Friday, July 25, 2014

Can Social Security Be Saved By Payroll Tax Reform? Maybe, Maybe Not.

A few days ago, the Congressional Budget Office (CBO) released their annual long-term budget outlook report. In this report, there was some not-so-shocking news about Social Security: the year in which Social Security funds will be exhausted has moved up to 2030 (p. 51). The lower interest rates and economic growth projections were reportedly the reasons for the timetable being pushed up a year from last year's projections. Although Social Security's Disability Insurance and Medicaid have more pressing fund exhaustion dates, this is still perturbing. The Left-leaning Urban Institute shows that across the demographic board, we receive more in Social Security and Medicare benefits than we pay in payroll taxes. What the government is doing is not fiscally sustainable. We need to find superior policy alternatives compared to the status quo. Back in 2010, the Congressional Budget Office (CBO) analyzed various methods of policy alternatives that would improve the longevity of Social Security. What tends to be a popular policy alternative, particularly those who are Left of center, is payroll tax reform.

Payroll tax reform takes a few forms. One is to raise the payroll tax. As of date, the current Social Security payroll tax is 12.4 percent, half of which is paid by the employer, and the other half by the employee. If you are self-employed, that means you have to pay the full 12.4 yourself directly. The proposal would be to raise the tax either in the amount of 1, 2, or 3 percentage points (CBO, 2010, p. 17). The other popular policy alternative is to remove or alter the payroll tax cap. With Social Security, there is a limit at which one's earning are subjected to the Social Security payroll tax. The current cap is at $117,000. Let's say you make $200,000. Only $117,000 would be taxed, and the remaining $83,000 would not be taxed. This means that there is a maximum amount of Social Security benefits one would receive. When Social Security was created, the reason for the cap was to make sure that Social Security was only meant to be a form of financial relief, as opposed as a full-blown welfare program.

In all honesty, I do not think that either raising payroll taxes or altering the payroll tax cap are good ideas. What's wrong with a payroll tax?

Let's start with that it causes moderate, adverse effects on hours worked (CBO, 2010, p. 15; Liebman and Saez, 2006). It also disincentivizes people from saving (CBO, 2010, p. 16), not to mention that it will incentivize employers to either pass the costs onto their customers or lay off workers. I have to wonder if it would actually work. Where the CBO gets the idea that a 2 percent increase in the payroll tax will prevent from funds being exhausted for another twenty-plus years, I'll never know (CBO, 2010, p. 12, Figure 5) because it won't. I literally cut and pasted this chart [below] from the Social Security Administration showing its negligible effect.

What about removing the payroll tax cap? What I can say for the tax cap removal is at least it would, according to SSA projections, help with maintaining funds.

Even if that were the case, and it might not be, I'm not satisfied with the cap removal as an alternative. First, there is no empirical evidence showing that trust fund assets do anything to improve publicly-held debt. Second, one of the talking points from proponents is that the removal of the cap would only affect about six percent of workers. What they forget is this little thing called income mobility. Most people don't maintain the same salary for their entire lives. Experience helps individuals "move up the ladder" and gain higher salaries, which would help explain why those who are older have a higher average salary than those who are younger. Since Social Security benefits are calculated based on lifetime average wages, as opposed to annual wages, a payroll tax cap would actually affect twenty percent of all workers. The Right-leaning Heritage Foundation also points out that removing this tax cap would substantially increase the marginal tax rate. Take a look at who is taxed by tax bracket, and I can tell you that this policy alternative would stick it to the middle-class more than the ├╝ber-rich. It would be even more problematic if removing the cap also meant making sure that higher-income individuals would receive the same benefits as they did without the cap. One of the reasons that Social Security isn't viewed as a form of welfare is because the link between contributions and benefits remains. The fact that Social Security is a modest form of supplemental income for retirees is what helps retain its popularity.

Let's say that either policy, or even both policies, could take care of some of the fiscal woes, even though the CBO doubted the fiscal solvency of either (CBO, 2010, p. 13). I would still have a problem with these policies because it does nothing to reform the quality of Social Security. Whether you propose payroll tax reform, raising the retirement age, or decreasing benefits, it doesn't change the fact that Social Security is still a coercive retirement savings program with a lousy rate of return and is one of the major cost drivers in the federal government budget. On a personal level, nothing short of retirement funds privatization would make me completely happy. Even treating the program as a safety net [in the strictest of terms, to be sure] or allowing for citizens to take part of that tax and stash it away in a private retirement account would at least be steps in the right direction (see Minneapolis Fed report here for similar reforms). Until quality can be addressed while discussing Social Security reform, we're merely perpetuating the same mediocre policy.

3-2-2015 Addendum: The American Enterprise Institute put out a nice list of eight reasons why raising the Social Security tax cap is a bad idea.

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