Sunday, December 26, 2004

Although President Bush has said he would not raise Social Security taxes to pay for private accounts, some of his aides are nevertheless floating the idea of a stealth tax increase on the wealthy. On Dec. 19, White House Chief of Staff Andrew Card and Treasury Secretary John Snow were asked on different Sunday talk shows if the administration would support an increase in the Social Security wage cap and both pointedly refused to rule it out.

Since the Social Security system was created, the payroll tax has applied only to a portion of total wages. Originally, the limit was $3,000, which Congress raised from time to time. Since 1972, the wage base has been indexed and rises automatically each year. This year, it was $87,900.

Starting Jan. 1, the taxable wage base will rise to $90,000. Thus the maximum tax one can pay will rise by $260.

When Franklin D. Roosevelt put this system into place, it wasn’t out of love for the wealthy. Rather, it was to maintain some reasonable relationship between taxes and benefits for everyone who pays into Social Security. Because one’s benefits are a function of covered wages, having no cap would either produce higher benefits for high-income workers than would be politically tolerable or minuscule benefits in relation to taxes paid.

As it is, there is already an increasingly tenuous relationship between taxes paid and benefits received by high-income workers. According to the Congressional Research Service, in 1980 a retiree with lifetime earnings at or above the Social Security wage cap got back all of his and his employer’s contributions in 3.1 years. By 2000, it took 24.9 years and by 2010 it will take 35.3 years. Under current projections, a high-income worker retiring in 2030 will need 55 years of benefits to get back all his contributions.

If the cap is removed and benefits are limited to current levels, the return for high-income workers will become nonexistent. This means Social Security will no longer be a pension system to which benefits are earned, but a welfare program. If the wage cap is raised and the benefit formula left unchanged, higher future benefits will consume all the revenue gain in the long run.

Even if benefits are frozen, the revenue gain from lifting the wage cap isn’t that great. According to Matt Moore of the National Center for Policy Analysis, it would only increase the life of the Social Security trust fund by seven years on a static basis. But this is a generous projection given that high-income workers would undoubtedly shift their income out of wages and into dividends and capital gains to which the payroll tax does not apply.

Of course, another consequence of raising the cap is that it would be a massive marginal tax rate increase. The top rate on wages will, in effect, rise 12.4 percent, raising the de facto top rate from 38 percent to more than 50 percent (including the 2.9 percent Medicare tax, which has applied to all wages since 1993). This will reduce labor supply, encourage tax-sheltering, and move tax policy in a direction opposite to the one Mr. Bush has pursued the last four years.

A study by the Institute for Research on the Economics of Taxation says the negative economic effects of raising the wage cap could be devastating: “On an income-weighted basis, there would be a net reduction in work incentives economywide.”

A Heritage Foundation analysis found lifting the wage cap would constitute the largest tax increase in American history, raise the unemployment rate and reduce the personal saving rate by about half of 1 percent, and reduce real economic growth by about a tenth of 1 percent yearly.

Among the hardest-hit will be owners of unincorporated businesses.

Economist Eugene Steuerle of the Urban Institute notes they must pay both the employer’s and the employee’s shares of the tax. Moreover, because sole proprietors cannot separate wage and capital income, in effect much of the tax falls on capital rather than just wages. To avoid this problem, every small business would have to incorporate, which may or may not be desirable economically.

Despite the many adverse results of raising the Social Security wage base, I believe Mr. Bush has little choice but to consider it to finance the estimated $1 trillion to $2 trillion cost of establishing private accounts. I think his and his senior aides’ conspicuous unwillingness to rule it out is a classic trial balloon. In the event of a strong negative reaction, it will be rejected. Given a passive reaction, it could move forward.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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