Posted January 17, 2023 at 12:19 pm by and

Social Security payroll taxes are not collected on earnings over a set cap. In 2021, this cap was $142,800, so workers making more than this enjoyed the benefit of zero Social Security taxes on all earnings in excess of this cap.

However, rising income inequality is skewing this tax structure even further to the benefit of top earners and diminishing funding for the crucial retirement program so many Americans rely on.

Social Security’s payroll tax—of which employees pay 6.2% and employers 6.2% each—has a cap that rises with growth in the national average wage index compiled by the Social Security Administration (SSA). In 2023, for example, the cap is set at $160,200. But since wage growth for top earners continues to outpace average wage growth, a growing share of total earnings is spilling over the cap and escaping taxation, eroding Social Security revenues.

Significant reforms to Social Security made in 1983 set the cap at a level so that 90% of all earnings would be subject to taxes. Over time, rising inequality meant that this share shrank as more earnings for higher-wage workers spilled over the cap. In 2020 and 2021, the share of earnings subject to Social Security taxes hit the lowest levels since before the 1983 reform. In fact, by 2021, the share of earnings subject to Social Security taxes was at the lowest level in nearly 50 years (since 1972).

This fact is important for at least two reasons:

• First, Social Security is likely to be under threat in coming years as part of a general return to debates over long-run fiscal sustainability in the United States.

• Second, a recent debate on earnings inequality trends has rightly highlighted a pronounced compression of wages among the bottom 90% of workers. But the Social Security data we highlight in this brief show that growth at the very top of the earnings distribution—the top 1% and above—continues to exceed growth of the bottom 99% of the workforce. This means there has been very little (or no) compression between earnings for the bottom 90% and those at the very top of the earnings distribution.

Earnings growth at the top in recent years

According to our latest research using SSA data, annual earnings rose fastest for the top 1% of earners (up 9.4%) and top 0.1% (up 18.5%), while those in the bottom 90% saw their real earnings fall 0.2% between 2020 and 2021. As wage growth over the cap continues to outpace average wage growth, a higher share earnings fall above the Social Security tax cap. This costs the Social Security system significant amounts of revenue relative to a scenario where wage growth was more equal and there was no growth in the share of overall earnings above the cap.

Figure A shows the share of aggregate earnings subject to the Social Security tax between 1950 and 2021. The share of earnings subject to Social Security taxes hit a record high of 90% in 1982 and 1983. This was an intentional choice made as part of a significant reform to Social Security meant to shore up its long-run actuarial balance. Because wage inequality was not visibly rising when these reforms were made, it is safe to assume that the reform was meant to set the earnings cap at 90% into the future. But this target has been undercut since by steadily rising wage inequality: In 2021, only 81.4% of all wage earnings were subject to Social Security taxes.

Figure B tracks the share of earnings above the Social Security tax cap alongside the share of earnings accruing to the top 1% of wage earners. The share of earnings above the cap increases as the top 1% share of earnings rises.

The costs of letting the cap wither as wage inequality increases are enormous. What might look like small changes in the share of earnings covered by Social Security taxes (a percentage point or two) have large implications for the program’s revenues. Each one percentage point drop in the share of total earnings subject to Social Security taxes (moving from 82.4% to the current 81.4%, for example) reduces revenue by an additional $12.6 billion.

From 2019 to 2021, the share of earnings subject to the Social Security tax fell by 2.1 percentage points. On an earnings base of $10.2 trillion in 2021, this translates into roughly $26 billion in lost revenue to Social Security.

Figure C shows the annual revenue loss to Social Security stemming from earnings spilling over the cap since 1983, expressed as a share of total taxes collected through the Social Security payroll tax. By 2021, the leakage from revenues caused by growing inequality reached almost 11% of total taxes paid. This is equivalent in fiscal impact to an unlegislated 11% cut in the Social Security tax rate (or equivalent to a 1.1 percentage point cut from the 12.4% Social Security tax) by the end of this period. The implied cumulative loss since 1983 is enormous: The ongoing leakage out of Social Security’s revenue has led to a Social Security Trust Fund holding 50% fewer reserves in 2022 ($1.4 trillion fewer) than it would have if inequality had not increased (even before accounting for the larger interest income that a higher level of reserves would have been generating over this entire period).

Why this matters II: Telling a richer story of inequality trends

Recent research by Autor, Dube, and McGrew finds a pronounced degree of wage compression among the bottom 90% of workers in the pandemic labor market. That is, pay at the bottom has risen more rapidly than at the middle or the top. Our prior research also found similar patterns of low-wage workers experiencing disproportionate wage gains in the past two years—gains that even beat out high inflation for roughly the bottom third of workers.

Both of those findings rely on the Current Population Survey (CPS) to examine changes in hourly wages. However, the CPS makes it difficult—if not impossible—to examine what’s going on above the 90^th percentile of the wage distribution. But the SSA data used in this piece allow us to look within the top 10%, specifically within the top 5% and even 1% of earnings. The SSA data measure annual earnings (hourly earnings cannot currently be calculated from the SSA public data). The SSA data also include some wage and salary income not captured by the CPS—stock options and bonus pay, most importantly. This SSA data tell us that while there has indeed been pronounced compression of hourly wages among the bottom 90% (and there’s even some speculative evidence of annual earnings compression within the bottom 90%), annual earnings for the top 5% and above continue to rise substantially faster than average growth. Annual earnings compression does not seem to be happening much between the top 5% and everybody else.

Another way to illustrate the role of rising wage inequality on the declining share of earnings subject to the Social Security tax is to look at the cumulative change in the earnings cap against the growth in average earnings of the top 5%. Because roughly 6% of workers have annual earnings that exceed the Social Security taxable maximum, growth in the top 5% relative to the earnings cap should be a good proxy for just how fast inequality is eroding Social Security revenue. Figure D below shows the growth rate of earnings for the top 5% and growth in the average earnings cap since 1979. The rise in inequality (i.e., faster growth among the top 5% relative to the average) is constant and has not slowed down in recent years.

Policy lessons

In the long run, stopping the growth of earnings inequality should be a key goal of policymakers. Given that this growth has been largely policy-driven, its reversal could also be secured by better policies (i.e., stronger labor standards, effective labor law reform that allows workers to more easily form unions, and macroeconomic policy that targets low unemployment rates over longer periods of time).

However, even with the growth of inequality as given, Social Security’s finances can be protected from erosion by simply changing how the earnings cap is set.

At a minimum, ensuring the cap is set at a level that restores 90% of earnings to being subject to Social Security taxes should be done. However, further reforms that remove the cap entirely, or even allow a greater range of income (investment income, for example) to be subject to Social Security taxation should be considered. What should not be allowed to continue is the status quo where rising earnings inequality steadily throttles revenue available to the Social Security system.