The Social Security Tax Cap

Should the earnings cap for paying Social Security taxes be raised? The author says it has a downside and offers an analysis with examples.

According to the Congressional Budget Office, raising the federal retirement age to 70 would solve about half of (the) Social Security funding problem, while lifting the payroll tax cap would solve all of it.

The Washington Post  Oct 15, 2012

There is a good deal of concern, and much discussion, about entitlement changes.  Regarding Social Security, in particular, should the full retirement age be raised to 70?  Maybe a better idea would be to raise the earnings cap (aka: tax max) for paying Social Security taxes.  This idea seems to be more in favor than raising the retirement age.   However, like so many other ideas that look pretty good, it has a down side.  What is the down side?  What is the impact?

Lifting the cap on contributions to Social Security would simultaneously lift the cap on how much salary is included for calculation of the retirement benefit, or Primary Insurance Amount (PIA) .  It appears to be a “wash” – take more money from the high earners and then pay them a correspondingly higher benefit. Experts call the higher benefit “leakage.” But the leakage is not really a wash.

Social Security commissioned an interesting study on leakage, by three outside professors. A primary finding of the study is that even with the leakage, raising the tax cap would still result in a reduction of the SSA deficit, long-term.  The same conclusion was reached, to one degree or another, by the Congressional Budget Office, by the Congressional Research Service, and by the SSA Office of the Actuary, in a 2010 study for the Senate Committee on Aging..

Calculation of the PIA benefit favors low earners.  That is, a three-tier formula is configured to provide low earners a higher percentage of their earnings (Average Indexed Monthly Earnings, or AIME).  High earners get a lower percentage.  Let’s look at three 2013 examples:

Earner AIME Benefit Percent of AIME
John $700 $630.00 90.0
Mary $2400 $1226.38 51.1
Leonard $6000 $2248.44 37.5

Clearly, the higher the earnings, the lower the percent of earnings recovered.

Cap lift example.  Employee has been a high earner for 34 years.  Calculation is for earnings in 2012, his 35th year of earnings, which are $200,000 for the year.

Tax Additional Monthly
Employee Employer Total Benefit (aka: leakage)
Cap ($110,100) $6,820 $6,820 $13,640 N/A
Cap Lifted $12,400 $12,400 $24,800 $32.10 ($385.20 annual)

Without the cap, the employee pays $5,580 more in taxes, and his monthly benefit increases $32.10.  Including the employer contribution, the total additional taxes received by the trust fund in this example are $11,160.

Raising the earnings tax cap increases revenue for the fund significantly, even though the employee receives a higher benefit.  The high earners get something for their increased contributions, but the return is less generous than at the lower levels. Greater income for the fund means greater solvency for the Social Security program, which is what policy makers – and the rest of us – want.

However, questions remain.  Should there be no earnings cap at all?  Or should it be raised significantly?  It would seem there should be some kind of upper limit.  This would rule out extreme situations, like high earners who make, say, 500k or more per year and who would receive disproportionately large benefits out of line with Social Security intentions.

Retaining the cap for benefits calculation makes the claim “…lifting the payroll tax cap would solve all of it” (i.e., the funding problem) more plausible.  At the same time, however, it would mean high earners would receive no return at all for their higher contributions.  As a practical matter, this could be a real problem.

How much would lifting the cap save?  Due to complexity, uncertainty, and variability, this is quite difficult to calculate precisely.  But, as the Social Security professors study points out, there is no question among authorities that this initiative would be a net benefit to the fund:

To be sure, our estimates of the size of leakage of additional taxes into benefits are bracketed by the estimates of the CBO and CRS.  However, the differences are substantial, with the CBO estimate of leakage at about one-third, the CRS estimate at about two-thirds, and ours falling between, at roughly one-half.

In conclusion, despite leakage, and the unanswered questions, lifting or removing the earnings cap definitely appears to be a worthwhile policy change for improving the health of Social Security.

About the Author

Robert Benson served 35 years in various Federal agencies, as both a management analyst and IT specialist. He is a graduate of Northwestern University.