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Should We Tax the Rich to Save Social Security? - The Motley Fool

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Despite the program's incredible track record and its ability to significantly reduce elderly poverty rates, Social Security is facing some serious financial hurdles in the years to come. According to the 2020 Social Security Board of Trustees report, the most successful social program is contending with a nearly $17 trillion funding shortfall between 2035 and 2094. Between 2021 and 2035, a number of ongoing demographic changes are expected to result in the depletion of Social Security's nearly $2.9 trillion in asset reserves.

Although Social Security doesn't need a dime in excess cash to remain solvent or make payouts to eligible beneficiaries, the lack of any asset reserves would necessitate across-the-board benefit cuts that could total as much as 24% for retired workers. This long-term funding shortfall is something lawmakers have known about for 35 years and counting. The question is, how best to fix it?

Two Social Security cards lying atop a W2 tax form.

Image source: Getty Images.

What does "tax the rich" actually entail?

Among the many ideas put on the table to strengthen Social Security, none has garnered more popularity with the American public (via surveys) than raising or eliminating the maximum taxable earnings cap associated with the payroll tax.

Social Security's 12.4% payroll tax on earned income is unquestionably the program's funding workhorse. In 2019, almost $945 billion of the $1.06 trillion collected was derived from the payroll tax. Take note that while the self-employed are responsible for the full 12.4% tax, workers employed by a company or someone else split this payroll tax liability with their employer. Thus, most workers only pay 6.2% of their earned income into Social Security, with their employer also covering a 6.2% share.

The catch is that the payroll tax only applies to earned income (that's wages and salary, but not investment income) between $0.01 and $137,700, as of 2020. This $137,700 figure is what's known as the maximum taxable earnings cap. The year-over-year percentage increase in the National Average Wage Index dictates how much the tax cap will rise each year.

Approximately 94% of working Americans won't earn $137,700 in wages or salary this year, which means they'll be paying into Social Security with every dollar they make. Comparatively, the roughly 6% of workers who will top $137,700 will see a portion, or perhaps the majority, of their income exempted from the payroll tax. Between 1983 and 2016, the amount of earnings exempted from the payroll tax roughly quadrupled from north of $300 billion to $1.2 trillion.

Thus, raising or eliminating the payroll tax cap is a means of taxing well-to-do workers in order to generate additional income for Social Security.

A businessman placing crisp one hundred dollar bills into two outstretched hands.

Image source: Getty Images.

Why taxing the rich makes a lot of sense

Now that you have a better idea of how the tax-the-rich strategy would work to save Social Security, let's take a closer look at why this strategy would make a lot of sense.

To begin with, the idea of taxing the rich obviously has a lot of public support. Remember, since 94% of workers are already paying into the system with every dollar they earn, increasing or eliminating the maximum taxable earnings cap isn't going to have an impact on their payroll tax liability. If anything, raising or eliminating the payroll tax cap would be viewed as leveling the playing field with those folks who have some, or most, of their income exempted.

A second reason to consider a tax-the-rich strategy to strengthen Social Security is that the well-to-do are likely able to afford a higher level of taxation. The rich are rarely reliant on their Social Security income to make ends meet during retirement.

But the top reason to consider taxing the rich is that it gives Social Security the best chance to resolve its expected near-term funding shortfall.

You see, Republican lawmakers would prefer to strengthen Social Security by reducing long-term expenditures. This would be done by gradually increasing the full retirement age. The issue with this strategy is that it can take decades before real savings are realized. By taxing the wealthy, Social Security would receive an immediate infusion of extra revenue that could prolong the program's asset-reserve depletion until a later date.

Sounds like a no-brainer Social Security fix, right? Well, there's another side to this story.

A visibly annoyed senior man in a suit staring intently.

Image source: Getty Images.

Here's why taxing the rich isn't a slam-dunk solution

One reason the tax-the-rich proposal fails to hold water is that it can be argued the rich are already paying their fair share. Since the Social Security Administration caps the amount of monthly benefits paid at full retirement age, it only makes sense that the amount of earned income subjected to the payroll tax is capped, too. In other words, taxing $10 million in earned income would generate extra revenue for Social Security, but it wouldn't bring an additional cent in benefits to the well-to-do individual being taxed.

Additionally, it should be understood that the rich would likely shift how they generate income in order to reduce their payroll tax liability. This could mean that wealthier individuals will choose to generate more of their income from investments, thus avoiding the payroll tax. This is a roundabout way of saying that raising or eliminating the payroll tax cap may not lead to as much money being collected as initially expected.

A third issue the tax-the-rich strategy runs into is congressional support. Most Republicans in Congress have made clear that they won't support increased taxation solely on the rich. That's a problem when 60 votes will be required to amend the Social Security Act in the Senate. It's worth mentioning that the wealthy also happen to be core election-campaign donors. Upping taxation on these high-income earners may cost lawmakers campaign donations and votes.

But maybe the biggest knock against taxing the rich is that it doesn't fully resolve Social Security's funding shortfall. While there's no question that it pushes back the program's asset-reserve depletion date and resolves a lot of Social Security's short-term funding concerns, it also fails to account for other ongoing demographic changes. These changes include record-low birth rates, declining net legal immigration rates, and a prolonged period of low inflation that's adversely impacting wage growth.

The idea of taxing the rich should, rightly, remain on the table for discussion on Capitol Hill to save Social Security. However, it's unlikely to be the only solution implemented when the time comes for lawmakers to act.

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