If Payroll Taxes Increased by This Much, There Would Be No Social Security or Medicare Shortfall

By Markets Fool.com


Image source: Getty Images.

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It's a pretty fair statement that without Social Security or Medicare our nation's seniors would be in a world of trouble.

According to the December fact sheet from the Social Security Administration, 48% of elderly married couples and 71% of elderly individuals relied on Social Security income to make up at least 50% of their monthly income. Suffice it to say, without the safety of this income, a majority of seniors would struggle to make ends meet. {%video%}

Likewise, the importance of Medicare is growing for our aging population. Medical cost inflation has handily outpaced the national rate of inflation in all but one year over the past decade, led primarily by surging brand-name prescription drug costs. Without Medicare to cover approximately 80% of the costs for seniors ages 65 and up, many could be buried under the weight of cripplingly high procedure and drug prices.

Social Security and Medicare are on a perilous path

Yet both critically important programs are headed down the wrong path. Due to factors unforeseen when Social Security and Medicare were created, strains are being placed on both programs that have them on track to burn through their spare cash in less than two decades.

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For the Social Security's Old-Age, Survivors, and Disability Insurance Trust (OASDI), the culprit has been the retirement of baby boomers at a pace of more than 10,000 per day, as well as extended life expectancies. With the number of beneficiaries rising, and those beneficiaries living longer than ever, the OASDI is on pace to begin hemorrhaging its spare $2.8 trillion in cash by 2020, eventually running out of its excess reserves by the year 2034.

For Medicare, the Hospital Insurance (HI) Trust is being decimated by a rising tide of elderly Americans becoming eligible, as well as inflationary costs that are consistently outpacing the rate of general inflation. According to the Board of Trustees, Medicare's HI Trust could be completely out of spare cash by the year 2028, two years earlier than the report estimated in 2015.

A final issue for both Social Security and Medicare is low lending rates. Though low lending rates are great news for homebuyers and businesses looking to expand and hire for a relatively cheap price, they're wreaking havoc on seniors' bank accounts by pushing fixed-income asset yields down. Social Security and Medicare rely, at least for a small amount of revenue, on fixed-income bonds to generate interest income and extend funding a little longer. With yields falling precipitously, net interest income is reduced.

Understanding how Social Security and Medicare payroll taxes work

In addition to analyzing the financial situation of both Social Security and Medicare, the Board of Trustees 2016 report also examines the crudest solution to fix the expected budgetary shortfall over the next 75 years: payroll tax increases.

Currently, workers pay a cumulative 15.3% in payroll taxes on the money they earn, with a few exceptions that we'll get into in a moment.


Image source: 2016 Social Security and Medicare Board of Trustees report.

As you can see above, 12.4% of the aforementioned 15.3% in payroll taxes goes toward the OASDI, with the Old-Age and Survivors Insurance Trust getting 10.03%, and the Disability Insurance Trust receiving 2.37%. The DI is receiving an extra 0.57% between 2016 and 2018 to make up for a budgetary shortfall that would otherwise have seen it exhaust its spare cash sometime this year. The DI Trust is still on track to run out of its excess reserves by 2023.

This 12.4% payroll tax that goes directly to the OASDI is typically split between you and your employer, with each party paying 6.2%. If you're self-employed, you're responsible for the full 12.4%.

Furthermore, payroll taxes on Social Security accrue at the 12.4% rate up to $118,500 in earned income. This payroll tax earnings cap tends to increase annually with the rate of inflation. What this means is any income earned above $118,500 is free and clear of the 12.4% OASDI payroll tax.

In the other column we have a cumulative 2.9% payroll tax that heads to the HI Trust. Again, this tax is typically split between you and your employer at 1.45% a piece -- but if you're self-employed, you'll owe the full amount.

Unlike Social Security, which has a payroll tax earnings cap, there is no earnings cap for Medicare-based payroll taxes. In fact, individual tax return filers who earn in excess of $200,000, and joint filers that bring home more than $250,000, are subject to an additional 0.9% tax on any amount over these thresholds.


Image source: Getty Images.

You may not like this fix, but it would work

The easiest way to fix a budgetary shortfall is with across-the-board payroll tax increases.

According to the Trustees, increasing taxes on the OASDI by 2.66% and HI by 0.73% should reduce the long-range actuarial deficit and allow both programs to pay benefits at a level commensurate with 2016 levels. Combined, we're looking at about a 3.39% payroll tax increase. With the typical American family earning $51,939 a year in 2013 according to the U.S. Census Bureau, we're talking about nearly 18.6% of that income being set aside for Social Security and Medicare. This would work out to an additional $1,761 out of the pockets of the average American family each year, or about $147 a month.

Image source: Pixabay.

It's also worth noting that the Trustees believe that the longer lawmakers wait to increase payroll taxes, the more they'll need to go up later to make up for the shortfall. By 2090, an actuarial deficit of 4.35% of taxable payroll is expected.

The big problem with this legitimate fix is that most people are against paying higher taxes. Instead, the most popular solution to fix Social Security's shortfall has been to have the rich pay more. There have been calls to raise, or eliminate, the payroll tax earnings cap so that well-to-do persons pay more into the program. Because such a move would only affect a relatively small percentage of the population, and the average American worker is already paying payroll taxes on every dollar he or she earns, it's a solution that's receiving a lot of support.

Unfortunately, taxing the rich isn't going to completely solve Social Security's or Medicare's woes. It would make a dent of about 30% for Social Security's projected budget shortfall between now and 2090, but it wouldn't close the gap entirely. The implication is that benefits cuts to these programs could be needed, which few people support, or across-the-board payroll tax hikes could be warranted, perhaps in conjunction with a lifting of the payroll tax earnings cap.

While solutions abound, an agreed upon fix remains elusive for now.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

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