The Economic Cost of the Social Security Payroll Tax

Policy Reports | Social Security

No. 252
Friday, June 28, 2002
by Liqun Liu and Andrew J. Rettenmaier

Executive Summary

The payroll tax that funds Social Security, Medicare and Disability Insurance, called FICA (Federal Insurance Contributions Act), is already the largest tax most American families pay. In the future, it will claim an even greater share of Americans' incomes. From its current level of 15.3 percent (combining the employer and employee shares), the payroll tax will need to rise above 25 percent of workers' incomes by the middle of the century in order to pay benefits to today's teenagers when they retire.

Adding this tax to other taxes on labor income results in a surprisingly high marginal tax rate for average-income families:

  • When all taxes on labor income are combined, the average American family faces a 44 percent marginal tax rate.
  • This implies that, on the average, families get to keep only 56 cents out of each additional dollar they earn.

Because of the growing burden of elderly entitlement programs, these tax rates are expected to rise through time:

  • By 2050, when today's teenagers reach retirement age, the marginal tax rate the average family faces will be 53 percent.
  • If the system is not changed, by the time today's newborns retire, taxpayers will keep only about 40 cents of every additional $1 they earn.

These very high tax rates cause economic harm. The current system encourages people to work fewer hours and produce fewer goods and services, relative to an efficient tax system. We estimate that:

  • The cost to society as a whole from the Social Security payroll tax alone is between 11 cents and 18 cents for every dollar of tax revenue collected.
  • For society as a whole, this loss amounted to between $49 billion and $82 billion in 2001, an amount equal to as much as $804 for every household in America.

Looking to the future, we find that the payroll tax required to pay benefits will rise and the cost of the tax to the country as a whole will rise even faster:

  • By the time today's teenagers reach the retirement age in 2050, the nation will be sacrificing as much as 30 cents for every dollar collected in payroll taxes.
  • By the time today's newborns retire in 2070, the cost to society as a whole will be as much as 34 cents for every dollar collected.

One way to avoid these high costs is to move to a system that requires people to save for their own retirement, instead of paying taxes to support the retirement of others. Such a mandatory savings program would not discourage people from working because they would get to keep every dollar they earned.

We have examined several ways of reforming the current system, including complete privatization. However, even a totally privatized system must include a mechanism for funding the benefits people have already earned under the current system. One way is to issue bonds to people (equal to the present value of their already earned benefits) and to pay interest on the bonds with revenue from a payroll tax. Another way is to use the payroll tax to pay accrued benefits directly. Either alternative will provide big gains for the country as a whole:

  • Under the bond approach, by mid-century the reformed system will have reduced the annual cost of the payroll tax by 60 percent.
  • Under the tax approach, by mid-century the reformed system will have lowered the annual cost by 72 percent.

The Bush administration and Congress are discussing a more limited reform that would allow workers to deposit 2 percentage points of their Social Security payroll tax in a personal retirement account (PRA). Over time, PRA accumulations would partially replace Social Security benefits, leaving total benefits virtually unchanged. Even this limited reform will have a substantial payoff:

  • By mid-century, the reform will have reduced the economic losses of the current system by almost one-third.
  • By the time today's newborns reach retirement, it will have reduced the losses by more than half.

This report focuses on only one of the social costs of pay-as-you-go Social Security. There are also other costs. For example, the payroll tax encourages employers and employees to substitute non-taxed fringe benefits for taxable wages. It also induces workers to save less than they otherwise would because (a) Social Security promises are a substitute for private savings and (b) the payroll tax leaves them with less income from which to save. These distortions also have economic costs. When all costs are considered:

  • The total cost to society of operating our Social Security system was as high as $328 billion last year.
  • To put this in perspective, the U.S. government spent $439 billion on Social Security retirement benefits last year.

Roughly speaking, for every four dollars the system pays out in benefits, society as a whole bears up to a three dollar cost.

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