The Most Obvious ‘Solution’ for Social Security is Among the Worst

Eliminating the payroll tax cap would waste money on wealthy seniors and break the principles of Social Security without fixing its finances.

Capitol Hill has begun waking up to the fact that Social Security now faces insolvency before the end of the next presidential administration, threatening seniors with an automatic 22% benefit cut. In response, some lawmakers are already reaching for the simplest solution they can think of: eliminating the payroll tax cap.

Currently, the payroll tax that funds Social Security applies to just the first $184,500 of a worker’s wages. In a recent New York Times op-ed, Sens. Elizabeth Warren, a Democrat from Massachusetts, and Bernie Moreno, a Republican from Ohio, argued that Congress should do away with the limit to stabilize the program’s finances.

“Why should a middle-class nurse pay a larger share of her paycheck than a wealthy corporate lawyer?” the bipartisan duo wrote. “This is doubly unfair in an economy in which top earners’ wages, over time, have pulled far ahead of those of the average worker.”

Warren and Moreno are right to be concerned about the fairness of our present payroll tax system, which makes U.S. income taxes less progressive and eats into wages. And new revenue, particularly from the wealthiest Americans, must be part of any reasonable solution to our fiscal challenges. But simply eliminating the cap and pouring all the new money into Social Security would be an irresponsible waste — one that would put wealthy seniors above working Americans and would make it more difficult to address other pressing national priorities.

It’s important to understand that eliminating the payroll tax cap would not actually fix Social Security’s finances on its own. Without other changes, the program would still run persistent annual deficits and tumble into insolvency several years before people entering the workforce today retire.

Meanwhile, eliminating the cap would make raising taxes on the rich to solve any of our country’s other needs much harder, both politically and as a matter of economic math.

The top federal tax rate on wages is already more than 40%, including 37% for income taxes on individual incomes over $626,000 and 3.8% in Medicare taxes. Adding the full payroll tax on top — 12.4% split equally between employee and employer — would effectively push that rate above 50% through one of the largest tax hikes in American history.

I have no philosophical objection to a top income tax rate near 50%. In fact, I proposed one for incomes over $10 million as part of PPI’s comprehensive budget blueprint. But in the unlikely event Congress raised rates that high for even six-figure incomes, it seems inconceivable they would ever increase them further.

One key reason why is that the combined federal income and payroll tax rate is just the minimum rate Americans pay on their earnings. Many high-earners live in states and cities with income taxes of their own that would face total combined marginal tax rates in the mid-to-high 60s — higher than the top rate in any European country.

Which brings us to the math problem. Multiple studies have found the revenue-maximizing level of income tax is somewhere in the range of 60-70%. Further tax-rate increases are likely to reduce rather than increase revenue, as high earners work less, relocate, and pursue increasingly aggressive tax avoidance strategies.¹ In fact, some high-tax states and localities might actually lose revenue just by keeping their policies as they are in the event the payroll tax cap vanishes.

Some additional revenue could still be raised from closing loopholes. And novel taxes like Warren’s proposed wealth tax might raise a bit more on the margin too (though those taxes both have serious structural flaws and would be cannibalizing from the same base of rich-person incomes over the long-term). But for practical purposes, scrapping the payroll tax cap would take the biggest chunk of potential revenue from taxing the rich off the table for any other use.

That’s a big problem considering our other national needs — not just new programs progressives might want, but the promises our government has already made. The total federal budget deficit will be five times the size of Social Security’s annual hole when the trust fund is depleted in 2032. Significant revenue increases should be part of any balanced Social Security reform package, but using one of the biggest potential tax hikes on the table just to calcify a single program’s benefit structure would be a mistake.

In the worst-case scenario, much of that money would end up going to seniors who are already quite well off. Since its conception, Social Security has operated with an “earned-benefit” structure — the more someone pays in payroll taxes, the higher the benefit they receive. If the current benefit formula remains unchanged, half the savings from scrapping the payroll tax cap would eventually be spent providing a massive benefit increase for wealthy Americans. That makes little sense at a time when seniors already hold a greater share of national wealth than ever before.

It would also be at odds with the founding principle of Social Security, which was to ensure older Americans were not condemned to poverty simply for outliving their savings — not to lavish wealthy retirees with six-figure pensions.

The alternative is to raise the tax without awarding additional benefits. But that still wouldn’t be enough to fix the program’s shortfall, and it would be raising taxes on current workers just to keep benefits relatively high for wealthy older Americans.

And speaking philosophically, it would still mean a fundamental change in the structure of Social Security. FDR founded it as a program that workers pay for through their own contributions. Making it an explicit wealth transfer would lay bare the end of that paradigm.

If policymakers are willing to violate the principle that someone’s Social Security benefits should be based on the taxes they paid into the program while working, they should replace it entirely with a smarter system for determining how benefits are earned. As I discussed in our inaugural post last week, awarding benefits based on how many years someone works rather than how much they paid in payroll taxes would strengthen Social Security’s finances, while reinforcing the principle that benefits are earned instead of undermining it. It would also save a great deal of money by lowering benefits for higher earners even as it raises them for needier seniors.

Scrapping the payroll tax cap would be one of the biggest one-time tax increases in American history, leaving us with top tax rates that would make Scandinavians blush — something which should be anathema to anyone who considers themselves a small-government conservative, like Moreno. Using it just to keep funneling ever-larger benefits to wealthy retirees who don’t need them makes little sense when we have so many other pressing national needs — something that should concern anyone who considers themselves a progressive, like Warren. And breaking the core principles upon which Social Security was established without even fixing its finances is something that should alarm everyone. It may sound simple, but just scrapping the payroll tax cap isn’t a serious solution.

1. Some might believe the employer-side payroll tax doesn’t have the same effect on work incentives as the employee-side payroll and income taxes. But it does: someone will only work at the margin if the after-tax income they can generate from providing a good or service is worth the effort it takes to do so. Raising the employer-side tax increases the gross price a customer or an employer must pay to result in that after-tax income for the employee. And if that price rises to the point that the good or service is no longer worth it to the employee, then the work simply doesn’t happen and revenue from a previously taxable translation is lost.

In any case, even if one disregards the employer-side portion of the payroll tax, residents of high-tax jurisdictions such as New York City would still face a top marginal rate higher than anywhere in Europe. And whether scrapping the cap puts the top marginal rate within 1 percentage point or 4 percentage points of the revenue-maximzing rate is a small detail, because there are diminishing returns and the precise revenue-maximizing rate doesn’t change the fundamental point as long as the top rate is within the ballpark of it.