Why Taxing The Rich Isn't A Social Security Cure-All

Ready or not, Social Security is in trouble.

Although its "Judgment Day" changes frequently, the past 34 reports from the Social Security Board of Trustees, dating back to 1985, have shown that the program won't collect enough revenue over the next 75 years to cover expenditures. As of the 2018 report, there's a cash shortfall of a whopping $13.2 trillion between 2034 and 2092.

As a number of demographic changes continue to take shape, the program -- possibly beginning in 2019 -- will expend more than it collects for the first time since 1982. These net cash outflows are expected to widen with each passing year, leading to the complete exhaustion of the program's $2.9 trillion in asset reserves by 2034.

If there is a silver lining here for seniors and future generations of retirees, it's that Social Security doesn't need a dime in asset reserves to remain solvent. Recurring revenue sources that include the payroll tax on earned income, and the taxation of benefits, ensure that the program is incapable of going bankrupt. However, it won't save Social Security from an across-the-board benefit cut of up to 21% if Congress doesn't do something to raise additional revenue, reduce expenditures, or enact some combination of the two.

Raising or eliminating the payroll tax cap is the most popular solution

Among the boatload of solutions on the table in Capitol Hill, none is more popular with the American public than raising or eliminating the earnings cap associated with the 12.4% payroll tax on earned income (i.e., wages and salary paid to you). An informal online poll from TheWashington Post in 2014 showed that almost 70% of online readers would stand behind raising the earnings tax cap, with none of the other 11 solutions garnering more than 45% support. (Users were free to choose as many ideas as they'd stand behind.)

In 2019, all earned income between $0.01 and $132,900 is subject to the payroll tax, meaning more than nine out of 10 workers is paying into the program on every dollar they earn. Meanwhile, earned income above $132,900 is exempt from the payroll tax, allowing the rich to escape paying tax on some, or perhaps a majority, of their income. Between 1983 and 2016, the amount of earned income to be exempted each year has quadrupled from about $300 billion to $1.2 trillion.

Raising or eliminating the payroll tax cap wouldn't affect the vast majority of the population, and in a way would be viewed as a means of leveling the playing field by making all earned income taxable, which is one reason it's so popular. At the same time, it offers the potential to dramatically increase taxable revenue collection, putting Social Security on firmer ground over the long run. Some pundits have even suggested that eliminating the cap completely could resolve Social Security's long-term cash shortfall.

Sorry, folks, but taxing the rich isn't a Social Security cure-all

The reality, though, is that taxing the rich isn't likely to be a cure-all for Social Security, even if it does provide an immediate lift in taxable revenue.

The first problem with taxing well-to-do workers is that ignores a trend that's persisted since Social Security was signed into law in 1935: increasing longevity. As a result of easier access to medical care, better pharmaceutical products, and improved health education, life expectancies have been on the rise over the long run. Between 1960 and today, the average individual is living about nine years longer. More specifically, as it relates to Social Security, the average 65-year-old is going to live about two more decades. The program was never designed to support retired workers for two-plus decades. Even with added revenue from the taxation of most or all earned income, increasing longevity may push expenditures well beyond collected revenue.

Second, a more recent problem that's cropped up over the past decade is the precipitous decline in fertility rates. Over the long run, the trustees project an average birth rate per woman of 2. But in 2018, fertility rates hit a 40-year low of 1.76 births per woman. If fertility rates continue to decline, or even if they maintain the existing birth rate of less than 1.8 births per woman over their lifetime, it's going to have a notably negative impact on Social Security's worker-to-beneficiary ratio, and it'll almost certain cause the program's cash shortfall to widen. As with increasing longevity, a "tax-the-rich" strategy may not account for the magnitude of cash shortfall that persistently low fertility rates could bring about.

Third, and finally, we have to remember what happened when the wealthy had significantly higher marginal tax rates imposed decades ago. Despite peak marginal federal income tax rates of 70% to 90%, most rich Americans avoided an effective tax rate of anywhere near this number. Yes, tax loopholes helped, but the response by the wealthy to shift their earned income made an arguably bigger difference.

What does this have to do with payroll tax revenue? The simple answer is that there are a number of income sources that aren't subject to the payroll tax, including pretty much all types of investments and rental income. Wealthy individuals could simply repurpose their income generation to these exempt sources and retain more of their money. Not to mention, the response by the rich to higher Social Security payroll taxes may disrupt economic growth via lower reinvestment. That would be a secondary means of lowering taxable revenue collection.

Don't get me wrong: I do believe that a bipartisan approach that includes a higher tax rate on upper-income earners is needed to help shore up Social Security. But taxing the rich may not be enough by itself to fully fix Social Security.

This article originally appeared in the Motley Fool.

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