Following President Obama's State of the Union address in January, it's clear that there are two hot-button issues to be tackled in the coming years. The first is how to support middle-class workers and families, and the second is how to ensure that Americans have enough income when they retire.
The coming Social Security crisis The latter issue is of particular concern because the Old Age & Survivors Insurance Trust Fund is set to burn through its remaining cash reserves (which total nearly $3 trillion right now) by 2033. The primary reason the fund has begun paying out more than it's collecting in revenue is a large demographics shift as more baby boomers retire and fewer workers take their place. As the worker-to-beneficiary ratio shrinks, the revenue being brought in by the payroll tax simply isn't enough to cover the amount currently being paid out by the Social Security Administration.
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On top of the that, Americans are living longer than ever. Based on mortality statistics released by the Centers for Disease Control and Prevention in October, the average American is living 78.8 years -- a record high. This the SSA needs to make benefit payments to eligible individuals over a longer period of time.
If nothing is done by Congress and the president, by 2033 beneficiaries will see their Social Security benefits cut by 23%. The cut would allow benefit payments to be maintained through 2087, at which point another cut would be needed. The problem is that few (if any) seniors or Americans are in favor of cutting Social Security benefits for retirees.
The simple way to eliminate 80% of the Social Security shortfall However, a new report released last month by the Center for Economic and Policy Research, or CEPR, suggested that making one critical move could eliminate up to 80% of the current Social Security shortfall.
The simple fix in question: eliminate the Social Security payroll tax earnings cap.
Source: Flickr user ptmoney.com.
What's a payroll tax earnings cap, you ask? It's the income level above which an individual no longer pays Social Security taxes on their earnings. In 2015 this cap moved up 1.3% to $118,500. In other words, any income earned beyond $118,500 in 2015 is free of Social Security taxation. For wages below the $118,500 mark, workers usually pay half the Social Security payroll tax, while their employer picks up the other half. With the Social Security payroll tax at 12.4% right now, that means you're paying 6.2% of your wages, and your employer pays the same amount. If you're self-employed, you're responsible for the full 12.4%.
Why this move might make sense So why eliminate or raise the payroll tax cap for Social Security? Think about it this way: More than nine out of 10 workers in the U.S. make less than $118,500 per year. This means these individuals will pay Social Security taxes on every single dollar they earn in 2015. Now consider a person who earns $1 million a year or more. By no later than mid-February, a person earning a million dollars or more would be done with the year's Social Security tax obligations. In other words, the payroll tax cap is perceived as being proportionately unfair, and the CEPR is calling for higher-income earners to pay more into the system.
Eliminating the payroll tax cap would be particularly beneficial for low-income retirees and women. Low-income retirees are often forced to begin taking benefit distributions as early as they are eligible (age 62), and therefore they wind up with a reduced benefit because they couldn't wait until their full retirement age to claim benefits. If upper-income earners are pumping more money into the Social Security trust funds, there would be less concern about low-income retirees' benefits being cut.
Further, women tend to be less financially prepared for retirement, according to a report from Financial Finesse. Although women tend to their retirement preparation plans earlier than men and are more likely to go to college, women are more prone to be single parents, have part-time jobs, and work fewer years than men. Ultimately, it means they often have less money to work with in their retirement plans than men do. Therefore boosting the payroll tax cap on earnings, per the CEPR, would raise taxes on just 3.1% of all female workers compared to 6.1% of the entire population (including men). Not to mention that women live 4.8 years longer than men on average, so they are more liable to be reliant on Social Security in their golden years.
It isn't that simpleThat said, simply raising the Social Security payroll tax cap or eliminating it entirely may not be the right solution.
Even though this was by far the most popular solution to fix the Social Security crisis when The Washington Post conducted a poll back in September, we also have to consider the implications of what would happen if upper-income people paid more in Social Security payroll taxes.
For starters, if wealthy Americans pay more into the system, that doesn't necessarily mean they'll get much more in return. Because of Social Security's progressive structure, higher levels of income are repaid at a lower percentage. As a result, the more you earn throughout your career, the lower the proportion of your income Social Security will replace.If the payroll tax cap were doubled or tripled, the resulting increase in eventual Social Security benefits for upper-income earners would be considerably smaller on a percentage basis than the potential payroll tax increase. True, Social Security was designed to protect lower-income retirees, not to pad the income of wealthy individuals. Nevertheless, the wealthy may argue that they should not be made to pay more with little added benefit to themselves.
Source: Wikimedia Commons user Djembayz.
We should also consider that upper-income earners are a strong source of investment and job creation in this country. Taxing them at a higher rate may shore up Social Security's trust funds, but it may come at the cost of jobs and investments for those who are currently employed.
Another point worth keeping in mind is that high wage earners are also some of the biggest contributors to political campaigns. If lawmakers push for Social Security reform, those who could be most affected by such a change may retract their support and their money for politicians. This makes raising the payroll tax cap a politically difficult proposal.
Lastly, the exact amount of the shortfall that would be reduced by raising the Social Security payroll tax cap is far from certain. Per the Center for Retirement Research, raising the cap to cover 90% of all earnings (it currently covers about 83% of all earnings) would only reduce the shortfall by 30%. The CERP, on the other hand, touts the potential for up to an 80% reduction of the current shortfall. It's uncertain exactly where the real answer lies, though it's likely in between those figures.
Change is comingAbout the only certainty is that change is coming to the Social Security system. I personally don't believe raising the payroll tax cap is the only solution that should be explored here, though an increase in the cap at some point can't be ruled out. With about a dozen options on the table, there are certainly a number of combinations lawmakers could choose in order to "fix" Social Security. The real question is whether or not the "change" will come sooner or later.
The article Is This Social Security Fix Actually the Best Choice? originally appeared on Fool.com.
Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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