Social Security is funded primarily through a dedicated payroll tax on earnings. The tax, which is equal to 6.2 percent and is paid by both employees and employers (self-employed individuals pay 12.4 percent), is applied on earnings up to a level known as the taxable maximum. The taxable maximum changes from year to year with changes in the national average wage index. In 2020, the taxable maximum equals $137,700.
Yet largely as a result of growing earnings inequality, the percentage of earnings above the taxable maximum has risen over the years. When the last major changes to Social Security were made in 1983, 90 percent of earnings in the United States were at or below the taxable maximum level. However, with greater growth in earnings above the taxable maximum since the mid-80s, the percentage of earnings subject to the tax has fallen to around 83 percent.
This gradual shift has significant implications for Social Security. Greater earnings growth above the taxable maximum adversely impacts Social Security’s financial health because less money is being collected to fund benefits. This report examines that impact.
The report numerically estimates the impact that growing earnings inequality has on Social Security’s finances. Specifically, the report examines system revenues and benefits assuming the distribution of earnings had been more equal and similar to past levels, such that 90 percent of earnings had been taxed by Social Security since 1983, and that this ratio had continued through 2092. The analysis compares system revenues and costs under this alternative scenario with historical outcomes and intermediate projections made by Social Security actuaries.
Earnings inequality accounts for a considerable portion of Social Security’s fiscal challenges. If 90 percent of earnings had been subject to Social Security payroll taxes since 1983:
1) the system’s long-term financing gap would be 25 percent lower today and,
2) the life of the combined trust funds would last an additional four years above current Social Security projections.
Johnson, Richard W. How Does Earnings Inequality Affect Social Security Financing? Washington, DC: AARP Public Policy Institute. May 2020. https://doi.org/10.26419/ppi.00104.001