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Here's How the Rich Avoided Paying $149 Billion in Social Security Payroll Tax in 2016

Sean Williams, The Motley Fool

Social Security is vital social program that most elderly Americans simply couldn't live without. According to data from the horse's mouth (the Social Security Administration), some 62% of retired workers lean on their monthly check to provide at least half of their income. In turn, this payout keeps millions of retired workers above the federal poverty level.

Social Security's cash shortfall comes into focus

It's also a program that collects, and pays out, a large amount of cash each year. The latest report from the Social Security Board of Trustees shows that the program is expected to bring in just over $1 trillion in revenue this year. Mind you, it's also expected to pay out a little more than $1 trillion in benefits, leading to a net cash outflow of a projected $1.7 billion. It's this net cash outflow that has a lot of people rightfully worried about the future.

A Social Security card wedged in between cash bills.

Image source: Getty Images.

With the exception of 2019, where the intermediate-cost model suggests that the net cash outflow will shrink from $1.7 billion to $0.2 billion, Social Security's payouts will accelerate at a rapid pace relative to the growth of its revenue. By 2027, $169 billion more per year may be flowing out of the program to eligible beneficiaries than is flowing in. That's a big problem.

By the year 2034, the Trustees believe that the $2.9 trillion Social Security has built up in asset reserves since 1983 will be completely gone. Should that happen, an across-the-board cut to benefits of up to 21% may be needed to sustain payouts through 2092, without any additional benefit cuts. Keeping in mind just how reliant seniors are on Social Security, a cut to benefits of any significant amount could prove devastating. 

Here's how the rich have sidestepped paying $149 billion in Social Security tax

One of the presumed easiest way to resolve Social Security's imminent cash crunch is to raise more revenue. And the easiest way to do that would be to adjust its most important source of income: the 12.4% payroll tax on earned income.

In 2017, Social Security's payroll tax provided $873.6 billion of the $996.6 billion collected by the program. As time passes and the interest income Social Security earns from its asset reserves dwindles, the payroll tax is expected to play an even more important role in generating revenue to be disbursed to eligible beneficiaries.

But there's just one catch that I haven't yet mentioned: This 12.4% payroll tax only applies up to a certain wage income level. In 2018, that level is $128,400. Though this figure tends to adjust in-step with the National Average Wage Index (NAWI) each year -- it remains unchanged in years where no cost-of-living adjustment is passed along, even if the NAWI has shown a positive increase -- it means the rich will be exempted from Social Security's payroll tax on their earned income above $128,400 this year.

A man with a stack of cash held behind his back and his fingers crossed.

Image source: Getty Images.

Just how much is sneaking by without being taxed? According to data from the Social Security Administration in 2016, when the maximum taxable earnings cap was $118,500, approximately $1.2 trillion in earned income avoided being taxed. Based on the 12.4% payroll tax rate, that suggests the rich sidestepped paying $149 billion in payroll tax to Social Security. 

Now, before you get too angry, understand that this is a peak estimate of avoidance on an individual basis. Employees who work for a company or someone else are only on the hook for half of their payroll tax liability (6.2%), with their employer picking up the other half of the tab (6.2%). Only the self-employed get hit with the full force of Social Security's 12.4% payroll tax rate.

Nevertheless, the thesis is pretty clear that a lot of potential revenue is escaping the system.

Why don't we just end this silliness and tax the rich?

The initial thought you're probably having, and one that's shared by a lot of the working public who pay into Social Security with every dollar they earn, is this: "Why not just raise or remove the maximum taxable earnings cap?" Doing so would only affect a small percentage of workers, and it would supply added revenue to Social Security. In fact, eliminating the cap may erase the entire $13.2 trillion cash shortfall the program is estimated to be facing between 2034 and 2092.

While this is indeed the most popular solution among the public, there are valid reasons why placing this fix on the shoulders of the wealthy hasn't panned out.

An angry, wealthy senior man in a suit with a scowl on his face.

Image source: Getty Images.

For starters, the Social Security Administration sets a maximum monthly payout amount for retired workers who've hit their full retirement age. In 2018, this figure is $2,788 per month. That means no matter how much a wealthy individual earned during their lifetime, the most they could receive in 2018 at full retirement age is $2,788 per month (assuming they're eligible for benefits). Because there's a maximum payout amount each month, there's also a maximum earning amount that's taxed. If the cap were raised or lifted, but the maximum payout was not, the rich would be paying more into the program without receiving one extra cent in benefits come retirement. Admittedly, the wealthy are far less likely to need Social Security income during their golden years, but "fairness" is still an issue here.

Another genuine reason we've not seen any attempt to tax the rich is that Republicans have no desire to do so. Raising payroll taxes on the wealthy is a core proposal of Democrats on Capitol Hill. Meanwhile, Republicans have favored gradually raising the full retirement age -- i.e., the age where you become eligible to receive 100% of your retirement benefit -- to account for increased longevity. Doing so would reduce the lifetime benefits of future generations of retirees. No Social Security legislation is going to pass without 60 votes in the Senate, and it's been four decades since either party had a supermajority (60 seats) in the Senate. That means the need for bipartisan cooperation, which simply isn't going to happen.

For the time being, there are no easy pathways to fix Social Security. This means a growing likelihood that the wealthy will out-earn Social Security maximum's taxable cap and have some portion of their income exempted from the payroll tax.

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