Two Misleading Narratives on the Social Security Funding Crisis - Part 2

False narratives about widening income inequality

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This is the second part of a two-part series examining misleading narratives about the causes of Social Security’s funding crisis. Read part one, which explores how wage indexing of initial benefits has made demographic pressures on the program far more difficult to manage.

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In the previous blog post, I discussed how the common narrative that Social Security’s funding crisis is caused by demographics is misleading: for most of Social Security’s history, economic growth helped boost the program’s finances, but changes enacted in 1977 caused the initial benefits paid to retirees to grow along with the economy. That policy change, which Congress was warned at the time was financially unsustainable, caused demographics to be the main driver of Social Security’s financial solvency.

In this second post, I discuss another common narrative in Social Security policy circles: that widening income inequality has undermined Social Security’s funding base by allowing the rich to avoid paying their fair share into the system. But this, too, is misleading.

Social Security is funded via a 12.4 percent tax on earnings up to a specified cap, which in 2025 is $176,100. Participants pay taxes on earnings up to $176,100, and their benefits are calculated on those same capped earnings.

In 2023, the Social Security payroll tax was applied to 83 percent of total earned income. But back in 1983, 90 percent of total earnings were taxed.

Seemingly, this is a rich-get-richer kind of story where the wealthy avoid paying their fair share, denying Social Security of revenues that could pay benefits and put off insolvency.

And, to address it, many believe it is common sense to increase or even eliminate the ceiling on wages subject to payroll taxes. Restoring Social Security’s taxes to cover 90 percent of total earnings would require the payroll tax ceiling to rise to about $350,000. For workers in this income group, it would be a substantial increase in their taxes.

But there’s more to this story than the rich getting richer. In fact, income inequality, as we typically think about it, plays a much smaller role than one might presume, for two reasons.

First, the 1986 Tax Reform Act altered tax rates and regulations such that it made sense for so-called S Corporations to report income as wages paid to employees rather than dividends paid to shareholders (who were, in fact, the same people as the employees). As a result, reported wage income increased, and by enough to matter. In Congressional Budget Office data, the top 1 percent of households received 30 percent of their total incomes via earnings in 1985. By 1992, their earnings share of total income had risen to 42 percent. These newfound earnings weren’t taxed by Social Security, as they were above the payroll tax ceiling.

Now, in a sense that didn’t matter: that income wasn’t taxed before, either. But once that income began being reported as wages, it reduced the share of total earnings hit by the Social Security tax and created the rich-getting-richer narrative, even if income inequality didn’t change.

There’s a second factor that reduces the share of earnings covered by the Social Security tax: rising premiums for employer-sponsored health insurance. Specifically, when the premiums that employers pay for their employees’ health insurance increase, employers tend to cover those costs by reducing the growth of their employees’ wages. That reduces employees’ salaries subject to Social Security payroll taxes. In addition, the premiums that employees pay toward their workplace health plan also typically are not taxed by Social Security.

Okay, but how does this affect Social Security? The reason is that employer-sponsored health insurance premiums are larger relative to salaries for lower-paid than for higher-paid employees. Let’s say that an employer currently pays $10,000 per year for health premiums, but then the cost rises to $12,000 per year. To keep himself whole, the employer reduces every employee’s salary by $2,000. For an employee earning $20,000 annually, this reduces his pay by 10 percent. But for an employee earning $200,000 per year, his pay is reduced by only 1 percent.

This isn’t just theory. Various papers have shown that rising health insurance premiums have disproportionately eaten away at the earnings of lower-income employees. As Gary Burtless and Sveta Milusheva stated in a 2012 Brookings Institution study, “because employer health insurance premiums represent a much higher percentage of compensation below the maximum taxed earnings amount, the effect of health cost trends exerted a disproportionate downward pressure on money wages below the taxable maximum, reducing the percentage of compensation subject to the payroll tax.”

To address the role of health premiums in reducing Social Security’s funding base, one option would be to make premiums subject to the payroll tax. One such policy analyzed by Social Security’s actuaries would address about one-third of the program’s long-term funding gap. While it would increase taxes, in particular on low earners, low earners also receive back more in Social Security benefits than they pay in taxes. In other words, while many would not be happy in the short term, in the long term, low earners would actually be made better off.

So what does all this add up to?

First, the cause of Social Security’s $26 trillion long-term funding gap isn’t simply demographics. It’s demographics coupled with a policy, enacted over 40 years after the 1935 Social Security Act was passed, that automatically increases future benefits in line with wage growth, which historically tends to exceed the rate of inflation. Congress can’t (easily) change demographics, but it sure can change policy.

And second, the idea that Social Security’s funding has been undermined by letting the rich off the hook for their obligations has a remarkably weak basis in fact. Two factors that have nothing to do with income inequality – a tax law-induced shift in how income is reported and the rising cost of employer healthcare premiums (and their exclusion from the taxable base) – likely account for most of the decline in the share of earnings subject to Social Security taxes.

Social Security is the federal government’s largest spending program, the largest tax most American workers pay, and the largest source of income for most retirees. And it’s over $26 trillion in the financial hole. Lawmakers should revisit whether automatic wage indexing remains appropriate in today’s fiscal environment. They should also consider whether certain forms of compensation, like employer-sponsored health insurance premiums, should be included in the taxable base. Most importantly, they should reject the idea that tax hikes alone are the logical means to save Social Security—and consider structural benefit reforms before time runs out.

At the very least, it’s crucial that Americans and their elected representatives have an accurate picture of the forces and policies that are leading Social Security toward insolvency.

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This is the second part of a two-part series examining misleading narratives about the causes of Social Security’s funding crisis. Read part one, which explores how wage indexing of initial benefits has made demographic pressures on the program far more difficult to manage.

Andrew G. Biggs is a senior fellow at the American Enterprise Institute (AEI).

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