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A Magazine of Ideas

Tax to the Max?

Friday, July 2, 2010

Should we lift the payroll-tax ceiling to fix Social Security?

Over at ThinkProgress, Matt Yglesias argues that a sensible solution to Social Security’s long-term funding shortfalls would be to eliminate the so-called “tax max,” the $106,800 maximum earnings on which Social Security’s 12.4 percent tax is levied and upon which benefits are calculated. In other words, individuals would pay taxes and earn benefits based on their total earnings, no matter how high. According to the Social Security Administration’s (SSA’s) Office of the Actuary, this step—if implemented immediately—would eliminate around 95 percent of the long-term “actuarial deficit.” Yglesias calls eliminating the tax max “a very reasonable response to the fact that over the past thirty years the share of national income accruing to very high income individuals has gone up dramatically.”

Here are two thoughts, dealing with the effects of eliminating the payroll tax ceiling on Social Security’s financing and on marginal tax rates.

First, while eliminating the payroll tax ceiling would solve most of the 75-year actuarial deficit, bear in mind that this is a trust fund-based measure. Most economists and government analysts view government trust funds as accounting mechanisms, but not a vehicle that truly saves and transfers resources over time. For instance, the Congressional Budget Office’s Long-Term Budget Outlook, released Wednesday, states with reference to the Medicare trust fund that

Although the HI trust fund has important legal meaning, in that its balances are a measure of the amounts that government has the legal authority to spend under current law, it has little economic significance.

The economic consensus appears to be that Social Security surpluses effectively subsidize current consumption in the rest of the budget, not to improve the overall budget balance or raise national saving. That’s a really important point in this context, since eliminating the payroll-tax ceiling would produce large short-term payroll-tax surpluses, which would be credited to the trust fund and then “drawn down” to pay benefits in the future.

This chart, from SSA data, shows the program’s net cash flows (taxes minus benefits) under current law and for a no tax-max scenario. Eliminating the tax cap does improve Social Security’s long-term cash flows, reducing annual deficits by around half. But the big improvement to the system’s actuarial balance hinges on a large trust fund buildup in the short term, as higher taxes produce a bubble of payroll tax surpluses. If these surpluses aren’t truly saved—and there’s very good reason to believe they won’t be—then Social Security’s financing will be improved more on paper than in reality. It would cut annual deficits in half—which is great, but a far cry from eliminating them.

Biggs 7.1.10

Second, raising or eliminating the payroll-tax ceiling would constitute a significant increase in marginal taxes for many people with middle-class standards of living. Consider a person earning $107,000 annually, which is just above the current tax ceiling. That person pays a marginal federal income tax rate of 28 percent, a combined Medicare tax rate of 2.9 percent, and a state income tax rate that averages around 5 percent. In total, that person pays the government almost 36 cents of each additional dollar he or she earns.

If the payroll tax ceiling were eliminated, that same person would pay an additional tax of 12.4 percent (nominally split between employer and employee, but almost universally believed to be fully borne by the worker through reduced wages). The worker would receive additional benefits in exchange for higher Social Security taxes, but these are tiny at the margin due the progressivity of the benefit formula. I believe his net tax rate (the payroll tax rate minus benefits earned) would approach 11 percent. This would put this worker’s marginal tax rate at around 47 percent of his or her income.

And note that a) in many urban areas around the country $107,000 is a middle-class income, so these aren’t the super-rich; and b) these would be the marginal tax rates paid before we’d fixed even a penny of Medicare and Medicaid’s multi-trillion-dollar deficits, which—as the Left likes to remind us—are so much bigger than Social Security’s.

It’s pretty much accepted, even among policy folks well to the left-of-center, that the trust fund isn’t real savings and that marginal tax rates do matter. Given this, I don’t think a straight-elimination of the payroll tax ceiling really passes muster as a practical solution to Social Security’s funding problems. Philosophically and emotionally, a lot of liberals want to do it, but I suspect many of them know that eliminating the payroll-tax ceiling also presents some significant practical problems.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute. From 2008 to 2009 he served as principal deputy commissioner of the Social Security Administration and as secretary of the Social Security Board of Trustees.

FURTHER READING: Biggs details “The Straw Men of Social Security,” warns of relying on the government’s “Full Faith and Overextended Credit,” and pits “Obama vs. FDR.” He explains “The Crisis in Public-Sector Accounting Plans,” “The Market Value of Public-Sector Pension Deficits, “ and the “Entitlement Apocalypse.”

Image by Rob Green/Bergman Group.