As you're probably well aware, the most important social program in this country, Social Security, is in some pretty big trouble.
Last year, the Social Security Board of Trustees released a report detailing the short- and long-term outlook for the program. Among its findings were that Social Security would experience a net-cash outflow in 2020 for the first time since 1982, and that the program's asset reserves (i.e., its net-cash surpluses built up since inception) would be completely depleted by 2035. While these asset reserves aren't necessarily for the program to remain solvent, it does imply that big benefit cuts could be headed retired workers' way within the next 15 years.
In short, Social Security has a lot of problems that are adversely affecting its financial well-being.
Surprise! Social Security missed out on $190 billion in tax revenue last year
But what you might be most surprised to learn is that a perfectly legal loophole being utilized by high-income Americans allowed a whopping $190 billion in would-be tax revenue to escape the program's clutches in 2019.
Although Social Security has three sources of funding, the 12.4% payroll tax on earned income is its workhorse. In 2018, the payroll tax was responsible for $885 billion of the $1 trillion collected.
The thing is, there are limits not only on what type of income the payroll tax can be applied to, but on the amount of earned income that's subject to taxation.
To tackle the former, earned income means wages and salary that have been disbursed to working Americans. Thus, investment income isn't subjected to the payroll tax. No matter how much income a worker generates from their investments, Social Security won't see a dime of that income via taxation.
With regard to wages and salary, Social Security's payroll tax was applicable in 2019 to earned income between $0.01 and $132,900, with this upper bound known as the "payroll tax earnings cap." With the exception of years where no cost-of-living adjustment is passed along, this cap adjusts upward annually on par with the percentage increase in the National Average Wage Index. Or, in layman's terms, more income for the well-to-do becomes applicable to the payroll tax with each passing year. In 2020, for example, the tax cap is $137,700.
However, any earned income above and beyond this cap is exempt from the payroll tax. For someone earning $150,000 in 2019, this would mean 11% of their earnings would be exempt. Meanwhile, an individual earning $1 million in 2019 would have close to 87% of their income untouched by the payroll tax.
According to the Social Security Administration, the percentage of earnings subject to the payroll tax has been declining for the past 35 years, and now sits at "about 83%," per the SSA's Fast Facts and Figures 2019 report. Extrapolating this 83% figure to the estimated $9 trillion in wages and salary distributed to workers in 2019 implies that $1.57 trillion in earned income wasn't subject to the payroll tax. With a tax rate of 12.4% (i.e., 12.4% times $1.57 trillion), it means $190 billion in potential tax revenue escaped the program last year -- and it's 100% legal.
Here's why the payroll tax has an earnings cap (and why efforts to adjust this cap have failed)
You might be wondering, "Why the heck does a payroll tax cap exist anyway?"
On the surface, the idea of capping the amount of earned income that's taxable probably doesn't make a lot of sense. Given that 94% of working Americans pay into Social Security on every dollar they earn, it would only seem reasonable for all workers to pay into the system on every dollar of wages and salary they earn.
However, what's often overlooked is that Social Security's monthly benefit at full retirement age is also capped. In other words, the reason a cap exists with regard to how much earned income is taxable in a given year is because there's also a limit to how much the Social Security Administration will pay a retired worker each month. In 2020, this limit is $3,011 per month at full retirement age. It wouldn't make much sense to tax say $3 million annually in earned income if the most a person could hope for in return is $3,011 a month from Social Security.
But make no mistake about it, certain lawmakers on Capitol Hill have pushed for reforms of the payroll tax cap. These proposals often call for the cap to be raised or removed completely, thereby requiring the rich to pay more into the program. However, these calls for reform haven't gained much traction.
One problem is that the tax-the-rich strategy has virtually no support among Republicans in Congress. It takes 60 votes in the Senate to reform the Social Security Act, which is going to require bipartisan support. Republicans, though, have made it clear that increasing taxation only on well-to-do workers isn't something they'll support.
I believe it's also worth mentioning that wealthier individuals tend to be among the most generous campaign contributors. Pushing policies that could lead to higher taxation on the rich may have negative consequences come election time.
It could also be rightly argued that high-income earners are already paying their fair share. While $190 billion in added tax revenue in 2019 would go a long way to shoring up Social Security, high-income earners paid into the program an amount that's commensurate with maximum benefit they could receive at full retirement age.
Clearly, this is going to remain a contentious subject. But if nothing is changed, we're liable to see more and more earned income exempted from the payroll tax with each passing year.