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


  1. These opposing forces can perfectly offset each other so that observed hours of work are unchanged after the tax. A payroll tax is a proportional tax because it rises in proportion to the hours of work. For a worker who earns $10 per hour, a payroll tax of 15 percent reduces the hourly take-home pay to $8.50. Suppose the worker worked 40 hours per week before the tax was levied, making $400. After the tax the worker realizes that each hour of work is worth only $8.50 in take-home pay. This gives him the incentive to work less. At the same time, however, the worker wants to put food on the table, so the tax also gives him the incentive to work more. These effects work in opposite directions so that the hours of work may be more, less or the same after the tax as before. The important point is that the worker is made worse off by the payroll tax in excess of the tax revenues collected. This excess burden of the tax, over and above the tax revenues collected, is the welfare loss.
  2. This estimate is derived from data on federal individual income tax returns. See David Hoffman, "Who Pays the Federal Income Tax?" Tax Foundation, Table 1, February 2002, Special Report No. 109. The estimate is a weighted average of the marginal tax rates at different levels of adjusted gross income. The marginal tax rate of 20.15 percent is higher than the average tax rate of 14.8 percent. It reflects the tax on an additional dollar of income.
  3. The Social Security program as a whole provides retirement pensions, survivors benefits and disability benefits. The Old-Age and Survivors Insurance (OASI) is currently funded by a dedicated tax of 10.6 percent of taxable payroll. The Disability Insurance portion is currently funded by a dedicated payroll tax of 1.8 percent of payroll.
  4. However, the effective marginal OASI tax rate is below the statutory level due to the formula linking Social Security taxable wages to future benefits, as will be discussed below.
  5. See Edgar K. Browning, "On the Marginal Welfare Cost of Taxation," American Economic Review, Vol. 77, 1987, pp. 11-23, and Edgar K. Browning, "The Marginal Social Security Tax on Labor," Public Finance Quarterly, Vol. 13, 1985, pp. 227-51, for discussions of the marginal tax rate on labor income. Browning (1987) used a range of 38 percent to 48 percent to identify the total welfare cost of taxes on labor. Martin Feldstein, "Tax Avoidance and the Deadweight Loss of the Income Tax," Review of Economics and Statistics, Vol. 31, No. 4, November 1999, pp. 674-80, used a range of 38.9 percent to 42.5 percent.
  6. James M. Poterba, "The Rate of Return on Corporate Capital and Factor Shares: New Estimates Using Revised Income and Product Accounts and Capital Stock Data," National Bureau of Economic Analysis, NBER working paper No. 6263, April 1999, estimated the pretax real rate of return on non-financial corporate capital at 8.5 percent. After accounting for corporate taxes at the federal, state and local level, the return falls to about 5.4 percent.
  7. This is based on the growth in the taxable wage base from the intermediate assumptions in The 2001 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, Washington, D.C.
  8. Steven Caldwell et al., "Social Security's Treatment of Postwar Americans," National Bureau of Economic Analysis, NBER Working Paper No. 6603, June 1998.
  9. For our estimates, we first calculate the pure tax share for each birth year and the proportion of total annual income earned by members of each birth year, and then determine what proportion of that total the pure tax represents. These proportions are used to weight the groups' pure tax share to arrive at the annualized pure tax.
  10. It identifies the percentage change in labor supplied divided by the percentage change in wages.
  11. Existing estimates of this responsiveness range from 0.2 to above 0.6. See the Appendix for additional discussion of the compensated labor supply responses used here.
  12. The welfare loss rises to between 2.69 percent and 4.48 percent by 2050, and to 3.39 percent and 5.64 percent of taxable earnings by 2070. For consistency with later estimates and with the recently issued report of the President's Commission to Strengthen Social Security, we use a 4.6 percent real rate of return rather than the 5.4 rate. The lower rate assumes a 50/50 split between equities and bonds. The assumed real equity yield is 6.5 percent, the corporate bond yield is 3.5 percent and the government bond yield is 3.0. The bond share is split 60 percent corporate and 40 percent government bonds. Administrative expenses are assumed to be 0.3 percentage points.
  13. Estelle James, "Social Security Reform Around the World: Lessons from Other Countries," forthcoming, National Center for Policy Analysis.
  14. Privatization in our usage requires individual ownership or claims on productive assets. Note that the government could also issue each Social Security participant a bond that guarantees future benefits and privatizes, or more accurately "individualizes," the ownership. This individualization does not result in prepayment.
  15. Bonds issued to current taxpayers and retirees equal to the present value of their accrued benefits "recognize" or denominate the implicit Social Security debt and are referred to as recognition bonds.
  16. The contribution rate necessary to prepay scheduled Social Security benefits varies with rate of return assumptions. With a 5.4 real return during both the accumulation phase and the annuitization phase, the contribution rate is on average 4.1 percent of taxable earnings. With the more conservative rate used here, 4.6 during the accumulation phase and 3 percent during the annuity phase, the contribution rate is 6.2 percent.
  17. Using a payroll tax to service the debt produces a conservative estimate of the welfare gain. As Laurence J. Kotlikoff has suggested, using a business cash-flow tax to finance the costs of accrued benefits will lower the welfare costs that were due to the payroll tax. Besides reducing the welfare costs, the broader base also distributes some of the burden to the older generation. See Laurence J. Kotlikoff, "Privatizing Social Security the Right Way," Independent Review, Vol. 5, No. 1, Summer 2000, pp. 55-63.
  18. The Social Security benefit formula currently indexes or translates past earnings into present values using a wage index. In so doing, real wage growth and price growth both affect the size of past earnings when they are indexed to the present. With price indexing alone, indexed earnings are smaller than wage indexed earnings, and as a result benefits are smaller. However, price indexing is phased in so that real benefits for new retirees after 2009 remain the size of those earned by new retirees in 2009. The commission's second option actually allows for contributions to personal accounts equal to 4 percent of wages up to $1,000. Though we use 2 percent on wages up to the taxable maximum our simulations provide a reasonable approximation of the change in the welfare costs associated with the Commission's second proposal.
  19. See Martin Feldstein, "The Missing Piece in Policy Analysis: Social Security Reform," American Economic Review, Vol. 86, No. 1, 1996, pp. 1-14, for a discussion of the magnitude of the welfare cost from Social Security wealth's crowding out of private savings; see Martin Feldstein, "Tax Avoidance and the Deadweight Loss of the Income Tax," Review of Economics and Statistics, No. 4, Vol. 81, November 1999, pp. 674-80, for an estimate of the welfare cost from the income tax's distortion to the form of compensation as compared to its distortion to labor supply; see Edgar K. Browing and William R. Johnson, "The Cost of Reducing Economic Inequality," Cato Journal, Vol. 6, No. 1, Fall 1986, pp. 85-109, for a discussion of the magnitude of the welfare cost from income tax's savings effect as compared to its distortion of the labor supply.
  20. Edgar K. Browning, "On the Marginal Welfare Cost of Taxation," American Economic Review, Vol. 77, 1987, pp. 11-23.
  21. Browning, ibid., 1987, also interpreted this welfare triangle as equal to the increase in earnings if the marginal tax rate is reduced to zero (but with the worker kept on the same indifference curve), abl1l0, less the value of leisure given up in generating that increment in earnings, adl1l0.

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