Extending the payroll tax cut — as the GOP leadership has now agreed with Democrats to do — may be good politics, but it is lousy policy.
For the average household with earnings of $49,445 a year (about the median), keeping individual payroll taxes at 4.2 percent as opposed to 6.2 percent will mean about a thousand dollars more in their wallets this year. And generally speaking, letting people keep more of their own money to spend and invest as they choose is a good thing, both for individuals and the economy as a whole.
But there is a difference when it comes to payroll taxes, whose specific purpose is to fund Social Security. Many people mistakenly believe that the payroll taxes they pay when they’re working actually provide the funds for their own future Social Security benefits. But that is not the case.
Payroll taxes of currently employed workers end up paying for the benefits of current Social Security recipients, with any excess retained by the Social Security Trust Fund. But because, on average, Social Security recipients receive more in benefits over their lifetimes than they and their employers contributed in taxes during their working years, the system functions only because there are enough current workers making additional payments into the fund. This is why some people describe Social Security as a giant pyramid scheme.
There are only four ways to keep the system solvent: Hope there are always more people paying into the system than drawing from it; increase taxes; raise the retirement age; or lower benefits for some, if not all, recipients.
For much of the history of the Social Security Administration, the first option took care of the problem. There were always more people paying in at the bottom of the pyramid than were drawing out at the top. But that’s changing, with the huge cohort of Baby Boomers now drawing or about to draw benefits and with people living longer than they used to.
When the first monthly Social Security checks started being distributed in 1940, there were 9 million Americans over the age of 65. Today there are more than 41 million. What’s more, in 1940, the average lifespan for a man who reached 65 was an additional 12.7 years. Today, the average 65-year-old man will live an additional 15.3 years and the average 65-year-old woman will live almost 20 more years, which is why benefits almost always exceed contributions.
Congress has slowly raised the payroll tax over the years to help make up for the shortfall. Unlike federal income taxes, which almost half of Americans don’t pay at all, all workers must pay payroll taxes. Congress has increased payroll taxes in two ways over the years: by increasing the Federal Insurance Contributions Act (FICA) tax rate and by raising the cap on income subject to the tax. Currently, the first $110,100 of income is subject to FICA taxes, an amount that has been raised several times as the need arose to insure the system’s solvency.
If the administration and Congress continue to play politics with Social Security — as they are surely doing now by extending the temporary payroll tax cut — the system will eventually implode. It’s understandable that Republicans don’t want to be accused of giving all working Americans a 2 percent tax hike in an election year, but keeping payroll taxes low in order to avoid making other changes to the Social Security system is certainly not going to solve the problem. It will make things worse.
Unfortunately, politicians know that real solutions will entail difficult decisions: Raise the retirement age once again. Increase the FICA tax rate or raise the cap on how much income is subject to the tax. Or reduce benefits. It’s pretty simple, but painful, especially for politicians addicted to handing out goodies without figuring out a real way to pay for them.