For more than 80 years, Social Security has been laying a financial foundation for our nation's retired workers. More than 46 million retirees receive a payout each month from the program, with more than 3 in 5 counting on Social Security for at least half of their income.
It's also a program that collects and spends more than $1 trillion a year, with the payroll tax acting as Social Security's funding workhorse.
The 12.4% payroll tax on earned income (wages and salary, but not investment income) was responsible for $944.5 billion of the $1.06 trillion that Social Security collected in 2019. This 12.4% is fully applicable to the self-employed but is split down the middle for workers employed by a company (6.2% paid by the company and 6.2% paid by the worker).
However, the payroll tax offers a purposeful loophole that allows certain workers to escape its clutches -- at least partially.
President Trump will pay less in Social Security payroll tax than you realize
Take President Donald Trump as a perfect example. Although we don't have access to Trump's tax returns, we can say with some degree of confidence that he's generating millions of dollars a year in earnings on top of the $400,000 salary he receives as president. The thing is, most of this income is ultimately exempted from Social Security's payroll tax.
In the upcoming year, Social Security's payroll tax will be applicable to between $0.01 and $142,800 of earned income, with this $142,800 figure known as the maximum taxable earnings cap. Some 94% of working Americans are expected to earn less than the maximum taxable earnings cap in 2021 and will therefore be paying tax into Social Security on every dollar they earn.
But this won't be the case for Donald Trump. He'll owe 12.4% on his first $142,800 in earned income in 2021 -- that's $17,707.20 in owed payroll tax -- but will have all additional earned income above this figure totally exempted from the payroll tax. Because of this perfectly legal loophole that Trump is taking advantage of, the amount of earned income escaping the payroll tax has ballooned from a little north of $300 billion in 1983 to $1.2 trillion by 2016. Chances are good it's grown even more over the past four years.
Hypothetically speaking, if Trump made $10 million in 2021, it would take a little over five days to fulfill his payroll tax obligation for the entire year.
Social Security's payroll tax dilemma
You're probably wondering how it's in any way fair for Social Security's payroll tax to cap at $142,800 in 2021, thereby giving high earners a partial exemption on some or most of their income. The answer lies with the Social Security program also placing a cap on total benefits payable at full retirement age.
In 2021, the maximum a retired worker can receive as a monthly benefit at full retirement age is $3,148. To reach this maximum, a beneficiary must have 35 qualifying years of work taken into consideration and have hit or surpassed the maximum taxable earnings cap in each of these 35 years. The payroll tax cap exists because a monthly benefit cap exists. In other words, it doesn't make sense to tax high earners on $10 million in income if the most they can net each month during retirement is $3,148, assuming they claim benefits at full retirement age.
However, the taxable liability for well-to-do workers increases almost every year. The maximum taxable earnings cap is tied at the hip to the National Average Wage Index (NAWI). As long as there's a positive cost-of-living adjustment (COLA) in the upcoming year for Social Security, the payroll tax cap increases on par with the year-over-year percentage increase in the NAWI. In the rare event where there is no COLA, the payroll tax cap remains static from one year to the next. It will, however, play catch-up in future years (i.e., when COLA turns positive again) to the NAWI.
Making changes to the payroll tax cap may be necessary to strengthen Social Security
While it's reasonable to say that the rich are already paying their fair share into Social Security, it's also very likely that they're going to have to pay more to stave off sweeping benefit cuts of up to 24% for retired workers by 2035. That's the year when the Trustees have forecast Social Security's asset reserves will be exhausted.
There are two schools of thought as to how best to fix Social Security. Democrats would prefer to raise the maximum taxable earnings cap or remove it completely. For example, former Vice President Joe Biden has proposed creating a doughnut hole between the maximum taxable earnings cap and $400,000, where earned income would remain exempt. But for earnings above $400,000, the 12.4% payroll tax would be reinstated. Collecting additional revenue from those who are unlikely to need it during retirement may be the only way to stave off Social Security's near-term cash concerns.
But keep in mind that taxing the rich is, by itself, not a cure-all. There are a lot of moving parts with the program that aren't taking center stage, yet are nevertheless having a big impact. Examples include a halving in net legal immigration into the U.S., record-low birth rates, and increasing longevity, all of which are straining the program.
To really strengthen Social Security beyond the next couple of decades, a bipartisan proposal that raises additional revenue and includes the Republicans' core proposal of gradually raising the full retirement age to reduce program outlays will likely be necessary.