How growing inequality is worsening Social Security's financial crunch

Social Security's looming funding crisis is usually blamed on demographics, with an aging U.S. population and declining birth rates leaving fewer workers to support retirees. But another force is also draining the program's finances: widening income inequality.

In the last few decades, incomes of higher-paid Americans have soared, far outpacing those of low- and middle-class workers. That's become a problem for Social Security because the program only taxes annual earnings up to $184,500, meaning it loses out on much of the faster income growth among top earners.

As a result, Social Security's revenue base is eroding, according to the program's latest trustees' report. The share of total wages subject to Social Security taxes has fallen from almost 87% in 1984 to roughly 83% today, largely because high earners' pay has grown much faster than everyone else's, lifting more of their income above the tax cap, the report found.

"The Social Security trust fund is under strain because Congress has failed to update the program for the economy we actually have," Elizabeth Wilkins, CEO of the Roosevelt Institute, a progressive think tank, said earlier this month. "Too much income now flows to the top, where it escapes Social Security taxation."

Eliminating the $184,500 tax cap, one proposal for fixing Social Security, could shore up the program's finances by requiring high-income Americans to contribute more to support the retirement and disability program, according to some policy experts.

Without an overhaul, Social Security's trust fund is on track to become insolvent by the end of 2032, the trustees' report said earlier this month. At that point, the program's roughly 70 million beneficiaries would see a 22% cut to their monthly Social Security checks, an average reduction of about $500 per month.

That's an outcome that experts say would lead to widespread financial hardship among seniors, disabled people, and children and spouses of deceased workers. Social Security has faced a financial shortfall before, when in the early 1980s its trust funds were on the brink of insolvency due to economic turbulence over the previous decade.

In 1983, U.S. lawmakers overhauled Social Security by gradually increasing the retirement age and raising payroll taxes, among other changes. While the tax cap on wages adjusts each year to track inflation, it wasn't tweaked in the 1983 reforms to account for the labor market shifts that followed in ensuing years.

That was likely due to projections at the time that the distribution of wages and wage growth would remain similar to the past. Actuarial projections that Congress relied on in the 1980s assumed that the program would continue to tax the same share of wages for the next 75 years — about 87% — according to a January report from the Roosevelt Institute.

But as higher earners pulled ahead of other Americans, more of their income has escaped the Social Security payroll tax, the group's analysis found.

Real earnings for the top 6% of American workers rose 62% from 1983 through 2000, the Roosevelt report said. By comparison, the 94% of workers whose incomes were below the payroll tax cap saw average real earnings gains of 17%, the group found.

The trust fund has been "inadvertently starved of necessary revenue" since 1983, according to the Roosevelt Institute.

The tax cap, which has been in place since the program debuted in the 1930s, is frequently mentioned in plans to strengthen Social Security. Some proposals would phase it out over time, while others would create a "donut hole" for people earning $184,500 to $250,000, or even $400,000.

Under that approach, earnings in the donut hole would not be subject to payroll taxes, but the tax would resume above the higher income threshold.

Removing or phasing out the tax cap could close between 22% and 67% of the program's funding gap, according to the Social Security Administration's scoring of these proposals.

Another option would be to include automatic triggers that kick in when revenue is below projections, the Roosevelt Institute said. For instance, if the share of wages subject to Social Security taxes fell below 87%, the taxable maximum could automatically adjust to keep the share at that level.

Social Security is "a very strong program that can be fixed," said Joel Eskovitz, a senior director of Social Security and savings at the AARP Public Policy Institute, in a recent conference call to discuss the program's funding issues. "Most Americans want it to be fixed by not cutting benefits."