With baby boomers reaching retirement age, and retirees living longer and longer lives, Social Security is starting to have a bit of a cash flow problem. Specifically, more money is being paid out to beneficiaries than is being collected in Social Security payroll taxes, which is expected to result in the program running out of money by 2034.
There are two logical solutions to this problem -- cut benefits or raise taxes. And, since the majority of Americans are in favor of preserving benefits for retirees, should we expect the payroll tax to rise?
How the Social Security payroll tax works now
The Social Security payroll tax rate is currently 6.2%, although it's not quite that simple.
First of all, not all wages are subject to Social Security tax. As of 2016, only the first $118,500 is used to calculate Social Security tax -- anything above that amount is ignored. In other words, a worker who earns $118,500 per year pays the same Social Security tax as a worker who earns $1,000,000.
Secondly, the payroll tax rate is actually 12.4% -- but half is paid by the employer and half is paid by the employee. For example, a worker with a $50,000 salary will pay $3,100 in payroll tax from their paychecks and their employer will contribute an additional $3,100, for a total of $6,200. Self-employed individuals are responsible for paying both sides of the payroll tax.
The cost and effect of an increase
Theoretically, there are many different payroll tax increases that could possibly happen, but the most commonly discussed proposals seem to center around a 1% or 2% increase, phased in over a number of years. So, the payroll tax rate on employees would gradually rise to 7.2% or 8.2%.
For example, one popular version of a payroll tax increase calls for the rate to be raised to 7.2% for both employers and employees, and would be phased in over a 20-year period, so a 0.05% increase per year. The cost of this to an employee making $50,000 per year would be an additional $25 per year in payroll taxes each year for two decades.
According to a study by the National Academy of Social Insurance (NASI), this tax increase would take care of more than half (52%) of the projected Social Security funding gap all by itself. Increasing the tax rate in two steps -- to 7.2% in 2022 and to 8.2% in 2052 -- would have an even greater impact, covering 76% of the shortfall.
It's likely to happen, but not overnight
According to the latest research, the vast majority of Americans feel that Social Security is of paramount importance and needs to be saved, even if it means raising taxes. In the survey I referred to earlier, 85% agreed with the statement "Social Security benefits now are more important than ever to ensure that retirees have a dependable income."
The prospect of higher taxes is far more popular than any form of benefit cuts, plus it would have a greater effect on closing the funding gap. For example, increasing the full retirement age by one year to 68 would only solve 16% of the funding problem, and is extremely unpopular -- supported by just 35% of the population.
On the other hand, we've already mentioned the impact of a tax increase -- a pretty mild form of a payroll tax increase would knock out half of the funding gap. And, such a change is extremely popular -- 83% of the population is in favor of gradually increasing the payroll tax to 7.2%. To sum it up, since it's not only a more popular way to fix Social Security, but a more effective way, a gradual tax increase is likely to be a part of any Social Security reform package that successfully makes its way through congress.