The Economic Cost of the Social Security Payroll Tax
Friday, June 28, 2002
by Liqun Liu and Andrew J. Rettenmaier
Table of Contents
The Social Cost of the Social Security Payroll Tax
The formulas used to estimate the welfare loss are presented in the Appendix, but the basic intuition is that a payroll tax on labor income does two things: (1) it lowers individuals' willingness to work and (2) it lowers their discretionary income. These two effects work in opposite directions in terms of the impact on the number of hours people work. A tax on labor reduces the value of working another hour because people get to keep less of what they earn. Taken by itself, this effect tends to lower the number of hours individuals work. But because the tax also lowers income, workers tend to work more hours in order to replace at least part of that loss.1
The welfare loss arises from the first effect, not the second. The measure of this loss tells us how much worse off individuals are with the Social Security tax relative to a tax that raises the same revenue but does not distort labor supply decisions. Calculating the welfare loss requires estimates of how responsive workers are to changes in their wages and the levels of the various taxes on labor. To isolate the cost of the Social Security tax, we must first identify the welfare loss associated with all other labor taxes, then calculate the additional welfare loss that arises when the Social Security tax is imposed.
Direct and Indirect Taxes on Income. We begin with the weighted-average marginal tax rate on labor income from the federal income tax. We use an average of the marginal tax rates paid of 20.15 percent. This was the weighted average marginal tax rate paid in 1999 across all tax returns categorized by adjusted gross income categories.2
"The payroll tax imposes a burden over and above any revenues the government collects."
Since state income taxes yield about 20 percent as much revenue as the federal tax and use much the same tax base, we assume they increase the marginal tax rate on labor income by 20 percent of the federal marginal rate, or 4.03 percent. We treat sales and excise taxes as a uniform levy on labor income (and other income) at a rate of 4.4 percent, since that is their percentage of national income. All these direct and indirect levies on labor income together amount to a combined marginal tax rate on labor income of 28.58 percent. This rate is shown in the second column of Table I.
Other Payroll Taxes. The Medicare tax rate is currently 2.9 percent and the Disability Insurance tax rate is 1.8 percent. Since these rates are not high enough to maintain the programs' solvency, they are expected to increase over time. Adding the Medicare and Disability Insurance tax rates to the second column gives us the combined marginal tax rates for various years, shown in the fourth column of Table I.
The Social Security Payroll Tax. The Social Security payroll tax is the second-largest tax in the United States, following the federal individual income tax. The Old-Age and Survivors Insurance (OASI) component alone is 10.6 percent. Like Medicare and Disability Insurance, OASI will require additional funding in the future.3 To close the financing gap, we estimate that, beginning in 2017, the OASI payroll tax rate will have to increase to pay annual benefits.4 Adding this tax to other taxes on labor income results in a surprisingly high marginal tax rate for average income families:5
- 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.
- By 2050, when today's teenagers reach the retirement age, the average family will face a marginal tax rate of 53 percent.
- If the tax system is not changed, by the time today's newborns retire, taxpayers will get to keep only 40 cents out of every additional $1 they earn.
"When all taxes are considered, the average family gets to keep only 56 cents out of each additional $1 of earnings."
Estimating the Pure Social Security Payroll Tax. In general, only a loose relationship exists between the Social Security tax paid on a marginal dollar earned as wages and the incremental Social Security benefit produced by that tax. The strength of the relationship declines as income rises. One could argue that the average worker sees little relationship between taxes paid and benefits received, at the margin. However, to the extent that workers perceive they are getting back benefits directly related to the taxes they pay, they will not view the tax as a total loss. Instead, the net burden is the tax minus any perceived benefits the tax generates. Economists call this net tax a "pure tax."
One way to measure this net burden is to compare the rate of return workers can expect to receive on their payroll tax dollars with the rate of return they could have earned had those tax dollars been invested in the capital market instead. When the rate of return on Social Security tax payments is less than the market rate of return, a portion of workers' taxes are pure taxes. In what follows, we assume that the real return on capital, taking into account corporate taxes, is 5.4 percent.6 In contrast, the real rate of return from a mature, pay-as-you-go Social Security system is the growth rate of the Social Security payroll tax base, which in the long run is only about 1.3 percent.7
"By the time today's newborns retire, taxpayers will get to keep only 40 cents out of every additional $1 they earn."
Suppose a worker is taxed $1 and 35 years later the government returns to the worker an amount equal to the $1 plus annual compounded interest payments of 1.3 percent. The total will be $1.57. But how much would we need to invest today at the market rate of return of 5.4 percent to arrive at the same $1.57? The answer is $0.25. In this example, the pure tax is $0.75 or 75 percent of the original tax.
For workers born in different years, Social Security rates of return vary considerably. Individuals who retired soon after the system began did very well. But as the system has matured rates of return have fallen. In a study of Social Security's treatment of individuals born after World War II, Steven Caldwell and his colleagues reported that individuals born in 1946 can expect a 2.4 percent rate of return, while those born in the 1970s will earn a 1 percent rate of return.8 The study found that 74 percent of the OASI taxes paid by individuals born after WWII are a pure tax. For the oldest baby boomers, 55 percent of their OASI taxes are pure taxes, but for today's newborns the pure tax component will be 81 percent. Similarly, our estimates show that:
- Single men who retired in 2000 will receive a 2.2 percent rate of return.
- Married men with non-working spouses who retired in 2000 will receive a 4.4 percent rate of return.
- Recent male labor market entrants can expect a rate of return of only 1.6 percent.
"A worker's rate of return from Social Security is only about 1.3 percent, versus a market rate of return of 5.4 percent."
Given that the pure tax component of Social Security differs for different groups of taxpayers at any point in time, based on the taxes they pay and the benefits they receive, we identify each year's pure tax as the weighted average of each age group's pure tax.9 The statutory and pure Social Security payroll tax rates in the future are shown in the fifth and sixth columns of Table 1. Even after reducing the tax rate by expected benefits, the marginal tax rates are still quite high. As the table shows:
- Net of expected Social Security benefits, the average marginal tax rate today for the average worker is almost 40 percent.
- By the time today's newborns retire, it will exceed 50 percent.
Note that using a pure tax rather than the statutory tax is a conservative approach that probably underestimates the burden of Social Security taxation for two reasons. First, the calculation of the pure tax is based on average benefits paid, rather than on marginal benefits generated by marginal taxes paid. As noted above, there is a loose relationship between a worker's expected benefits and the tax on the wages earned by the last hour of work. Second, our approach treats benefits promised years from now as if they are certain to be paid. In fact, due to uncertainty about future taxes and benefits, individuals may discount promised benefits at a higher rate than we assume and, if so, the pure tax rate would be higher.
Estimating Labor Responsiveness. Calculating the welfare loss requires an estimate of how responsive workers are to changes in their realized wages as a result of changes in the tax rates they face. Economists call this measure the labor supply elasticity.10 For this study, we need a measure of how responsive a worker's labor supply is to changes in wages while keeping the worker as well off at each wage. We use a low number of 0.3 and a high number of 0.5.11 Thus if the wage rate rises 10 percent, labor supplied will rise between 3 percent and 5 percent.
"The economic loss associated with the Social Security payroll tax last year was as much as 18 cents out of each $1 of taxes raised."
Estimating the Welfare Loss. The two final columns of Table I show the welfare costs of the payroll tax as a percent of wage earnings under alternative estimates of responsiveness of the labor supply to changes in wages. As these numbers show:
- The Social Security payroll tax caused a welfare loss between 1.17 percent and 1.95 percent of taxable wage earnings in 2001.
- These losses amount to 11 percent to 18 percent of the taxes raised; thus for every dollar in payroll tax revenues, society as a whole loses as much as 18 cents.
- For society as a whole, the 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 welfare cost of the tax to the country as a whole will rise even faster:12 [See Figure I]
- By the time today's teenagers reach the retirement age in 2050, the nation will sacrifice as much as 30 cents in welfare for every dollar it collects in payroll taxes.
- By the time today's newborns retire in 2070, the loss will equal 34 cents for every dollar the government collects.