the new taxes imposed on this and other groups to finance Medicare and in the recent health care legislation to finance health insurance coverage for poor and middle-income households.“ The populist tendency is to want to “tax the rich.” But Mark points out that we have been hitting this group pretty hard. As he notes, “In 1991, the earnings cap for Medicare Health Insurance (HI) payroll taxes was increased, and in 1994, it was lifted entirely. So these workers already have seen a significant payroll tax increase of 2.9 percent of earnings. Moreover, under the new health care law, an additional HI payroll tax of 0.9 percent will be collected from workers with earnings over $200,000 for single filers and $250,000 for joint filers, effective for taxable years after December 31, 2012. These earnings thresholds are not indexed and hence many of the workers to be hit by this HI tax rate increase will be the same individuals to be hit by the proposed increase in the Social Security taxable maximum. In addition, there is a new tax of 3.8 percent on unearned income of individuals with modified adjusted gross income above $250,000 (in the case of a joint return) or $200,000 (in the case of a single filer return). On top, of course, a progressive income tax structure exists at the federal level and in most states and localities.”
- “It will cut private retirement savings.” Mark calculates that those people affected by this would reduce their private savings by about 4 percent, this coming at a time when personal savings rates are already abysmally low (and even if you do not care about their savings rates directly, it is important to remember that savings is what drives investment, which in turn is what drives economic growth.)
- “It represents an unnecessary expansion of the Social Security program.” This arises because these proposals would grant some additional benefits in return for the additional taxes (although the incremental benefits are a small fraction of the incremental taxes), meaning that we are expanding a fiscally unsustainable program for people who do not really need it (high earners). You might object by stating that we should treat it as a pure tax and not provide any incremental benefits, but then that just magnifies the other downsides.
Let’s be clear – our fiscal situation is pretty dire, and we need to balance the budget. As much as I would like this to be done primarily on the spending side, I recognize that we are going to need to raise some revenue. But of all the possible ways of expanding the nation’s revenue that might providing some efficiency gains (e.g., carbon tax, eliminating numerous corporate tax deductions, limiting tax expenditures, etc.), raising the cap on Social Security should be pretty low on the list.