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Don’t blame income equality for the fall of Social Security

In almost any debate about Social Security, someone will declare that eliminating the cap on taxable wages is the program’s salvation.  Eliminate the cap, problem solved.

The argument invariably justifies this change by asserting that income inequality is culprit behind the financial imbalances of the program. Specifically, supporters claim that the disproportionate growth in compensation over the cap has driven the amount of wages subject to FICA taxes down from 90 percent of total wages in 1983 to a share of 81 percent in 2007, (see note).  The argument infers that the wages which escape taxation are the downfall of Social Security.

{mosads}The data is accurate. Social Security’s hold on the wage base has declined over the last 30 years. The majority of that fall, however, occurred more than 25 years ago. It seems unlikely that income inequality in 2015 was a significant factor in wage-allocation during the 1980s.

The biggest drop in Social Security’s hold on wages occurred in 1987 and 1988.  These two years combine to account for nearly 50 percent of the overall fall in the system’s revenue base. By 1988, wages subject to FICA taxes had fallen below 86 percent of the total. Since that time, the figure has dropped to an average of 84 percent. So the trend is not current news.

The most likely culprit in the decline of Social Security’s hold on the wage base is the government’s tax policy. The Tax Reform Act of 1986 altered the incentives to how high-income earners recognize their income.  This law removed from the tax code many of the incentives and tools that high-income workers used to shelter wage earnings. As a result of this law, the wages above the cap likely rose more rapidly because high income earners chose to hide less earnings in non-wage compensation.

Income inequality may be rising in 2016. The phenomena is however not a cause of the erosion in the program’s finances. Much of the unevenness of income takes shape in capital earnings which are not part of the system’s revenue base.

Social Security’s portion of wages since 1988 have fallen modestly. Part of that drop stems from rising employment costs. Most economists accept that these costs, such as the employers’ share of payroll taxes, are passed on to employees in the form of lower wages. 

Research from the Social Security Administration supports that conclusion.  That paper asserted that employment costs that make-up a higher percentage of compensation below the wage cap will exert ‘a disproportionate downward pressure on money wages’ below that threshold.

Payroll taxes are such a cost.  The levy adds a fee of 6.2 percent to all wages below the cap.  It creates no incremental expense above the cap.  Employers have to slow the growth of wages on which the tax applies in order to recover the cost.

Introductory economics teaches us that people do not like to pay taxes. Common sense tells us that people will avoid the levies if possible. Both employers and employees want to maximize the value of a paycheck. Workers are more likely to shift compensation below the wage cap to benefits which fall outside of program’s reach.

It cannot surprise anyone that wages subject to a tax of 12.4 percent grow more slowly than those wages which are exempt. If tax policy targets a spectrum of wages, employers will offer more efficient pay, and employees take it.

If anything Social Security and its financing maybe the source of growing income inequality rather than a casualty of it.

Brenton Smith (A.K.A. Joe The Economist) is the founder of “Fix Social Security Now” which provides information on all alternatives in the public debate on Social Security through its site www.FixSSNow.Org. 


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