How Income Inequality Undermines Social Security's Finances

A recent study reveals how rising income inequality is jeopardizing Social Security’s finances.

It is by now common to hear Social Security advocates demand that we “scrap the cap” on earnings subject to the Social Security payroll tax.

This is an important appeal. Few Americans realize that millionaires only contribute to Social Security on the first $110,100 they earn. If they did, perhaps they’d be even more adamantly opposed to the benefit cuts many in Washington are proposing.

But even fewer people realize that the “cap,” or taxable maximum, as it is called more officially, at one time covered a far larger share of earnings, existing in harmony with fully-funded Social Security benefits. In fact, the cap was baked into Social Security from its inception.

The Evolution of Social Security’s Taxable Maximum [1], a recent study by Kevin Whitman and Dave Shoffner from the Social Security Administration’s Office of Retirement Policy, shows how rising income inequality has greatly increased the amount of earnings above the tax-max, depriving Social Security of much-needed revenue and shifting a larger share of its financing onto middle- and low-income workers.

The truth is that Social Security’s taxable maximum was born of smart policymaking. The tax max helped Social Security meet “the goal as a social insurance program of focusing on low- and middle-income workers who were more likely to be economically vulnerable in retirement.” FDR initially proposed to exempt high-income earners. The House Ways and Means Committee replaced the exemption with a taxable maximum on earnings, reasoning that virtually all workers need at least some basic level of protection against lost wages in old age. Moreover, fluctuations in individuals’ income above and below the exemption level would cause the number of workers covered by the program to fluctuate.

The tax max started at $3,000 in 1937, the first year covered workers began contributing to Social Security. Congress increased the dollar amount on an ad hoc basis for several decades thereafter, in much the way it raised benefit levels and expanded coverage to new sectors of employment. In 1972, Congress finally indexed the tax max to changes in the average wage index. Because the automatic indexing put in place in 1972 did not work as intended as a result of the unanticipated stagflation of that decade, Congress modified it and specified as a goal that 90 percent of all wages nationwide be insured against loss by Social Security. These measures were largely successful, bringing the portion of earnings covered by Social Security to 90 percent of earnings in 1982 and 1983.

Since that time, the tax max has continued to go up with average wage increases, but rising income inequality has caused the percentage of the country’s total earnings covered by the tax max to steadily decline. [2] “Wages above the tax max generally have grown more quickly than wages overall,” Whitman and Shoffner write. The percentage of the country’s earnings covered by the tax max has dropped from 90 percent in 1983 to 84.2 percent in 2010, and is slated to drop to 83 percent in the coming years. This seemingly small slippage translates to billions of lost revenue for Social Security every year.

While the percentage of the country’s earnings above the cap has increased, the percentage of workers with earnings above the cap has remained static—a telling reflection of the extent to which wealth is now concentrated in the hands of the few. In 1983, 6 percent of workers accounted for the 10 percent of the country’s earnings above the tax max. In 2010, the same percentage of the workforce accounted for a much greater portion of earnings above the tax max—nearly 16 percent.

Even if Social Security were not facing a modest shortfall beginning in 2036, the drop in the percentage of covered earnings below 90 percent deserves correction. Several Washington commissions have proposed raising the tax max to gradually cover 90 percent of earnings once again. This would in fact close one-third of Social Security’s projected long-term shortfall.

But increasing the tax max is often pitched as a major concession to the Left, rather than a correction for the consequences of rising inequality. As such, the price of its passage becomes wholesale passage of major benefit cuts that please the Right, but dismay the public.

If politicians in Washington want to be honest with the American people, they would raise the tax max as a matter of course – and should have decades ago—not use it as a pawn in negotiations to cut the program. Better still, they could enact policies to reduce income inequality so that more of Social Security’s earnings remain taxable.

If politicians want to completely restore Social Security to long-range balance, they should consider scrapping the cap entirely. That is what, poll after poll reports, the American people overwhelmingly favor.