The Economic Cost of the Social Security Payroll Tax

Studies | Social Security

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


Introduction

Social Security is an income transfer program that takes money from some and gives it to others. To that extent, one person's gain is another's loss. In the process of transferring income from some to others, certain social costs arise. These costs make society as a whole worse off. In general, three separate costs arise as a result of Social Security's existence and payroll tax financing:

  • The Social Security payroll tax makes work and production less attractive relative to an efficient way of raising the same revenue.
  • Because wages are subject to the tax while benefits are not, the Social Security payroll tax causes a shift from taxable wages to fringe benefits, a shift that leaves workers with a less desirable compensation package.
  • The Social Security system also encourages people to save less because (1) the payroll tax leaves workers with less disposable income from which to save and (2) Social Security benefits remove an important reason for people to save.

"There are hidden costs of Social Security."

These are the hidden costs of Social Security. This paper focuses on the first of these: the labor supply distortion caused by the Social Security payroll tax. With respect to these costs the theory is less controversial and there is a greater consensus on the empirical magnitude of the parameters involved. A payroll tax results in fewer hours of work than would a lump-sum tax that generates the same tax revenues. (A lump-sum tax is one that does not vary according to the amount of work.) Economists call these losses "welfare losses." The welfare loss of a tax system is the extra burden it imposes on taxpayers, over and above the revenue collected by government.


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