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The Harebrained Cap-Raising Idea
Bad for Social Security reform. Bad for the economy.


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Donald L. Luskin

Should advocates of Social Security reform accept a hike in the cap on wages subject to the payroll tax as a fair price to pay to get personal accounts enacted?

No way. I’ve heard all the rationales for this, and none stand up to scrutiny when you take a hard look at the numbers.

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Currently, only the first $90,000 of annual wages are subject to the 12.4 percent payroll tax dedicated to Social Security (a worker pays 6.2 percent directly, and an employer pays another 6.2 percent on his behalf). The wage cap is $90,000 today; on earnings above the cap, no payroll taxes are assessed. President Bush has said many times that he will not consider raising the payroll tax rate of 12.4 percent. But the White House and Republican leaders have let it be known several times recently that they might consider raising the cap above $90,000.

Raising the cap would have no immediate financial impact on anyone earning less than $90,000 — a considerable majority of the working population. But for anyone earning more than $90,000, it would be a tax increase of 12.4 percent on every dollar earned above $90,000 up to the new higher cap.

Let’s say the cap were moved to $150,000, and you earn $120,000. Your annual tax bill just went up by $3,720. And what would you get for your tax hike? Not enough.

If the current Social Security benefit calculations were kept in place, you would get an increase in future monthly benefit payments that would partially offset the tax hike. Let’s say you are 20 years from retirement at age 67. At retirement, the present value of the 20 years of additional taxes you will have paid is about $103,000 (in today’s dollars). But the present value of the additional benefits you can expect is only about $33,000.

That puts you behind by $70,000. Is that too high a price to pay for the privilege of being able to invest some of your payroll taxes in a personal account? Yes — way too high.

Under the current White House proposal, you would only be able to invest $1,000 each year into your personal account. According to my calculations, your personal account would have to earn at an average compound rate of 13.5 percent per annum for 20 years — after inflation — in order for your investment earnings to make you just whole for the $70,000 gap between higher taxes and higher benefits.

To put that in context, since 1926, the S&P 500’s total average annual return — again, after inflation — has been only 7.2 percent per annum (according to Ibbotson Associates). The 13.5 percent per annum required just to break even on a wage-cap tax hike to $150,000 has historically been achieved in only 41 percent of all 12-month periods.

Some persistently ask, Don’t personal accounts have to be financed somehow? Well, no — or at least they don’t need any additional financing that the Social Security system doesn’t already need. Under the White House proposal, a worker who elects for a personal account agrees to give up a proportionate fraction of his future benefits in exchange for that account. The cost of diverting payroll-tax dollars into personal accounts today is perfectly offset by reduced benefit payments that will have to be made in the future. Yes, that will entail some public borrowing in the near term, but it will all be paid back to the penny out of lower benefit payments down the road.

What about the idea that raising the cap on taxable wages will only fall on that minority of well-off workers who make more than $90,000 a year? Wouldn’t taxing that minority have the virtue of making personal accounts possible for the vast majority of less-well-off workers who, arguably, need them the most?

First, there probably aren’t that many people making $90,000 a year who would consider themselves rich. And as with all class warfare strategies, the ones who expect a free lunch out of the deal have to contend with the reality that you can’t eat the rich and have them too. Lifting the wage cap would impose a cruel marginal tax increase on anyone earning between $90,000 and the level of the new cap. Stunting job creation and labor-force participation among that population of workers would slow overall economic growth — and slower growth always ends up hitting the little guys hardest of all.

There’s no getting around the fact that raising the wage cap is a tax increase. For millions of workers — most of whom are hardly “rich” — such a plan would more than reverse the effects of the president’s 2003 tax cuts. Those millions of workers would not see their increased tax payments offset either by the gains of having Social Security personal accounts or by increases in Social Security benefits.

And the wage-cap tax increase is completely unnecessary as a means of financing the establishment of personal accounts — for that, no financing is needed in the first place.

President Bush recently said he was open to all “good ideas” that can help reform Social Security. Lifting the wage cap is a bad idea: bad for Social Security reform and bad for the economy.

– Donald Luskin is chief investment officer of Trend Macrolytics LLC, an independent economics and investment-research firm. He welcomes your visit to his blog and your comments at [email protected].



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