How Income Inequality Undermines Social Security

Posted by

Merrill Goozner

Published 10/31/11 in The Fiscal Times:

The income gap between the wealthy and everyone else has grown sharply since 1979, the Congressional Budget Office reported last week, while the Social Security trustees pointed out last June that for the first time since the early 1980s, the nation’s retirement system will dip into its interest earnings to pay the bills.

Although at first blush these two facts seem to be unrelated, they are intimately connected. Nearly 40 percent of the Social Security shortfall can be directly traced to the growing share of the nation’s total wages that are going to people in the upper income brackets.

Why does the uneven distribution of wage growth matter for Social Security? Each year, the Social Security trustees raise the level of wages subject to taxation by the average wage increase. But when people in the top income brackets get raises that are significantly higher than average while the bottom 80 percent get raises that are below average, a smaller portion of the total wage pie gets taxed.

The glacier-like impact of this shifting pattern of income distribution has reduced the share of the total wage pie subject to Social Security taxation to about 83 percent. When Congress last reformed Social Security in 1983, it assumed that 90 percent of wages would be taxed. It further assumed that the distribution of income would remain about the same over the ensuing decades.

That isn’t what happened. When the recommendations made by the Greenspan Commission were signed into law by President Ronald Reagan in 1983, Social Security faced an immediate crisis. An economic downturn had sent unemployment to its highest rate since the Great Depression (slightly higher than the worst of the current Great Recession). The Social Security system faced an immediate shortfall just as the Greatest Generation was entering retirement.

To preserve benefits for those deserving elders and to prepare the system for the Baby Boom generation just then entering its prime working years, the Commission called for radical changes in the program. The Reagan bill raised payroll taxes by 2 percentage points (a percent each on workers and employers) and gradually pushed the retirement age to 66 for people born after 1943 and 67 for people born after 1960.

The magnitude of those changes was driven in part by the demographics of the “baby bust” generation – those born between about 1965 and 1985 – which was just then beginning to enter the workforce. The number of retirees, about three for every retiree in the early 1980s, would eventually fall to two for every retiree by the time the Boomers were fully retired.

So the system needed huge surpluses to pay the bills. Unfortunately, the plan’s objective – to create a sufficiently large trust fund to pay for the boomers’ retirement – was only partially accomplished.

The Commission based its tax increase recommendation on the assumption it would hit 90 percent of the income for all American workers, adjusted for wage growth over the succeeding decades. This was the same assumption adopted by the original architects of the program.

But something happened on the way to that future. Growing income inequality became a defining feature of American life, which the CBO report documented last week.

Higher income people began grabbing a larger share of the nation’s income. The top one percent of the population saw real after-tax household income grow 275 percent between 1979 and 2007. The top 20 percent of the population (excluding that top 1 percent) saw their incomes grow by 65 percent. The middle-class (the 60 percent between the top fifth and the bottom fifth) saw its income rise only 40 percent, while the bottom fifth experienced only an 18 percent increase in average wages.

But Social Security’s “cap” for collecting payroll taxes to support the system — $106,800 in 2010 – increased at the rate of the average wage increase. As the well-off grabbed the lion’s share of wage growth, a growing share of the nation’s total income was earned by people with incomes beyond the reach of the payroll tax. “Since upper income people have higher than average wage growth, you saw more and more income fall above that cap over time,” said Andrew Eschtruth, a spokesman for the Center for Retirement Research at Boston College.

In a report issued last December, the Social Security Advisory Board said raising the wage cap to 90 percent of total income as originally intended would cover 38 percent of Social Security’s projected shortfall over the next 75 years. If Congress decided to exclude that newly taxed income in the wage base for determining Social Security benefits – a form of means testing – it would raise the shortfall coverage ratio to 48 percent. Even without making that other fix, raising the cap to about $170,000 a year would push off by several years the date when the system would need to dip into its interest earnings or the $2.4 billion trust fund.

“Raising the cap is the only thing the majority of the public supports because it’s equitable,” said Gary Burtless, a tax analyst at the Brookings Institution. “If we taxed 90 percent of earnings when Reagan was president, what’s the objection now when Obama is president? The center of the chattering class has moved way to the right compared to 1983.”

Merrill Goozner is an independent health care journalist. He blogs at Gooz News.

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