Is Wage Inequality Hurting Social Security?

Millions of seniors today rely heavily on Social Security to cover their living expenses. That’s in spite of the fact that beneficiaries have been losing buyer power for years as inflation has outpaced Social Security raises.

Making matters worse is the potential for Social Security cuts in the not-so-distant future. The program’s trust funds could be out of money in about a decade’s time. Once that happens, benefits could be slashed to a large degree in the absence of adequate revenue.

A big part of the problem stems from the fact that baby boomers are leaving the workforce at a rapid clip. Since payroll tax revenue is Social Security’s primary funding source, shrinking labor force participation rates could put the program in a financially fragile spot.

But that’s only part of the issue. What’s also problematic is the method by which payroll taxes are imposed — and the fact that they tend to burden lower earners much more so than the wealthy.

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When wage inequality rears its ugly head

Workers pay a 12.4% Social Security tax on earnings that’s split into two parts among salaried employees, with workers themselves paying 6.2% and employers picking up the second half of that tab. Those who are self-employed must cover the entire 12.4%.

That tax, however, doesn’t apply to all earnings. Rather, there’s an annual wage cap put into place that dictates the thresholds at which payroll taxes apply. This year, that limit is $147,000.

What this means, though, is that many high-income individuals get away with paying very little payroll tax relative to their total earnings. Meanwhile, lower earners commonly pay Social Security tax on their entire earnings.

But in recent years, wage growth among lower earners has stalled compared to wage growth among higher earners. And since 1983, the share of untaxed earnings has risen sharply from 10% to almost 17.5%, according to the nonpartisan Center for American Progress. As a result, Social Security has lost out on a world of revenue — revenue it needs to keep up with scheduled benefits.

Addressing the problem at hand

To address Social Security’s impending financial shortfall, lawmakers have proposed raising or eliminating the wage cap so that higher earners pay more Social Security tax on their income. This year, someone earning $147,000 pays the same amount into Social Security as someone earning $3 million, so getting rid of the wage cap or lifting it substantially could put an end to what many deem an extremely unfair system.

But it’s also important to remember that while higher earners don’t pay Social Security taxes on earnings beyond a certain point, income above the wage cap also doesn’t count for the purpose of calculating benefits, which are wage-based. And so if a higher threshold for payroll taxes is established, it’s going to be hard for Social Security to not readjust its formula to account for higher wages when determining what benefits recipients are in line for.

The end result could wind up being a wash. Social Security might see its revenue increase by taxing earnings at a higher level. But if it then has to pay higher earners a more generous benefit in retirement, the program doesn’t really come out ahead.

Of course, there’s always the option to tax wages above the cap but keep the maximum benefit as-is. But that’s a solution that’s unlikely to sit well with the wealthy, who tend to be politically influential.

All told, there’s really no obviously great solution to Social Security’s financial woes. But with any luck, lawmakers will at least start exploring ways to ease the burden of payroll taxes on lower earners.

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