The recent debates over how to fix growing budget deficits, recently highlighted by President Trump’s fiscal year 2021 budget proposal and the latest Congressional Budget Office report, have motivated major Democratic presidential candidates to propose tax changes to the federal government’s funding of Social Security and Medicare, the major federal entitlement programs driving much of the projected budget deficit over the next 10 years. Unlike proposals that rely on spending cuts to ensure that the budget deficit is closed, these tax proposals would raise payroll tax rates and expand the payroll tax base for high earners.
These Democratic candidate payroll tax proposals, while helping to close the budget gap driven by entitlement spending, would harm economic growth and would need to be paired with other reforms to ensure the budget shortfall is closed.
Currently, employees and employers both contribute 6.2% of employee wages for Social Security up to a wage cap, set at $137,700 in tax year 2020. This means that wages above $137,700 are not taxed for the Social Security payroll tax. In addition, employees and employers contribute 1.45% of wages to Medicare, totaling 2.9%. This amount is not capped, meaning all wages are subject to the Medicare payroll tax.
Workers with wages above $250,000 when filing jointly ($200,000 single) are also subject to a 0.9% additional Medicare tax on wages above that threshold for a combined payroll tax rate of 3.8%.
The payroll tax is typically considered a regressive tax, as lower-paid workers face a combined payroll tax rate of 15.3%, while higher earners pay marginal tax rates of up to 3.8% on wages above the Social Security wage cap. This regressivity is offset by the progressive nature of Social Security benefits, which provide greater benefits to lower earners when compared to the tax paid into the program.
The top five Democratic candidates coming out of Iowa all want to increase the amount of wages subject to the payroll tax. For example, former Vice President Joe Biden proposes to impose the 12.4% Social Security payroll tax on wages over $400,000.
Sen. Bernie Sanders, Sen. Amy Klobuchar, and former South Bend, Indiana, Mayor Pete Buttigieg propose a similar change, applying the 12.4% tax on wages over $250,000. Finally, Sen. Elizabeth Warren would levy a 14.8% payroll tax on wages over $250,000, raising the Social Security payroll tax rate on higher earners. This creates a so-called “donut hole” in the tax base between $137,700 and $250,000.
Each of these proposed changes would make the tax code more progressive by raising marginal tax rates on the wages of higher earners. These changes come at the cost of lower economic growth and fewer jobs. For example, the Tax Foundation estimates that Warren’s plan would lower long-term economic growth by 0.41% and cost about 530,000 jobs. Higher payroll taxes lower economic growth because they lower employee wages, reducing the return to working and making leisure more attractive. In the long run, this reduces how much is produced in the economy as people work fewer hours and are less productive.
Each proposal would raise revenue to support Social Security’s solvency, ranging from about $650 billion over 10 years from Biden’s proposal to just over $1.5 trillion raised over that time period from Warren’s payroll tax plan. These changes alone would not put Social Security completely in the black, but would extend the program’s solvency over the next 30 years.
Policymakers and presidential candidates should consider the trade-offs of raising payroll tax rates or the payroll tax base. Higher payroll taxes come at the cost of economic growth and job creation, with the benefit of helping to make our entitlement programs more sustainable. Payroll tax changes, if implemented, should be combined with other reforms to entitlement programs. This ensures that the programs are fiscally sound and minimize the impact on economic growth.
Garrett Watson is a senior policy analyst at the Tax Foundation, where he conducts research on state and federal tax policy.
