Social Security's Payroll Tax Can't Touch $1.2 Trillion in Annual Earnings

Social Security is quite possibly the most important social program in America. Each month, around 62 million people receive a stipend from the Old-Age, Survivors, and Disability Insurance (OASDI) Trust, of which 42.6 million (almost 69%) are retired workers. Though the average monthly payout of $1,407 to these retirees might not seem like much, it's enough to keep more than 15 million retired workers out of poverty, according to the Center on Budget and Policy Priorities.

Social Security is an estimated 16 years from disaster

Unfortunately, Social Security's long-term future is very much in doubt. The 2017 report from the Social Security Board of Trustees projects that the OASDI will begin paying out more in benefits than it's generating in revenue in 2022. By 2034, just 12 years later, Social Security's $3 trillion in asset reserves will be completely exhausted.

The good news in such a scenario is that Social Security won't go bankrupt. Social Security's 12.4% payroll tax accounts for a majority of funding for the program (87.3% in 2016), which means that as long as people keep working, there will be revenue coming in for disbursement. It does, however, mean that the current payout schedule isn't sustainable. The trustees have cautioned that cuts of up to 23% may be needed on an across-the-board basis to ensure solvency through 2091. With 62% of retired workers currently counting on Social Security for at least half of their monthly income, a 23% cut in benefits is a downright frightening forecast.

The writing on the wall is clear: Congress needs to act to either raise additional revenue, enact cuts, or do some combination of the two, to counter an expected $12.5 trillion cash shortfall through 2091, based on the current trajectory.

The rich are skirting Social Security's payroll tax

Arguably the most popular solution among the American public, and one most Democrats have long lobbied for in Congress, is that of increasing the scope of the payroll tax on wealthier Americans. You see, Social Security's 12.4% payroll tax only applies to earned income of between $0.01 and $128,400 as of 2018. That means any earned income above and beyond $128,400 escapes being touched by Social Security's payroll tax.

What isn't clear to most folks is exactly how much in earnings escapes taxation each year. However, the Social Security Administration has answers. Between 1983 and 2016, the value of earnings escaping taxation catapulted from a little over $300 billion each year to around $1.2 trillion as of 2016. In terms of percentages, roughly 10% of all earned income escaped Social Security's payroll tax in 1983, whereas more than 17% of earned income is untouched as of 2016.

What's this all mean? Namely that income inequality is becoming an increasingly big problem for Social Security.

Rising income inequality is causing two major problems

The first issue, as noted, is that around $1.2 trillion in earnings is escaping the system annually without being taxed. What we're seeing is that more than 90% of American workers are being subjected to Social Security's payroll tax on every dollar they earn, and they're struggling to see anything more than modest wage growth. Meanwhile, wealthier workers are seeing considerably stronger wage growth and wealth creation, but not having to pay an incrementally larger amount into the system as a result of it. Even though the maximum annual earnings cap (the $128,400 figure for 2018) increases in step with the National Average Wage Index, it's simply not keeping pace with the rapidly growing earnings of the rich.

Yet, here's thing: If workers were paying tax on this approximately $1.2 trillion in earnings, Social Security's long-term cash shortfall would completely disappear. That's to say if the maximum taxable earnings cap were removed entirely, and all earned income were exposed to Social Security payroll tax, Social Security wouldn't have to cut benefits at all by 2034.

The other problem is that income inequality is creating a defined gap in longevity. Well-to-do Americans rarely have financial constraints, which allows them to get preventative medical care and treatment when needed. Medical care for lower-income Americans, who are more likely to be reliant on Social Security during retirement, isn't always guaranteed. The result is a marked gap in average life expectancy between low- and high-income Americans. Not only are the rich living much longer, but that means they're able to pull a larger Social Security payment from the OASDI Trust for an extended period of time.

Income inequality isn't an easy fix

Income inequality is an oft-overlooked but glaring problem. Unfortunately, it's also not easy to fix. Yes, eliminating the maximum taxable earnings cap sounds simple, and it's supported by a lot of the public, but there are bigger ramifications to consider.

For example, your work and earnings history are supposed to be representative of the benefit you receive during retirement. Given that the maximum monthly payout at full retirement age caps at $2,788 in 2018, the rich probably wouldn't see a dime in extra retirement benefits despite having to pay a lot extra into the program if the payroll tax cap is removed or significantly raised. The whole purpose of having the payroll tax cap in the first place is to be reflective of the fact that Social Security also has a monthly maximum payout at full retirement age.

There's also virtually no consensus in Congress as to what should be done with Social Security given that Democrats and Republicans each have a plan that works. Gaining 60 votes in the Senate would be practically impossible given that few, if any, Republican senators would agree to removing or dramatically lifting the payroll tax cap. Without 60 votes -- i.e., if the two parties can't find a middle ground -- there's no chance of any meaningful reforms.

Ultimately, yes, income inequality is a problem. As to how to fix it? That remains the great mystery.

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