With Social Security in financial trouble, Democratic presidential candidate Joe Biden has put forth a plan to fix its funding problems.

Social Security gets the bulk of its income from payroll taxes, which are currently assessed on wages up to an annual wage base limit of $137,700. Biden would expand the wages subject to payroll tax by also assessing it on income above $400,000. That means higher earners would theoretically pay more to fund the program.

This plan, or similar ones, have repeatedly been proposed as a solution to Social Security's funding shortfalls. Unfortunately, Biden's own tax returns reveal why it may not work very well, as it will likely generate far less revenue than anticipated.  

Man with laptop and tax forms in front of him.

Image source: Getty Images.

New tax rules could open up the door to payroll tax avoidance

To understand the problem with Biden's plan to raise payroll taxes, you just need to take a look at his tax returns from 2017 and 2018. They show how the Bidens were able to avoid paying hundreds of thousands of dollars in payroll taxes that fund Medicare.  

The technique used to do this was a simple one, it was perfectly legal, and it was one I've personally made use of -- along with many other people, including both Newt Gingrich and John Edwards. It just involved a little bit of paperwork.

See, the Bidens created S-corporations and routed much of the money they earned through them. While their corporations paid them a salary of around $750,000, they classified another $13.3 million of their income as corporate profits. This money ultimately belongs to them and they can access it through distributions, which aren't subject to payroll taxes.

By employing this technique, the Bidens didn't save themselves any money on Social Security taxes under the current rules, since their salaries were already higher than the wage base limit. But payroll taxes that fund Medicare are assessed on all earned income.

That means they avoided paying Medicare taxes on the $13.3 million they took as distributions instead of receiving it in wages. And if Biden's plan to assess payroll taxes on income above $400,000 had been in effect at the time, they wouldn't have paid a single dollar of the extra tax on any of that money either. 

If Biden puts his plan into effect, many other wealthy people are likely to use the same technique he and his wife did to shield their income from the additional payroll taxes. After all, many high earners tend to have much more control than lower wage workers over how their earnings are structured, so can easily employ this tactic or others that shield income from payroll taxes, such as receiving a larger share of compensation in stock options. 

The big problem is, Biden's plan relies on people not changing their behaviors when tax rules change. That runs counter to reality, especially when there's already an easy-to-use loophole in place.

The bottom line is, individuals respond to incentives -- especially wealthy Americans who are really good at making use of strategies to legally reduce their tax bill. And with Social Security at serious risk of running short of money in 2035, a plan to raise taxes that even the Bidens already found a way to circumvent may not be the easy solution that current and future retirees were hoping for.