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October 20, 2003

Social Security Easy to Fix: Remove the Cap

No Crisis: The first thing to understand about Social Security is that there is no crisis, no need to do much of anything at all. On one hand, the economic assumptions used to promote a "crisis" in social security are just too pessimistic. Read this EPI brief.

Beyond the regular numbers, the general idea of crisis was always based on the idea of the population getting old and there not being enough workers to continue paying into the system. Increasing immigration is solving that problem as well.

A Fair Solution: But if any "solution" is needed, the simplest is the fairest. Currently, while a minimum wage worker pays 6.2% of his income into the social security trust fund -- $12.4% if you include the matching employers portion -- a CEO paid a $1 million dollars pays only 1% of his salary into the system. And Bill Gates pays nothing into the system from his billions in stock income.

This all stems from the fact that wage income above a certain level -- $87,000 per year in 2003 -- is completely untaxed by social security. Eliminating this so-called "cap" would raise plenty of income to help out the system. Only 83% of all wages paid are subject to social security taxes, so this would increase annual social security revenues 20%, or roughly $100 billion per year, plenty

This is hardly a radical idea-- the "cap" used to apply to the payroll taxes funding Medicare, but the 1993 tax bill removed the cap and now every dollar of wage income is taxed to help fund the Medicare system. There's no reason not to do the same for social security.

A "New" Tax on the Wealthy?: Now, conservatives will scream that this is an additional tax on the wealthy, but in reality it would be applying the same tax already paid by poorer working families to everyone the same way. Every dollar earned, whether by a minimum wage worker or by a CEO, would be taxed the same 12.4% (6.2% of employee income, an additional 6.2% from the employer).

With the social security "cap" in place, federal taxes on wages are not really very progressive, especially when you look at marginal tax rates-- ie. the tax on each additional dollar earned. Lifing the cap will just restore a marginal amount of progressivity to the tax system.

An Irrational Tax Code: Look at the following tables and accompanying chart for single taxpayers, which combines the standard deduction, Medicare tax, the regular income tax, and the social security tax (employee portion) to calculate the total marginal taxes paid at different income levels. Note that the social security portion is adjusted for the odd phase-in and phase-out of the Earned Income Tax Credit for the working poor. (For poor working families with kids, the EITC phaseouts play larger havoc with marginal rates reaching well over 40%, far higher than marginal tax rates paid by millionaires.)

MarginalTaxRates-table.GIF

MarginalTaxRates.GIF

What should be obvious is that millionaries are paying almost the same marginal tax rate on wage income as professionals making $75,000 per year and only a bit more than most working and middle class families. (If you add in the employer portion of social security, the wages of working families are taxed more heavily than CEO salaries.)

What we have is a truly bizarre system where all wages between $87,700 and $151,300 gets taxed at a LOWER marginal tax rate than wages paid to those making $40,000 per year. This is just a strange way to run a tax code.

Imagine getting rid of the cap-- doesn't the following seem like a more rational tax code? (Ignoring the EITC oddness, which Max Sawicky is working on).

MarginalTaxRatesWithoutCap.GIF

Ahhh....much better. And social security is saved!

A Conservative Complaint: I can hear them now, complaining that these charts are misleading, since they look at marginal tax rates rather than the actual percentage of income paid in taxes-- which would make taxes on wages look more progressive.

And they're right. Calculating the overall taxes paid is a bit complicated (as everyone knows from tax time), but the following table gives a stripped down accounting, pretending that none of these taxpayers take any deductions other than the standard one. To reiterate, this is not the marginal tax rate, but the overall percentage of all income paid in taxes at each income level:

TaxPaid.GIF

So that millionaire is paying a higher percentage of his or her salary in taxes than the janitor. Well, that's kind of comforting.

Lower Taxes on Investment Income: Except...that table applies only to WAGE income (and ignores all the fancy deductions used to avoid paying taxes), and richer folks tend to earn a large percentage of their income from capital gains and dividends. Such investment is income is not taxed at all for social security and now pays a much lower income tax rate, a maximum of 15% under Bush's new tax law.

So let's imagine three people, one making $50,000 in wages, another making $80,000 in wages, and another living off their investments, making $150,000 per year in capital gains. Here's what their marginal tax rates, total taxes paid, and overal taxes paid as a percentage of income look like:

CompareTaxRates.GIF

Essentially, in absolute taxes paid, the person with the $80,000 wage is paying the same amount of taxes as the rich investor, while both wage-earners are paying a much higher percentage of their annual income in federal taxes.

Which hardly seems right.

Adding Investment Income to the SS System: So since we're talking about expanding the base for social security, why shouldn't non-wage income be taxed to help fund the system? And to help out Medicare by assessing that portion of the wage tax as well on investment income.

There is roughly $147 billion in dividend income claimed annually by taxpayers. Back in 2000, there were about $650 billion in capital gains.

Even assuming that in the post-dotcom bust, the total of both of those added together is only around $500 billion per year in investment income, just taxing that amount at the employee social security and medicare rate (7.65%) would yield an additional $38.5 billion per year, or $77 billion if the equivalent of the employee and employer taxes was assessed (15.3%), as it is on self-employed wage earners, the best analogy to those living off their investments.

So between lifting the cap for higher wages and assessing the tax on investment income, we could add something on the order of $170 billion each year into the social security and Medicare systems.

Seems a far more compelling alterative to the privatization schemes being promoted by conservatives.

An Alternative View: Here's a Heritage Foundation critique of removing the cap.

Posted by Nathan at October 20, 2003 01:30 AM