An Argument For And Against Taxing The Rich To Save Social Security

As you're probably well aware, our nation's most successful social program, Social Security, is set to face what's arguably its biggest hurdle since inception more than eight decades ago.

Every year, the Social Security Board of Trustees releases a report detailing the short-term (10-year) and long-term (75-year) outlook for the program. Since 1985, this annual report has indicated that there wouldn't be enough revenue generated over the long term to support the existing payout schedule. Or, to put things in easier-to-understand terms, a benefit cut would be needed at some point before the next 75 years are up in order to ensure the program's solvency.

Now, to be clear, Social Security isn't going bankrupt. It's simply not designed to, with the majority of its annually collected revenue coming from the payroll tax on earned income ($885 billion in 2019) and the taxation of Social Security benefits ($35 billion in 2019). These recurring sources of income for the program ensure that it can never go belly up, meaning it will be there for you when you retire, whether that's 10 years from now or 50 years down the road.

But the $13.9 trillion in cash that the Trustees report estimates Social Security is short between 2035 (its estimated date of asset reserve depletion) and 2093 (the 75-year mark from the issuance of the latest report) is no laughing matter. If additional revenue isn't raised, or expenditure cuts made, retired workers could see their monthly payouts decline by a not-so-subtle 23%. And since more than three out of five retired workers receiving a benefit rely on this payout for at least half of their income, a 23% reduction could cause serious issues.

Now that you have the backdrop behind Social Security's imminent cash crunch, let's pivot to the most popular solution to resolve this crisis among the public: raising the payroll tax earnings cap.

The most popular Social Security fix: Tax the rich

In 2019, all earned income (salary and wages) between $0.01 and $132,900 is subject to the 12.4% payroll tax. Mind you, only the self-employed and self-proprietors are paying this 12.4%, with employees of businesses splitting their payroll tax obligation with their employer (6.2% each). However, earned income above $132,900 is completely exempt from the payroll tax.

In 2016, the Social Security Administration notes that $1.2 trillion in earned income escaped the payroll tax this way, thereby denying the program close to $150 billion in taxable revenue. The amount of earned income exempt from the payroll tax has risen considerably over the past three decades from a little over $300 billion to the noted $1.2 trillion.

The solution would simply be to increase the earnings cap, thereby capturing more of this earned income via the payroll tax. Some proposals from lawmakers have suggested implementing a doughnut hole between the cap of $132,900 and an arbitrary figure, such as $250,000 or $400,000, where earned income would remain exempt from the payroll tax. Once above this arbitrary level, though, the payroll tax would be reinstated to supply added revenue to the program.

The reason the idea of raising the payroll tax cap is so popular among the general public is because it would have no impact on most workers. Since more than nine out of 10 workers is already paying into the program on every dollar they earn (i.e., won't make $132,900 in 2019), raising the cap would only affect a single-digit percentage of well-to-do and rich workers.

But does the most popular Social Security fix hold water? Let's take a closer look at a solid argument in favor of taxing the rich to save Social Security, as well as a valid argument why taxing the rich isn't the appropriate solution.

Here's why taxing the rich is a really good idea

There are, ultimately, a number of reasons the American public prefers the idea of placing the onus of Social Security's fix on the wealthy.

For example, there's the idea that since the rich are unlikely to rely on Social Security income at all when they retire, they should be taxed at a higher rate to help support the lower-income folk who are unable to support themselves financially. And, as noted, since this fix wouldn't impact more than nine out of 10 workers, it has a lot of support.

But neither of these factors touches on the real reason why taxing the rich makes sense. The fact is it has little do with the wealthy "paying their fair share" and everything to do with resolving Social Security's imminent cash shortfall before 2035, which is when its $2.9 trillion in asset reserves are expected to run out.

The core Republican proposal of reducing program outlays by gradually increasing the full retirement age from a peak of 67 to perhaps as high as age 70 has a fundamental flaw. Specifically, it's going to take decades before any savings are realized by the program. That's because increasing the full retirement age protects current retirees and those very near retirement, meaning it's those folks set to retire 20, 30, or 40 years from now that would see a reduction in lifetime benefits. In short, the GOP proposal to reduce expenditures works, but not quickly enough to stop benefits from being cut.

If the payroll tax cap were raised, the additional revenue generated would halt the need for a benefit cut for {presumably) a couple of decades. Whereas the Republican plan slow-steps the fix, the Democrat proposal of raising additional revenue by taxing the rich gets right to the point.

And here's why taxing the rich doesn't make sense

However, there's another side to this coin.

As with the idea above, there are plenty of ancillary reasons not to tax the rich that make sense, but they aren't the primary reasons not to do so. For instance, a couple of reasons I've previously suggested as to why the wealthy aren't being taxed more include the lack of support from Republicans in the Senate for such a measure, as well as the possibility that the wealthy may reduce political campaign donations in response to such a move.

Yet, neither of these ideas gets to the crux of the matter: that the rich are already paying their fair share into the program.

Even if the well-to-do don't plan to rely on Social Security income during retirement, one fundamental fact that most folks overlook is that the payroll tax cap exists because a cap also exists on the amount a beneficiary can be paid monthly at full retirement age. In 2019, this figure is $2,861 a month. If a person averaged $150,000 a year in lifetime earnings or $50 million a year, the most they'd be able to receive each month in 2019 at full retirement age is $2,861 a month. The payroll tax cap makes sense because the cap on benefits exists, thereby validating the notion that the rich are, indeed, paying their fair share into Social Security.

My personal belief is that an eventual solution to Social Security's cash shortfall will involve an increase to the payroll tax, and possibly the earnings cap, but as you can see, this is far from a cut-and-dried issue.

This article originally appeared in the Motley Fool. The Motley Fool has a disclosure policy.