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

Conclusion: Where Do We Go from Here?

The Social Security payroll tax has a negative effect on labor supply and the overall output of goods and services. We estimate that the welfare cost of this effect is currently between 1.17 and 1.95 percent of taxable wages. By 2070 the cost will rise to between 3.39 percent to 5.64 percent without reform. These losses are equal to between one-fifth and one-third of the taxes raised.

This welfare cost is distinct from the low rate of return from Social Security itself. The low rates of return current and future workers expect to receive on their Social Security contributions are a consequence of the system's pay-as-you-go financing and the early participants' windfall gains. The presence of the substantial difference between the return earned from Social Security contributions and the return that could be earned in the capital market suggests that the Social Security tax is indeed a net tax on payroll that distorts labor supply decisions and causes a welfare loss.

"By 2070 the Social Security payroll tax will have a negative effect equal to as much as one-third of taxes raised."

The three reform scenarios we evaluated all produce long-run welfare gains. The more complete the reform, in terms of the amount of prefunding, the greater are these gains. In the first two scenarios involving total privatization, as private accounts are funded and accrued debts are paid, the welfare costs are higher than the status quo. But these higher costs produce substantial long-run benefits. In the last scenario, based on partial prepayment, welfare losses are ultimately reduced by more than 50 percent.

Further, as we mentioned in the introduction, the Social Security system causes other distortions. Incorporating these additional distortions would make the total welfare cost of the current system several times the estimate reported in this paper.

"The huge implicit debts of the current system significantly crowd out private investment."

First, the huge implicit debts of the current system significantly crowd out private investment. Because workers expect Social Security pensions when they retiree, they save less than they otherwise would. This has a devastating effect on the nation's capital stock, income and growth and a negative welfare effect due to the distortion in the capital market caused by taxes on capital income. The capital income tax is like the payroll tax in that it drives a wedge between the return individuals receive when they invest in the capital market and the returns to society. For each dollar in reduced savings, individuals lose only the after-tax rate of return, but society loses the gross rate of return in reduced future consumption. This is an additional welfare loss.

Second, the payroll tax skews the forms of compensation offered to workers. Remuneration tilts from taxable wages to untaxed fringe benefits and workplace amenities and causes a distortion similar to the one we analyze in this study. In the case of the labor supply, the payroll tax discourages work and encourages leisure. In the case of varying forms of compensation, the payroll tax encourages excessive nontaxable benefits.

"When all costs are considered, society bears as much as a $3 cost for every $4 the system pays out in benefits."

Third, because the payroll tax reduces disposable income, it tends to reduce individual savings as well. These negative savings effects could have significant welfare costs due to the distortion in the capital market caused by the taxes on capital incomes. In the presence of preexisting taxes, the saver does not bear the entire loss from reduced savings. Thus associated with each unit reduction in savings arising from the reduction in disposable income, there is a welfare loss - usually in the form of reduced tax revenue from the capital income taxes. Note that this welfare cost from reduced savings caused by the Social Security tax, though sharing a similar mechanism, is different from and in addition to the Social Security wealth's crowding-out effect on saving. Basically, the crowding-out effect comes from workers' perceived future Social Security benefits as "wealth." The Social Security tax's negative effect on saving comes from the fact that workers have less to save.

We estimate that each of the above distortions is of the same magnitude as the labor supply distortion caused by the Social Security payroll tax.19 Thus the total annual welfare cost was roughly 4.7 percent to 7.8 percent of aggregate wage earnings in 2001, or as much as $326 billion. In comparison, Social Security benefits equaled $439 billion last year. This sizable loss is also the potential economic gain promised by a swift reform of the current system. With any of the reforms outlined in this paper, real and favorable changes will take place only after privatization. Each type of reform - partial or full, debt- or tax-financed - produces different gains and has different generational consequences. However, with individuals saving and working more, the nation will have more resources to provide for consumption by the elderly. Not only will reform solve the financing problem and secure retirement benefits, it will also reduce the welfare cost associated with the current system - making both current and future generations better off.

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