Removing the Cap on FICA Taxes Is NOT the Answer to the tax problem

The Daily Kos features a nicely done argument, with good graphs, from Nathan Newman's blog, in favor of removing the cap on taxable earnings for Social Security. (Currently, only wage income up to $87,000 is subject to the FICA tax of 6.2%, as well as the employers' share which is another 6.2%. Above that income, no more tax is paid, which is one reason lower- and middle-income workers pay a higher effective tax rate, taking all federal taxes together, than those in the $100,000+ range.)

Lifting the cap on the payroll tax seems like it might catch on as an answer to the call that several of us have issued to consider wholesale reform of the tax system. But there is a significant pitfall to this proposal that advocates should at least be aware of: It would create a class of people for whom Social Security is a manifestly bad deal. And I think that when that happens, it will be much harder to save Social Security from its enemies.
Remember that the payroll tax is not a general tax paid for an array of government services, like the income tax. Thanks to FDR, it is a premium paid into an insurance system. That system is mildly redistributive, but one of its most distinctive features is that it offers a pretty good deal, at least a secure pot of savings, for almost everyone. For the most part, the only people who don't get at least a little more out of Social Security than they put in are those who die before collecting or within a few years after retirement, and whose children or spouse aren't in a position to collect survivors' benefits.

When the Bush gang went after Social Security in 2001, they struggled to show that it was a bad deal for workers, and even without the usual inhibition against totally false statements, they still couldn't make the case. Their most outrageous claim was that Social Security was somehow biased against African-Americans, which is true only because a greater number of African-Americans die at a young age, a fact that privatization of Social Security would not change and that the administration did not show much concern about. (See this response from three top economists to the Bush commission in July 2001.)

The best the Bush privatizers could do was argue that Social Security provided an inferior return on investment compared to equities, which is true, but didn't seem so compelling after the stock markets crashed. In fact, Social Security provides every family with a modest core of absolutely secure savings which then allows them to take greater risks with other investments. After all, if you didn't have Social Security, you would probably be well-advised to put at least a few thousand dollars a year into the safest investments possible, such as T-bills, passing up the returns on stocks for greater security.

In the end, there was no constituency for Social Security privatization other than Wall Street, and the idea collapsed. I think that's because there was no one for whom Social Security was a bad deal. If you live to the average life expectancy, you will get back more than you put in, after inflation, and then some. But all that changes if you eliminate the cap. All of a sudden, a worker earning $120,000 is paying almost $15,000 into Social Security (compared to $10,000 with the cap), and the most he will ever get under current law is about $1300 a month. That means, in short, that he will have to be alive and retired for as long as he was working at high wages, in order to get his money back. (Both figures are in current dollars, so don't need to be adjusted.)

I'm not in the business of feeling sorry for people who earn more than $100,000 a year, but about one-fifth of households earn more than the current FICA ceiling (although if the earnings are from two people and/or from investment income they might not be affected by removing the cap), and the experience with the estate tax shows that people can believe they will be affected by a tax even if the chances are remote. The last thing we need is a backlash from the mid- to upper-middle class.

There may be some room for increasing the cap into the 90s, but the real solution for regressive and over-complex taxation is within the income tax system, not within the payroll tax itself. It's possible to fix the regressivity of the payroll tax through refundable credits on the income tax side -- after all, that's what the Earned Income Tax Credit was originally intended to do. This has the effect of using general revenues to subsidize Social Security. Government is, in effect, paying the insurance premiums for low-income working people. We can improve that system by consolidating and increasing the four different credits that these families receive. And then we should pay for that by increasing income taxes, not payroll taxes, on the better-off. Doing so would capture their investment income, not just their income from work. The first step is to end all special preferences for investment income over income from work.

This approach is much wiser than a strategy that might put all of Social Security at risk by creating for the first time a class of people who would not benefit.