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Taxing the Rich Won't Save Social Security

By Sean Williams – Aug 8, 2020 at 6:06AM

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Though raising payroll taxes on high-income earners could buy Social Security some time, it's not the surefire solution people think it is.

Next week, Social Security will celebrate its 85th anniversary since being signed into law. Without question, it's America's top social program, supplying benefits to more than 64 million people a month and pulling 22 million of these folks out of poverty.

However, it's also a program facing its biggest crisis since inception.

Two Social Security cards lying atop and partially covering a one hundred dollar bill.

Image source: Getty Images.

Who's ready for a 24% across-the-board benefit cut?

Every year, the Social Security Board of Trustees releases a report detailing the short-term (10-year) and long-term (75-year) outlook for the program. In each of the past 35 years, the Trustees have cautioned that long-term revenue would not be sufficient to cover projected outlays. This is a fancy way of saying that the current payout schedule, inclusive of cost-of-living adjustments, isn't sustainable for 75 years following the release of a report.

As time has passed, the program's unfunded obligations have swelled many times over. As of the latest report, Social Security is estimated to be facing a $16.8 trillion funding gap between 2035 and 2094. If this shortage isn't dealt with, retired workers could see their payouts fall by as much as 24% by 2035.

How does such a time-tested program suddenly run into a nearly $17 trillion speed bump? Look no further than a host of ongoing demographic changes. Aside from visible shifts, such as the retirement of baby boomers and increasing longevity, we're seeing other trends, such as growing income inequality, contribute to Social Security's woes.

The question at this point isn't whether or not Social Security is in trouble, because it clearly is. Rather, it's how do lawmakers fix it?

Two Social Security cards lying atop a W2 tax form, showing payroll tax paid.

Image source: Getty Images.

Taxing the rich is the preferred Social Security fix

If you were to ask the public, the most favorable solution, by a long shot, would be to tax higher-earning workers.

In 2020, all earned income (i.e., wages and salary, but not investment income) between $0.01 and $137,700 is subject to Social Security's 12.4% payroll tax. This payroll tax was responsible for generating $944.5 billion of the $1.06 trillion the program collected in 2019, so it's incredibly important to Social Security.

The thing to note is that a cap exists at $137,700, which means that all earnings above this level are exempt from the payroll tax. Although this maximum taxable earnings cap increases almost every year in-step with the percentage increase in the National Average Wage Index, it still allows the rich to avoid the payroll tax on a portion -- or perhaps the lion's share -- of their earned income.

Between 1983 and 2016, the amount of earnings that were exempted from the payroll tax nearly quadrupled from north of $300 billion to about $1.2 trillion. This has allowed in the neighborhood of $150 billion in taxable revenue to "escape" the system on an annual basis in recent years.

The most-favored proposal to fix Social Security would see this maximum taxable earnings cap raised or eliminated in its entirety. Raising it often involves creating a donut hole between, say, the lower bound of $137,700 and $250,000 or $400,000, where this exemption would remain in place. Taxation would then recommence above $250,000 or $400,000, thereby boosting Social Security's collected revenue and making the rich pay their fair share.

Another factor to consider is that 94% of working Americans are likely to earn less than $137,700 in 2020 and are therefore paying into Social Security on every dollar they earn. Thus, raising or eliminating the payroll tax earnings cap would only affect 6% of workers. Since this change wouldn't impact a vast majority of workers, it's quite popular.

A visibly annoyed wealthy senior man in a suit.

Image source: Getty Images.

By itself, taxing the rich isn't enough to save Social Security

Unfortunately, there's a harsh reality that needs to be faced with the tax-the-rich thesis: It won't save Social Security.

Aside from being arguable that the rich aren't paying their fair share, there are two key reasons taxing high-income earners isn't going to be enough to bridge Social Security's funding gap over the next 75 years.

First off, the well-to-do are more likely to shift how they generate income if the tax rules for Social Security are changed. As noted, virtually all forms of investment income are exempted from the payroll tax. Reinstituting the payroll tax at $250,000 or eliminating it in its entirety will coerce the wealthy to generate more of their income from investments. This will shield additional income from the payroll tax and result in less revenue being collected by Social Security than initially forecast.

Secondly, but arguably even more important, taxing the rich doesn't take into account a number of other ongoing demographic changes that are negatively affecting Social Security. In no particular order:

  • Net legal immigration has fallen: The Social Security program relies on an expected level of younger legal migrants entering the U.S. each year to help offset the number of senior workers choosing to retire and claim their benefits. For the past two decades, the number of legal migrants entering the U.S. has been declining, which will weigh on the worker-to-beneficiary ratio.
  • U.S. birth rates are at an all-time low: The Social Security program is counting on an average of nearly two births per woman of childbearing age. However, the latest birth rate data shows the U.S. at an all-time low. If births don't pick up soon, it'll also weigh on the worker-to-beneficiary ratio.
  • Low-yield/low-inflation environment: For more than a decade, the Federal Reserve has kept its federal funds rate at historic lows, or well below their historic average. For Social Security, which has more than $2.9 trillion in asset reserves invested in special-issue bonds, this means less in the way of interest income.

The point is, even if Social Security is able to collect more income by taxing the rich, it's only going to buy the program a couple of additional decades of solvency. While I'm not saying that's a bad thing, it's important to note that raising taxes on the rich isn't a solution that, by itself, can save Social Security.

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