A stealth tax

Bruce Bartlett
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Posted: Dec 23, 2004 12:00 AM

Although President Bush has said that he would not increase Social Security taxes to pay for private accounts, some of his aides are floating the idea of a stealth tax increase on the wealthy, nevertheless. On Dec. 19, White House Chief of Staff Andrew Card and Treasury Secretary John Snow were asked on different Sunday talk shows whether the administration would support an increase in the Social Security wage cap, and both pointedly refused to rule it out.
 
Since the Social Security system was created, the payroll tax has applied only to a portion of total wages. Originally, the limit was $3,000, which Congress raised from time to time. Since 1972, the wage base has been indexed and rises automatically each year. This year, it was $87,900. Starting on Jan. 1, the taxable wage base will rise to $90,000. Thus, the maximum tax one can pay will rise by $260.

 When Franklin D. Roosevelt put this system into place, it wasn't out of love for the wealthy. Rather, it was in order to maintain some reasonable relationship between taxes and benefits for everyone who pays into Social Security. Because one's benefits are a function of one's covered wages, having no cap would either lead to much higher benefits for high-income workers than would be politically tolerable or benefits that were minuscule in relation to taxes paid.

 As it is, there is already an increasingly tenuous relationship between taxes paid and benefits received by high-income workers. According to the Congressional Research Service, in 1980 a retiree with lifetime earnings at or above the Social Security wage cap got back all of his and his employer's contributions in 3.1 years. By 2000, it took 24.9 years, and by 2010 it will take 35.3 years. Under current projections, a high-income worker retiring in 2030 will need 55 years worth of benefits to get back all his contributions.

 If the cap is removed and benefits are limited to current levels, the return for high- income workers will become nonexistent. This means that Social Security will no longer be a pension system to which one earns benefits, but will instead be nothing but a welfare program. If the wage cap is raised and the benefit formula is unchanged, then higher future benefits will eat up all the revenue gain in the long run.

 Even if benefits are frozen, the revenue gain from lifting the wage cap isn 't that great. According to Matt Moore of the National Center for Policy Analysis, it would only increase the life of the Social Security trust fund by seven years on a static basis. But this is a generous projection given that high-income workers would undoubtedly shift their income out of wages and into dividends and capital gains, to which the payroll tax does not apply.

 Of course, another consequence of raising the cap is that it will constitute a massive marginal tax rate increase. The top rate on wages will, in effect, rise by 12.4 percent, raising the de facto top rate from 38 percent to more than 50 percent (including the 2.9 percent Medicare tax, which has applied to all wages since 1993). This will reduce labor supply, encourage tax-sheltering activities and move tax policy in the opposite direction that President Bush has been going for the last four years.

 A study by the Institute for Research on the Economics of Taxation says that the negative economic effects of raising the wage cap could be devastating: "On an income-weighted basis, there would be a net reduction in work incentives economy-wide."

 A Heritage Foundation analysis found that lifting the wage cap would constitute the largest tax increase in American history, raise the unemployment rate, reduce the personal saving rate by about one half of a percentage point and reduce real economic growth by about a tenth of a percent per year.

 Among those hardest hit will be owners of unincorporated businesses. Economist Eugene Steuerle of the Urban Institute notes that they must pay both the employer's share and the employee's share of the tax. Moreover, because sole proprietors cannot separate wage and capital income, in effect much of the tax falls on capital rather than just wages. To avoid this problem, every small business would have to incorporate, which may or may not be desirable economically.

 Despite the many adverse consequences of raising the Social Security wage base, I believe that President Bush has little choice except to consider it in order to finance the estimated $1 trillion to $2 trillion cost of establishing private accounts. I think that the conspicuous unwillingness of he and his senior aides to rule it out is a classic Washington trial balloon. If there is a strong negative reaction, it will be rejected. But if the reaction is passive, it could move forward.