Reuters

(Reuters)

Should the Cap on Social Security Payroll Taxes Be Lifted?

Taxes

The Social Security system has served to keep many elderly Americans out of poverty since its inception in 1935. It faces a looming funding crisis as the large Baby Boomer generation begins to retire. Our expanded life spans mean that fewer workers are supporting more retirees for a longer time.

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The Social Security Trustees Report shows that the system is funded through 2035, at which time benefits will need to be cut by around 25% unless action is taken. The Disability Insurance component (DI), around 18% of Social Security spending, is projected to have its trust fund depleted as early as 2017. How do we handle the shortfall?

Many proposed solutions involve the benefits side by trimming benefits in some fashion. Pushing back the Full Retirement Age is one path that has been used before. Others suggest means testing for benefits based on income, crackdowns on system fraud, and other spending cuts. Of course, increasing income could also solve the problem.

Raising the Social Security tax rate across the board is probably a non-starter, but Social Security taxes as collected now are very different from income taxes: they are not progressive, and they have a cap on upper income.

Your Social Security payroll tax is split into two components, the Old Age, Survivors and Disability Insurance (OASDI) component that covers what most people think of as Social Security, and the Health Insurance (HI) component that funds Medicare. The combined rate for both taxes is 7.65% for 2015, with 6.2% of that as OASDI and 1.45% as HI. (If you are self-employed, double that because you will also pay an employer's share).

However, the HI rate applies to all taxable income, while the Social Security tax applies to taxable income up to a cap level ($118,500 in 2015). The cap is adjusted slightly based on an average wage index formula.

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Thus, not only are Social Security payroll taxes not scaled as income increases, they stop completely beyond a given level, making them quite regressive. Very high wage earners pay far less of their income in payroll taxes than lower wage earners do.

The Center for Economic and Policy Research notes that in 1983, the cap was set to cover 90% of all taxable wages. At the time, it was assumed that automatic cap adjustments would keep Social Security covering that same 90%. However, increased income inequality since that time means that the cap only covers around 84% of the available taxable wages. In 2014, raising the income cap to $180,000 would have restored the 90% mark and logically filled the income shortfall.

Not so fast, says the Heritage Foundation. They argue that raising payroll taxes would dramatically raise the marginal tax rate on the upper-middle class as well as the wealthy. For example, a married dual-earning couple bringing home $250,000 would have their marginal tax rate raised from 36.8% to almost 50% (citing a proposal at the time to increase the cap to $240,000). Ill effects would show up as smaller savings, lesser investment, and lower spending, creating an economic slowdown.

The Heritage Foundation makes another interesting point — all studies assume that more money means that no new benefit programs would be created (questionable) and that the funds would not simply be used to borrow against for greater Congressional spending (highly unlikely). As it is, we must borrow to repay the IOU's Congress has left in the trust fund.

Ultimately, whether you think the cap should be raised or abandoned depends on how you feel about progressive or regressive taxation — and most likely, how much money you make. Our biggest concern is how to keep the extra revenues from being absorbed and lost in an administrative shell game of increased spending that puts us right back in the same shortfall mess in the future.

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