Social Security--which consists of Old-Age, Survivors, and Disability Insurance (OASDI)--is financed by payroll taxes on employers, employees, and the self- employed. Only earnings up to a maximum, which is $106,800 in 2011, are subject to the tax. That maximum usually increases each year by the growth rate of average wages in the economy.
When payroll taxes for Social Security were first collected in 1937, about 92 percent of earnings from jobs covered by the program were below the maximum taxable amount. During most of the program's history, the maximum was increased only periodically, so the percentage varied greatly. It fell to 74 percent in 1965 and, by 1977, was 87 percent. Amendments to the Social Security Act in 1977 boosted the amount of covered taxable earnings, which reached 91 percent in 1983. That law also indexed the taxable maximum to match annual growth in average wages. Despite those changes, the percentage of taxable earnings has slipped in the past decade because earnings for the highest-paid workers have grown faster than the average. Thus, in 2009, about 83 percent of earnings from employment covered by OASDI fell below the maximum taxable amount.
This option would increase the share of total earnings subject to the Social Security payroll tax to 90 percent by raising the maximum taxable amount to $170,000 in 2012. (After being increased, the maximum would continue to be indexed as it is now.) Implementing such a policy change would increase revenues by $182 billion from 2012 through 2016 and by $468 billion over the 2012-2021 period. (The estimates include the reduction in individual income tax revenues that would result from a shift of some labor compensation from a taxable to a nontaxable form.)
Because Social Security's retirement benefits are tied to the amount of income on which taxes are paid, however, some of the increase in revenues from this option would be offset by the additional retirement benefits paid to people with income above the current maximum taxable amount. On net, the option would reduce federal budget deficits by $180 billion over the 5-year period and by $457 billion over the 10-year period.
Enacting this option would enhance the long-term viability of the Social Security program, which, according to the Congressional Budget Office's projections, will not have sufficient income to finance the benefits that are due to beneficiaries under current law. CBO projects that, in combination, the two Social Security trust funds will be exhausted in the late 2030s. Under this option, exhaustion of the combined trust funds would be delayed until after 2050.
In addition to improving Social Security's long-term financial outlook, this option would make the payroll tax less regressive. People whose income is above the ceiling now pay a smaller percentage of their total income in payroll taxes than do people whose total earnings are below the maximum. Making more earnings taxable would increase payroll taxes for those high-income earners. (Although that change also could lead to higher benefit payments for people with earnings above the current maximum, the additional benefits would be modest relative to the additional taxes those earners would pay.)
An argument against this option is that raising the earnings cap would weaken the link between the taxes that workers pay into the system and the benefits they receive (because the addition to benefits would be modest relative to the increase in taxes). That link has been an important aspect of Social Security since its inception. Another drawback is that people whose earnings fall between the existing and proposed taxable limits would earn less after taxes for each additional hour worked, which would reduce the incentive to work and encourage taxpayers to substitute tax-exempt fringe benefits for taxable wages. People whose earnings are well above the proposed limit would not see any reduction in the return on their additional work, but they would have less income after taxes, which would encourage more work.