The Corner

Lifting the Payroll Tax Cap Will Only Increase Spending

As you know, part of the deficit commission’s proposal for Social Security reform is an increase in the maximum earnings level to which the payroll tax applies. Peter Orzsag justifies lifting the cap in this piece from Sunday’s New York Times:

First, it would make the payroll tax more progressive by increasing the maximum earnings level to which it applies. Over the past several decades, as higher earners have enjoyed particularly rapid wage gains, a growing share of their wages has escaped the tax because they have been above the maximum taxable level. Today, about 15 percent of total wages are not taxed. The chairmen recommend gradually raising the maximum threshold so that, by 2050, only 10 percent of total wages wouldn’t be taxed — decreasing the 75-year Social Security deficit by more than a third.

I’m very happy that the commission is tackling the problem of Social Security, but this particular idea is a terrible one. What it would actually do is increase the spending power of the federal government and, eventually, increase the government’s need to raise taxes or borrow more money.

The rationale behind lifting the payroll tax cap is that, if we collect more payroll tax in a given year than we need to pay in benefits, we can delay by a little bit the day when the Social Security Administration starts running a cash-flow deficit permanently (which is now scheduled to happen in 2014), and we will be able to pour more into the Social Security trust funds, which would push back the day when the trusts run out of assets (which now is scheduled to happen in 2037).

But lifting the cap won’t accomplish these things. There is roughly $2.5 trillion in the Social Security Trust Fund, made of the extra payroll tax collected from taxpayers since 1983. However, the Social Security Trust Fund is required by law to purchase Treasury securities with its tax income, which means that the fund contains $2.5 trillion worth of IOUs. Treasury has long spent this $2.5 trillion as part of the general fund — so, in other words, since 1983, Social Security taxes have been subsidizing other parts of the federal government. More importantly, it means that if we put more money into the trust funds, it will just increase the federal government’s spending power.

It will also increase the need to increase taxes or borrow more in the future. What happens once the Social Security Administration starts running a cash-flow deficit? It will ask the federal government for its money back by cashing in its IOUs. The federal government doesn’t have the money anymore, so it will have to either raise taxes or borrow even more from domestic and foreign investors. The more taxes are collected today to put in the trust funds, the more the federal government borrows and the more it will have to pay back with future taxes or borrowing. 

So, while on paper it may look as if the math adds up, it really doesn’t. Also, lifting the cap is a terrible deal for taxpayers, whether they are high- or low-income earners.

If solvency is the goal (speaking for myself, I would rather privatize the whole thing), there are ways to reach solvency without raising taxes. I asked my colleague Jason Fichtner for some suggestions, and he sent me the following:#more#

The following estimates are done by the Social Security Administration’s Office of the Chief Actuary. They are based on the 2009 Trustees Report (they haven’t updated the provisions to reflect the 2010 Report yet).

In the 2009 Report, there was a long-range actuarial balance of -2.0 of taxable payroll.  For 2010, it’s -1.92. This means you could raise taxes by 2 percentage points and have solvency over a 75 year period if you raised them today. The key is to find a few provisions that when added together get you to the 2.0 or 1.92 figure so you don’t raise taxes. For example:

1) Starting with the December 2012 COLA (which would take effect December 2012/January 2013, 2 years from now), compute the COLA using chained-weight CPI instead of the CPI-W. This is estimated to result in COLAs that are 0.3 percent less. “Savings”: 0.36.

2) Index the retirement age to longevity. Under current law, the retirement age will go to 67 for those born in 1960 or after. This also means that the retirement age will be 67 for those turning 62 starting in 2022 (62 is the earliest eligible for benefits). At that point, this provision would raise the retirement age by 1 month EVERY OTHER YEAR beginning after 2022 and get going in order to adjust for longevity. 0.4

3) For all individuals becoming eligible for OASDI benefits in 2010 and later, use a modified primary insurance amount (PIA) formula. The modified formula would increase the first bend point to the wage-indexed equivalent of $800 in 2009. Also, a new bend point would be placed between the reset first bend point and the current-law second bend point. The new bend point would be equal to the reset first bend point plus 75 percent of the difference between the bend points. The PIA formula factor between the new bend point and the upper bend point would be lowered from 32 percent to 20 percent. The PIA formula factor above the upper bend point would be lowered from 15 percent to 10 percent. (Note: this estimate was done assuming the provision would start in 2010. But the estimate is still very close to what it would be if estimated today). 0.23

4) Currently Social Security benefits are based on a 35-year work history. To account for the fact that people are living longer, make it 38 years. 0.29

5) Invest 40 percent of the Trust Fund in equities and assume a 6.4% real rate of return on the equities. The estimate for this provision phases in the investments over 12 years to easy the shock on the equity markets. 0.67

Summary: 0.36 + 0.4 + 0.23 + 0.29 + 0.67 = 1.95

Bingo! We’ve got 1.95 and now, with these 5 tweaks, we’ve “fixed” Social Security without tax increases.

Veronique de Rugy — Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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