Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens

Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Thomas L. Hungerford Specialist in Public Finance February 5, 2013 Congressional Research Service 7-5700 www.crs.gov RL33943 CRS Report for Congress Prepared for Members and Committees of Congress Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Summary According to the Social Security Trustees, assets in the two Social Security trust funds will be exhausted by 2033, and, thereafter, Social Security payroll tax revenues will cover about threequarters of promised benefits. Over the past decade several proposals have been put forward which could help to close the Social Security program’s long-term financing gap. One proposal would increase the Social Security payroll tax base so that 90% of covered earnings are taxable— the same proportion as in 1982. This policy would increase the payroll taxes paid by higherearning workers and not affect workers earning less than the current Social Security maximum taxable limit, which is $113,700 in 2013. Some analysts have proposed raising the Social Security payroll tax base and reducing the payroll tax rate. This policy would increase the taxes paid by higher-earning workers and reduce taxes paid by low- and middle-income workers. This policy proposal could raise revenue for the Social Security program or be revenue neutral. Although the legislated Social Security payroll tax rate is 12.4%, the average Social Security payroll tax is slightly progressive throughout the bottom 80% of the income distribution in that lower-income families pay a lower proportion of income in payroll taxes than higher-income families. At the higher-income levels—the top 20%—the payroll tax is regressive in that the proportion of income paid in payroll taxes falls as income rises. The richest 1% of American families pay a smaller proportion of their income in payroll taxes than the poorest 20% of families. Four policy options, which raise the payroll tax base, are examined; two of the policies also provide tax relief to low- and middle-income workers. Each of the three policies reduces the regressivity of the payroll tax at the upper end of the income distribution. Currently, less than 10% of families contain a worker earning more than the maximum taxable limit. Consequently, over 90% of families would be unaffected by increasing the maximum taxable limit. And if this change were combined with a payroll tax rate reduction, over 90% of families would pay lower payroll taxes. It has been argued that the revenue increases from raising the payroll tax base would be significantly less than expected because of indirect behavioral changes by workers. These predicted behavioral effects would reduce taxable earnings, the proportion of family income subject to payroll taxes, and tax revenue. But recent research raises doubts concerning this position and suggests these behavioral effects would likely be negligible. Congressional Research Service Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Contents Taxable and Covered Earnings ........................................................................................................ 2 The Distribution of Tax Burdens ..................................................................................................... 3 Behavioral Effects of Tax Changes .................................................................................................. 7 Figures Figure 1. Taxable Earnings as a Percentage of Social Security Covered Earnings, 19502011 .............................................................................................................................................. 3 Tables Table 1. Average Social Security Payroll Tax Rates, 2012 .............................................................. 4 Table 2. Average Change in Annual Social Security Payroll Taxes, 2012 ....................................... 6 Table 3. High-Earning Workers and Taxable Earnings by Quintile, 2012 ....................................... 8 Contacts Author Contact Information........................................................................................................... 10 Congressional Research Service Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens T he payroll tax for Social Security and Medicare is the largest federal tax many lowerincome families pay. The Congressional Budget Office (CBO) estimates that the poorest 20% of U.S. households paid about 8.3% of their income on social insurance payroll taxes in 2009.1 In contrast, these lower-income households paid negative income taxes because of the refundable earned income and child tax credits. Indeed, a justification for the earned income credit (EIC) is “to provide work incentives and relief from income and Social Security taxes to low-income families who might otherwise need large welfare payments.”2 The tax rate under current law on covered earnings is 12.4% for Social Security and 2.9% for Medicare.3 Half of the tax rate is paid by the employee and the other half by the employer; the self-employed are responsible for the entire amount.4 The tax rate for Social Security applies only on covered earnings below the maximum taxable limit, which is $113,700 for 2013.5 The Medicare tax rate applies to all covered earnings. The Social Security Trustees project that the assets in the two Social Security trust funds will be exhausted in 2033, and after that, Social Security payroll tax revenue will cover about threequarters of promised benefits.6 To help close Social Security’s long-term financing gap, some analysts have proposed increasing the Social Security tax base by raising the maximum taxable limit so that 90% of aggregate covered earnings are taxable (the percentage in 1982).7 CBO estimated that the maximum taxable limit would have had to been $186,000 in 2008, almost double the actual limit, so that 90% of covered earnings are taxable. They estimated that this policy could have increased payroll tax revenues by $503.4 billion over the 2010-2019 period.8 The Urban Institute reports that the Social Security Administration estimates the 2012 maximum taxable limit would have had to been $214,500 so that 90% of covered earnings were taxable.9 Since 1982, the ratio of taxable earnings to covered earnings has fallen from 90%, reaching 82.7% in 2007. 1 CBO, The Distribution of Household Income and Federal Taxes, 2008 and 2009, July 2012. Social insurance payroll taxes include Social Security and Medicare payroll plus Unemployment Insurance payroll taxes. 2 U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue Act of 1978, joint committee print, 96th Cong., 1st sess., Mar. 12, 1979 (Washington: GPO, 1979), p. 51. 3 Covered earnings are earnings from employment covered by the Social Security and Medicare programs. Most workers in the United States are covered by the Social Security and Medicare programs. Some federal, state, and local workers, however, are not covered by these programs. The Health Care and Education Reconciliation Act of 2010 (P.L. 111-152) increased the Medicare payroll by 0.9 percentage points for high income taxpayers (to 3.8%). 4 Most economists agree that workers ultimately bear the full burden of the payroll tax. Employers typically pass on their share of the payroll tax to employees through paying lower wages. See CBO, Effective Federal Tax Rates, 19791997, October 2001. 5 The maximum taxable limit is adjusted annually to keep pace with changes in average earnings. Covered earnings below the maximum taxable limit are referred to as taxable earnings. 6 This projection is based on the Trustees’ intermediate cost assumptions. Under the low cost assumptions, Social Security does not face long-term financial problems, and under the high cost assumptions, the Social Security trust funds will be depleted in 2027. See The Board of Trustees, The 2012 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds, April 25, 2012 (Washington: GPO, 2012). 7 Provisions in the 1977 amendments to the Social Security Act were designed to increase the percentage of covered earnings subject to the payroll tax to 90% by 1982. 8 CBO, Budget Options, volume 2, August 2009, p. 234. 9 See The Urban Institute website at http://www.urban.org/retirement_policy/sstaxableminimum.cfm. Congressional Research Service 1 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Although most analysts advocate raising the maximum taxable limit to increase revenues for the Social Security program, some would use the increased revenues for other purposes. For example, one analyst suggested reducing the payroll tax rate and keeping it revenue-neutral by raising the maximum taxable limit.10 This change would provide payroll tax relief to low- and middleincome workers. This report examines changes in the distribution of the tax burden of four policies involving raising the Social Security maximum taxable limit. Taxable and Covered Earnings The portion of Social Security-covered earnings subject to the payroll tax has fluctuated since its inception. Taxable earnings as a percentage of covered earnings was 92.4% in 1940 and dropped as low as 71.3% in 1965. The trend in this percentage since 1950 is displayed in Figure 1. Prior to 1972, the Social Security maximum taxable limit was updated periodically by Congress, which contributed to the dramatic and abrupt fluctuations in the 1950s and 1960s. After 1972, the maximum taxable limit was automatically updated as annual average earnings increased, which moderated the fluctuations somewhat. In response to Social Security funding problems, the 1977 amendments to the Social Security Act increased the Social Security tax base by raising the maximum taxable limit so that 90% of covered earnings were taxable by 1982. This change explains the increase in the proportion of covered earnings that are taxable from 84% in 1976 to 90% in 1982. After 1982, the maximum taxable limit was automatically updated as annual average earnings increased. Although the maximum taxable limit is updated annually in response to increases in average wages, the proportion of covered earnings subject to the payroll tax is not constant—it has fallen since 1983. A primary reason is an increase in wage inequality. Wages have become more unequally distributed since the early 1980s, mostly due to wage gains at the top of the income distribution.11 Consequently, a larger share of earnings of high-wage workers will be above the maximum taxable limit. 10 Dalton Conley, “Turning the Tax Tables to Help the Poor,” New York Times, Nov. 15, 2004, p. A21. Robert G. Valletta, Computer Use and the U.S. Wage Distribution, 1984-2003, Federal Reserve Bank of San Francisco Working Paper 2006-34, October 2006. 11 Congressional Research Service 2 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Figure 1. Taxable Earnings as a Percentage of Social Security Covered Earnings, 1950-2011 Taxable to Covered Earnings 100 Percentage 90 80 70 60 50 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Year Source: Social Security Administration, 2012 Annual Statistical Supplement to the Social Security Bulletin, Table 4.B1. The Distribution of Tax Burdens The distribution of tax burdens is simulated for three policy options, two of which have been proposed by various policy analysts. The base year for the simulation is 2008, the last year for which appropriate data is available.12 The policy options compared in this report are as follows: • Policy Option 1. This policy would increase the maximum taxable limit to $214,500 (up from the 2012 limit of $110,100), which is the maximum taxable limit required so that 90% of covered earnings would have been subject to the payroll tax in 2012. The additional tax revenues are targeted to help close Social Security’s projected long-term financing gap. Consequently, the payroll tax rate remains at 12.4%. • Policy Option 2. This policy would also raise the maximum taxable limit to $214,500 but reduce the payroll tax rate to 11.4% so payroll tax revenues remain 12 The data source for the simulations is the Annual Social and Economic Supplement of the March 2012 Current Population Survey (CPS). For this survey, the Census Bureau collects survey information for over 200,000 people living in almost 100,000 households. The survey is representative of the civilian noninstitutionalized population in the United States. The March supplement includes detailed information on family and individual income for the previous year (2011). Earnings were adjusted to 2012 by SSA’s average wage index. Congressional Research Service 3 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens unchanged. In essence, the additional payroll tax revenues from increasing the maximum taxable limit are used to offset the reduction in the payroll tax rate. • Policy Option 3. This policy option would raise the maximum taxable limit to $214,500. However, half of the additional revenue is targeted to reduce the projected long-term financing gap and the other half is used to offset a payroll tax rate reduction. The payroll tax rate is reduced to 11.9%. • Policy Option 4. This policy would raise the maximum taxable limit to $214,500. The payroll tax rate remains at 12.4% on earnings below the limit and a 2% payroll tax rate is levied on earnings above this limit.13 Simulation results of the average Social Security tax rate for families with workers in different parts of the income distribution are reported in Table 1. The average tax rate is the total payroll tax (employee and employer shares) of each worker in the family and divided by total family income. Total family income includes wages, dividends, farm income, retirement income, royalties, and government cash transfers, among others. It does not include capital gains and inkind government transfers such as food stamps and housing assistance. The average tax rate is reported for all families, each income quintile (20% of families), the richest 10% of families, the richest 5%, and the richest 1% of families.14 Table 1. Average Social Security Payroll Tax Rates, 2012 90% of Covered Payroll is Taxable Current Policy Option 1 Policy Option 2 Policy Option 3 Policy Option 4 All 9.61% 10.37% 9.53% 9.95% 10.47% Quintile 1 10.44 10.44 9.60 10.02 10.44 Quintile 2 10.61 10.61 9.76 10.12 10.61 Quintile 3 10.84 10.84 9.96 10.40 10.84 Quintile 4 11.03 11.10 10.20 10.65 11.10 Quintile 5 8.54 9.91 9.11 9.51 10.10 Top 10% 7.49 9.32 8.57 8.95 9.61 Top 5% 6.18 8.46 7.78 8.12 8.89 Top 1% 3.19 5.56 5.11 5.34 6.51 Source: Author’s analysis of the March 2012 Current Population Survey. Note: The sample includes only families that contain at least one worker. The first column of numbers in Table 1 shows the average tax rate under current law. The average tax rate for all families is 9.6%, which is less than the 12.4% statutory payroll tax rate on 13 This is a variation on a proposal that Representatives Sam Johnson, Kevin Brady, and Paul Ryan requested the Social Security Administration to estimate. See the 2010 letter from Stephen Goss, Chief Actuary for SSA to Representatives Johnson, Brady, and Ryan (http://www.ssa.gov/OACT/solvency/JohnsonBradyRyan_20100512.pdf). 14 Families are assigned to income quintiles based on equivalence-adjusted total family income (total family income divided by an equivalence scale). The equivalence scale is the one proposed by the National Research Council. See Constance F. Citro and Robert T. Michael, eds., Measuring Poverty: A New Approach (Washington, DC: National Academy Press, 1995). Congressional Research Service 4 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens earnings. This occurs because only earnings are subject to the payroll tax while income from other sources is not. In addition, only the first $110,100 earned in 2012 was subject to the payroll tax while earnings above $110,100 were exempt. The average tax rate, however, varies across the income distribution. Families in the bottom income quintile (that is, the poorest 20% of families) have an average tax rate of 10.4%. The average tax rate slightly increases in moving from the poorest quintile to the fourth quintile. Throughout the bottom 80% of the income distribution, the Social Security payroll tax is slightly progressive in that higher-income families pay a larger proportion of their income in payroll taxes than lower-income families. The average tax rate for families in the richest income quintile, however, is 8.5%.15 The rate falls in moving up through the upper part of the income distribution. The richest 10% of families pay a smaller share of income in payroll taxes than the poorest 20%, while the share of the richest 1% is about a third that of the poorest 20%. Above the 80th percentile, the payroll tax is a regressive tax in that the average tax rate falls as income rises.16 The second column of numbers shows the simulated average tax rates for policy option 1— raising the maximum taxable limit and maintaining the current legislated tax rate. For all families, the average tax rate rises by about 0.7 percentage points (a 7% increase) to reach over 10%. This policy option, however, only affects workers whose earnings are above $110,100. Families in the bottom two income quintiles contain no workers earning more than $110,100, and about 0.01% of the families in the middle income quintile (quintile 3) contain such workers. Consequently, the average tax rates for the bottom three quintiles are largely unaffected by this policy option. The average tax rate for the families in the top 40% of the income distribution, however, rises under policy option 1. The tax rate increases slightly for families in the fourth income quintile (from 11.0% to 11.1%) since only about 2% of these families contain a worker earning more than $110,100. The families in the top quintile, however, experience an 15% percent, or 1.3 percentage point, increase in their average tax rate. The average tax rate increases by 1.8 to 2.5 percentage points for families in the top 10% of the income distribution. Policy option 2 raises the maximum taxable limit but reduces the tax rate so that total tax revenues remain unchanged. Since the policy is revenue neutral, the average tax rate for all families is the same as for current law (see the first row of Table 1). The average tax rate for most families, however, does change. The average rate falls for families in the bottom 80% of the income distribution (quintiles 1 to 4), and increases for families at the top. In general, workers earning less than $119,760 will pay less in payroll taxes than they do under current law; workers earning more than this will pay more in payroll taxes. The third option, policy option 3, is a blend of the first two policy options. Half of the increased revenue from raising the maximum taxable limit is used for financing the Social Security program and the other half offsets a payroll tax rate reduction. As was the case with policy option 2, this policy option reduces the average tax rates for families in the bottom 80% of the income 15 The average tax rate for high-income families may be artificially high because income from capital gains is not included in the measure of total income. 16 The results are broadly consistent with an analysis by CBO. Any differences are due to differences in the unit of analysis (family versus household), income definition and data source. See CBO, Historical Effective Federal Tax Rates: 1979 to 2006, April 2009. Congressional Research Service 5 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens distribution and increases it for families in the top income quintile. For the richest 1% of families, this option raises the average tax rate by 2.2 percentage points, a 67% increase. The poorest 20% see their average tax rate fall by 0.4 percentage points, or by about 4%. The final option is a variant of option 1—the maximum taxable limit is increased to $110,100 and a 2% payroll tax is applied to earnings above this level. Overall, the average tax rate increases by about 9% . Tax rates for the bottom 80% of families are unchanged; the average tax rate for the top 1% increases from 3.2% to 6.5%. Table 2 provides an alternate view of the effects of the three policy options by reporting the simulated average dollar change in Social Security payroll taxes paid by families in different parts of the income distribution. The reported dollar amounts include the change in both the employee’s and employer’s portion of the payroll tax. It is important to keep in mind that a family may contain more than one worker. Table 2. Average Change in Annual Social Security Payroll Taxes, 2012 Policy Option 1 Policy Option 2 Policy Option 3 Policy Option 4 $571 $0 $256 $612 Quintile 1 $0 -$117 -$58 $0 Quintile 2 $0 -$263 -$131 $0 Quintile 3 $0 -$428 -$214 $0 Quintile 4 $47 -$613 -$283 $47 Quintile 5 $2,141 $890 $1,516 $2,449 Top 10% $3,765 $2,225 $2,995 $4,361 Top 5% $6,092 $4,273 $5,183 $7,240 Top 1% $12,616 $10,224 $11,420 $17,677 All Source: Author’s analysis of the March 2012 Current Population Survey. Note: The sample includes only families that contain at least one worker. The dollar changes are consistent with the changes in the average tax rates reported in Table 1. The first policy option increases the payroll tax for the average family by $571. This policy option does not affect families in the bottom three income quintiles and increases the tax payments for families in the fourth quintile by less than $50, on average. The average family in the richest income quintile would pay $2,141 more in taxes, and the richest 1% of families would pay, on average, $12,616 more in payroll taxes under this policy. The second policy option is revenue neutral; consequently, the average tax change is zero. Families in the bottom four income quintiles would pay between $117 and $613 less in taxes, on average. Families in the top quintile would pay higher taxes (about $890, on average) and the richest 1% of families would pay $10,224 more. The impact of policy option 3 on payroll tax payments follows the same patterns as policy option 2, but the amounts are larger. On average, families will pay $190 more in payroll taxes under this policy. However, families in the bottom 80% of the income distribution will pay lower taxes, on average. High-income families (the top quintile) pay $1,516 more in taxes, while the richest 1% pay about $11,420 more in payroll taxes. Congressional Research Service 6 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Lastly, policy option 4 not only raises the maximum taxable limit but also taxes earnings above this limit (a 2% tax rate). This policy increases the payroll taxes of the top 20% by about $300. The top 1% would pay about $5,000 more in payroll taxes compared to just raising the maximum taxable limit. Behavioral Effects of Tax Changes It has been argued that the revenue increases from raising the payroll tax base would be significantly less than expected because of indirect behavioral changes by workers. Based on this interpretation, workers may respond to having more earnings subject to the payroll tax, which in effect is a reduction in earnings, by reducing their work effort (a labor supply effect) or shifting their income to forms that are not subject to the payroll tax (a taxable income effect). These behavioral effects would thus reduce taxable earnings, the proportion of family income subject to payroll taxes, and tax revenue.17 As discussed below, however, recent research raises doubts concerning this position and suggests these behavioral effects would likely be negligible. Relatively few families would be negatively affected by the four policy options examined. Of the families with at least one worker, about 9% contain a worker earning more than the maximum taxable limit (see Table 3). Families in the bottom three income quintiles contain no workers earning more than the maximum taxable limit ($110,100 in 2012). And few families in the next two quintiles contain high-earning workers—about 2% of the fourth quintile. About 30% of the families in the richest income quintile contain workers earning more than the maximum taxable limit. The percentage is significantly higher for the richest 10% of families. Consequently, most of the 6% of families with high-earning workers are at the top of the income distribution—71% are in the richest 10% of U.S. families. For the few families with high-earning workers, changing the payroll tax rate can affect labor supply in two possible ways. The first is the direct effect in which tax changes affect the wage received by the worker. Reducing wages could lead to a reduction in work effort (that is, labor supply). The empirical evidence indicates that men’s labor supply is relatively inelastic (that is, changes in the wage have little effect on labor supply) with estimated elasticities close to zero.18 In the past, women’s labor force behavior differed significantly from that of men. This was especially true for married women. But recent research indicates a convergence in the labor force behavior of the sexes. A recent study suggests that over the past two decades, women’s labor supply elasticities have fallen and converged with that of men.19 One study, specifically examining the effect of the payroll tax on women’s labor supply, concludes there is a work 17 D. Mark Wilson, Removing Social Security’s Tax Cap on Wages Would Do More Harm Than Good, Heritage Foundation, Center for Data Analysis Report #01-07, Oct. 17, 2001. 18 Early studies include Mark R. Killingsworth, Labor Supply (New York: Cambridge University Press, 1983), and Richard Blundell and Thomas MaCurdy, “Labor Supply: A Review of Alternative Approaches,” in Orley Ashenfelter and David Card, eds., Handbook of Labor Economics (Amsterdam: Elsevier, 1999), pp. 1559-1695. For a recent review see Robert McClelland and Shannon Mok, A Review of Recent Research in Labor Supply Elasticities, CBO working paper 2012-12, October 2012. 19 Francine D. Blau and Lawrence M. Kahn, “Changes in the Labor Supply Behavior of Married Women: 1980-2000,” Journal of Labor Economics, vol. 25, no. 3 (July 2007), pp. 393-438; Bradley T. Heim, “The Incredible Shrinking Elasticities: Married Female Labor Supply, 1978-2002,” Journal of Human Resources, vol. 42, no. 4 (Fall 2007), pp. 881-918; Kelly Bishop, Bradley Heim, and Kata Mihaly, “Single Women’s Labor Supply Elasticities: Trends and Policy Implications,” Industrial and Labor Relations Review, vol. 63, no. 1 (October 2009), pp. 146-168. Congressional Research Service 7 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens disincentive effect for women over 50.20 Since less than 4% of women over 50 earn more than the maximum taxable limit, few would potentially be affected by the three policy options analyzed. Furthermore, this study is based on labor force data from the 1970s—a time when women’s labor supply was more responsive to wage changes. Table 3. High-Earning Workers and Taxable Earnings by Quintile, 2012 Percentage of Families with at Least One Worker Earning More than Maximum Taxable Limit Taxable Earnings as a Percentage of Total Family Income 8.8% 77.5% Quintile 1 0.0 84.2 Quintile 2 0.0 85.6 Quintile 3 0.0 87.4 Quintile 4 2.2 89.0 Quintile 5 31.6 68.9 Top 10% 50.5 60.4 Top 5% 72.2 49.8 Top 1% 96.9 25.8 All Source: Author’s analysis of the March 2012 Current Population Survey. Note: The sample includes only families that contain at least one worker. The second effect is an indirect effect in which a change in the wage of one spouse affects the labor supply of the other spouse. Empirical studies, however, suggest married men are largely unresponsive to changes in their wives’ wages with estimated elasticities close to zero.21 While women’s labor supply, however, is thought to be responsive to changes in their husband’s wage, recent research suggests women’s responsiveness has declined over the past two decades.22 The cited studies suggest that raising the maximum taxable limit will have little effect on workers’ labor supply. Relatively few workers earn enough to be affected by such a policy change (about 7% of all workers earn more than the maximum taxable limit). Additionally, men’s labor supply appears largely unaffected by changes in their own wage and their spouse’s wage. And women’s labor supply behavior has increasingly become like that of men, and consequently they too appear largely unaffected by changes in their own wage and their spouse’s wage. While work effort or labor supply may not be affected by changes in the payroll tax, earnings subject to the payroll tax may be affected. In the aggregate, about three-quarters of U.S. families’ income comes from taxable earnings (see the last column of Table 3). Of the rest, most comes 20 Therese A. McCarty, “The Effect of Social Security on Married Women’s Labor Force Participation,” National Tax Journal, vol. 43, no. 1 (March 1990), pp. 95-110. 21 Paul J. Devereux, “Changes in Relative Wages and Family Labor Supply,” Journal of Human Resources, vol. 39 (Summer 2004), pp. 696-722, and Francine D. Blau and Lawrence M. Kahn, “Changes in the Labor Supply Behavior of Married Women: 1980-2000,” Journal of Labor Economics, vol. 25, no. 3 (July 2007), pp. 393-438. 22 Francine D. Blau and Lawrence M. Kahn, “Changes in the Labor Supply Behavior of Married Women: 1980-2000,” Journal of Labor Economics, vol. 25, no. 3 (July 2007), pp. 393-438. Congressional Research Service 8 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens from earnings above the maximum taxable limit, retirement income (Social Security and pension income), and investment returns (interest, dividends, and rental income). The proportion of family income from taxable earnings is over 80% for the bottom 80% of the income distribution. While the richest 20% of families derive about 69% of their income from taxable earnings. This proportion falls to under 50% for the richest 5% of families, and to about 25% for the richest 1%. Consequently, there may be some opportunities for workers with earnings more than the maximum taxable limit to shift their earnings to a nontaxable form of compensation. The economics research before 2000 generally suggests taxable income is responsive to changes in marginal tax rates.23 As marginal tax rates rise, the pre-2000 studies indicate taxpayers reduced their taxable income through tax avoidance strategies or tax evasion. They can do this by increasing deductions to reduce taxable income or by taking compensation in forms that are untaxed (such as stock options, which are untaxed until exercised) or subject to lower tax rates. A recent study, however, concludes that methodological problems lead to the estimated elasticities likely being overstated.24 More recent research suggests that the earlier results may have been due to the behavior of a few taxpayers in the extreme upper part of the income distribution.25 Several recent studies estimate that taxable income is much less responsive to changes in tax rates and suggest that relatively large increases in tax rates could lead to relatively small decreases in taxable income.26 In addition, one study found that tax rate changes have no effect on wages, one component of taxable income.27 Raising the maximum taxable limit would increase the marginal tax rate on wages, but this recent empirical research suggests that workers’ wage earnings would be largely unaffected.28 This research also suggests that reducing the payroll tax rate (as in policy options 2 and 3) would not affect workers’ behavior. 23 Martin Feldstein, “The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act,” Journal of Political Economy, vol. 103, no. 3 (1995), pp. 551-572; and Gerald Auten and Robert Carroll, “The Effect of Income Taxes on Household Behavior,” Review of Economics and Statistics, vol. 81, no. 3 (1999), pp. 681693. 24 CRS Report RL33672, Revenue Feedback from the 2001-2004 Tax Cuts, by Jane G. Gravelle. 25 Robert A. Moffitt and Mark O. Wilhelm, “Taxation and the Labor Supply Decisions of the Affluent,” in Joel B. Slemrod, ed., Does Atlas Shrug? The Economic Consequences of Taxing the Rich (Cambridge, MA: Harvard University Press, 2002); and Costas Meghir and David Phillips, “Labour Supply and Taxes,” in Dimensions of Tax Design: The Mirrlees Review, ed. Stuart Adams and others (Oxford: Oxford University Press, 2010), pp. 202-274. 26 Jon Gruber and Emmanuel Saez, “The Elasticity of Taxable Income: Evidence and Implications,” Journal of Public Economics, vol. 84 (2002), pp. 1-32; and Emmanuel Saez, “The Effect of Marginal Tax Rates on Income: A Panel Study of ‘Bracket Creep,’” Journal of Public Economics, vol. 87 (2003), pp. 1231-1258. For an extensive review of the literature see Emmanuel Saez, Joel Slemrod, and Seth H. Giertz, “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review,” Journal of Economic Literature, vol. 50, no. 1 (March 2012), pp. 3-50. 27 Emmanuel Saez, “The Effect of Marginal Tax Rates on Income: A Panel Study of ‘Bracket Creep,’” Journal of Public Economics, vol. 87 (2003), pp. 1231-1258. 28 Workers with earnings above the higher maximum taxable limit of $213,900 would not face an increase in the marginal tax rate after the change—their marginal tax rate would remain at zero. Congressional Research Service 9 Increasing the Social Security Payroll Tax Base: Options and Effects on Tax Burdens Author Contact Information Thomas L. Hungerford Specialist in Public Finance thungerford@crs.loc.gov, 7-6422 Congressional Research Service 10