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One of the most popular proposals for eliminating the Social Security funding shortfall is largely a mirage.
I’m referring to the proposal to make all wages subject to the Social Security payroll tax, as opposed to current law in which only wages up to $168,000 are subject to that tax. You’ll undoubtedly be hearing a lot about it this election year since it has obvious populist “tax the rich” appeal. But the plan does not boost Social Security revenue by nearly as much as its proponents would lead you to believe.
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That’s because a taxpayer’s Social Security benefits are directly proportional to how much he or she pays into the system over his lifetime. As you increase Social Security tax you would simultaneously increase the benefits received in retirement. While there is not an exact correspondence between the two, they largely offset each other.
This was recently highlighted by Steve Robinson, chief economist of the Concord Coalition, in an issue brief entitled “The Limit on Social Security Taxes and Benefits.” The Concord Coalition describes itself as “a nonpartisan organization dedicated to educating the public and finding common sense solutions to our nation’s fiscal policy challenges.”
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Robinson writes that “the limit on [Social Security payroll] taxes also serves as a limit on [Social Security] benefits. Without this limit, higher wage workers would pay unlimited taxes and receive unlimited benefits. The additional benefits would offset much of the additional taxes.”
To illustrate, consider first the situation that prevails under the current law: Someone who earned as much as, or more than, the maximum taxable wage over the last 40 years would, according to Robinson’s calculations, “be eligible to receive a monthly benefit of $3,653, prior to any adjustments for early or delayed retirement”—equivalent to $43,836 per year.
Contrast that with the proposal to make all wages subject to the Social Security payroll tax. Robinson calculates that a person who made an inflation-adjusted $1 million per year throughout his working life “would be eligible to receive a monthly benefit of $14,289 – equivalent to $171,471 per year.”
One seemingly obvious comeback to this analysis is that Congress could sever the connection between how much a taxpayer pays into Social Security and how much he gets back in retirement. The taxable wage cap could be removed while nevertheless keeping benefits capped at current levels.
Robinson’s response is that severing the payment-benefit connection isn’t that simple or straightforward. Doing that would represent “a fundamental departure from Social Security’s tradition of linking both contributions and benefits to taxable wages.”
The financial impact of removing the taxable wage cap
Calculating the net effect of unlimited taxes and unlimited benefits is complicated, since the calculation depends on a large number of assumptions, including ripple effects on Medicare, the federal budget deficit, and the economy as a whole. Robinson calculates that, for every additional dollar of revenue produced by removing the taxable wage cap, benefits would increase by anywhere between 40 cents and 64 cents. Removing the taxable wage cap would not by itself eliminate the Social Security shortfall, Robinson told me in an interview.
Politicians may still be eager to remove that cap, however, since it would temporarily improve Social Security’s finances. That’s because it would immediately increase revenue while the offsetting increase in benefits would be many years into the future. It therefore would be another instance of politicians’ perennial instinct to kick the can down the road.
Increasing the taxable wage cap might very well be one part of a broader solution to Social Security’s funding shortfall. Robinson’s point is that the role it could play is smaller than you may have thought.
“It is not a panacea,” he said.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
