How income inequality undermines Social Security, and what to do about it

The drawbacks of rising income inequality have been well documented and widely analyzed, from its corrosive effect on social cohesion (see Benjamin Friedman’s work on the subject) to its stultifying effect on economic growth.

The concentration of wage income at the top of the income scale also has contributed to the projected erosion of the fiscal balance of Social Security. That long-understood fact is newly documented by Rebecca Vallas and her colleagues at the Center for American Progress. “Recent trends in workers’ wages have eroded the finances of our Social Security system,” they write, “and put American families at risk.”

Their analysis lends credibility to the best and fairest proposed fiscal change for Social Security: eliminate the cap on wage income subject to the payroll tax, which this year is set at $118,500. Wages over that level are assessed no payroll tax at all. Eliminating the tax cap will eliminate almost the entire actuarial shortfall projected for the program over the next 75 years, depending on how much of a benefit increase one wishes to give to the highest earners now paying the lowest share of their incomes in payroll tax.

The report analyzes the effect on Social Security of two aspects of income inequality. One is the failure of worker wages to rise at the same rate as productivity, a gap that first surfaced in the 1970s and has grown wider ever since. (See accompanying graphic.)

The second is the increase in the portion of American wages that exceed the income cap on the Social Security payroll tax. In 1983, the wage cap was $35,700 (the equivalent of about $80,000 today, adjusted for inflation). That year, the payroll tax covered about 90% of all wages. Thanks to income inequality, the payroll cap only covers about 83% of all wages today. That’s a giveaway to the wealthiest Americans, a larger share of whose earnings escape taxation.

The report calculates that if workers’ wages grew at the same rate as productivity between 1983 and 2013 (and the wage distribution among income levels remained the same), the Social Security trust fund would have $753.8 billion more in assets than it did in 2013--that is, $3.5 trillion instead of less than $2.8 trillion.

Furthermore, if the payroll tax cap kept pace with income gains so it still covered 90% of all wages today, the trust fund would be $1.1 trillion larger in 2013, or $3.9 trillion. That alone would have reduced the projected imbalance in Social Security by 10%.

Scrapping the cap entirely would obviously have a more powerful effect. As Congress is dithering over how to close a more modest shortfall in the disability insurance reserve and threatening to cut Social Security benefits across the board, there’s no reason why the option of raising the tax should be off the table.

But is it fair to subject high incomes to the full 12.4% Social Security tax (including the portion paid by employers)?

It’s eminently fair. For one thing, the projected shortfall derives in part from the policy America set forth at the inception of Social Security in 1935: that older retirees and near-retirees, who would be unable to contribute fully to their pensions prior to collecting benefits, should be covered anyway. The cost of that legacy remains baked into Social Security even today, and all Americans should shoulder its burden equally.

Moreover, high earners already get a huge break from the payroll tax because it’s charged only on wages, which account for smaller proportions of total income as one rises up the income scale. On average, households earning $40,000 a year get about 80% of their income from wages. But for those in the range of $1 million-$1.5 million, the proportion is only about 45%, and for those in the $5-million category, it’s 37%.

To put it another way, the payroll tax rate on those who earn $1 million in cash salary this year will be less than 1.5%. Those workers fulfilled their Social Security tax withholding obligations for the year Feb. 12.

The imbalance in payroll tax obligations is wrong and getting more wrong with every percentage point that wage income flows up to the richest Americans. Redressing the balance is an indispensable step to making the country economically more equal again.

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