Wage Gap Figures in Social Security's Ills

By Greg Ip

Wall Street Journal

The debate over Social Security has managed to drown out other longstanding issues in American society, including the widening gap between rich and poor and surging health-care costs. Yet these two phenomena play an important, though little appreciated, role in Social Security's problems. That is because they are eroding the base of taxable wages available to support Social Security benefits.

As the population ages, benefits paid to retirees will steadily outstrip payroll taxes of workers. Between 2030 and 2080, the annual shortfall will soar from 3.5% to 5.8% of wages subject to the Social Security tax (called "taxable payroll"), the Social Security trustees say. Compared with gross domestic product, the imbalance rises far more gently, from 1.3% to 1.9% of GDP.

 The reason is that taxable payroll is expected to expand more slowly than is GDP and, by 2080, to equal just 33% of GDP, compared with 38% now. Stephen Goss, Social Security's chief actuary, says there are two main reasons why. One is that a "somewhat increasing share of all the earnings in the economy [is] above our taxable maximum," and the second is that a growing share of "employee compensation...is going not to wages but to fringe benefits, which are not included in our tax base," Mr. Goss says.

Social Security payroll taxes are levied on wages up to a certain cap, currently $90,000 a year, which rises annually with the average wage. In the past 25 years, a growing share of income has been paid to people who earn more than the cap.

This increasing concentration of income at the upper strata of society is an important reason why, from 1980 through 2000, taxable payroll fell to 83% of wages of contributing workers from 90%.

Both these trends partially were reversed in 2001, but there are signs inequality is growing again: The Federal Reserve estimates that the pay of managers and supervisors is rising much faster than that of production workers. Meanwhile, Social Security actuaries expect taxable payroll, which rebounded to 86% of total wages in 2002, to return to 83% by 2013.

Even if inequality stopped widening, Social Security's tax base probably would continue to be eroded because of rising health-care costs. Since 1996, health-care costs have risen to 7.3% of employee compensation from 6.3%, and Social Security's actuaries expect it to keep rising. This is a big problem for Medicare, the federal health program for the elderly, but it also affects Social Security, because payroll taxes aren't levied on health-care insurance premiums. Mr. Goss says that is the main reason for taxable payroll's shrinking share of GDP.

Can policy makers do anything about these phenomena? Income inequality defies any easy solution. Mr. Orszag says its impact on Social Security revenue can be alleviated by raising the payroll cap. This would fall hardest on those earning between the old and new cap: They would get higher pension benefits, but not enough to outweigh their increased taxes.

The erosion of the taxable payroll due to health costs could be dealt with either by taxing health-insurance benefits, as some tax-overhaul advocates have proposed, or finding some way to slow health inflation.

Ultimately, income inequality and health-care inflation are thornier than the more basic problems that policy makers now are dealing with on Social Security. Still, their role demonstrates that the program's problems aren't simply the result of demographics.