The salutary news from Capitol Hill this summer is the steady movement toward reforming Social Security's Old-Age Program. Despite news stories and public opinion polls, many Members of Congress in both parties have pushed forward with serious debate over Social Security financial future and analysis of ways to make that future more secure. Everyone who cares about Social Security's retirement programs applauds that effort.

Indeed, it appears likely that the principal bill writing committees of the House and Senate may complete work on reform legislation over the next few months. Given that increasing probability, it is important now to consider the ramifications of reform plans on a host of factors, not the least of which is U.S. economic activity.

My testimony today focuses on how raising taxes to pay for Social Security's expected financial shortfalls would likely affect major economic indicators. That is, what does mainstream economic theory tell us are the likely effects on the general economy if Congress increases dedicated revenue flows to finance projected shortfalls between Social Security's income and its outlays?

Why start with the question rather than with one focusing on the economic effects of using higher taxes to fund the transition costs to an improved Social Security retirement program? Clearly, Congress will need many answers to this question. However, I believe it should first ponder an often heard "reform" to the current system that its advocates claim would avoid any necessity for embracing Personal Retirement Accounts: raise taxes to fill in the financing shortfalls either by increasing the payroll tax rate or raising the maximum taxable income amount.

Research conducted by me and my colleagues at Heritage's Center for Data Analysis indicate that either approach to revenue enhancement comes with an economic price. Of course, so does the President's plan. The economic costs, however, are significantly different.

President Bush proposes to solve the problem of Social Security's unfunded liabilities by enacting a reform plan that includes personal retirement accounts (PRAs). Proponents of PRAs argue that this sort of reform would increase national savings, bolster employment, and improve economic growth, all while closing Social Security's funding gap. Opponents of the President's approach argue that Social Security's funding problems do not demand wholesale reform and that Social Security's shortfall is only a "challenge" that can be addressed by making small changes to the current program.

One such change that has been proposed would be to raise payroll taxes enough to render Social Security solvent. Opponents of real reform are right that raising payroll taxes could close a portion of Social Security's funding gap, but they are wrong in saying that doing so would require only a small change. Raising payroll taxes would make Social Security a worse deal for millions of working Americans, harm the economy, and cost thousands of jobs, and still would not fix Social Security.

Social Security faces an unfunded liability of $3.7 trillion in today's dollars over the next 75 years. This number represents the amount that the system, despite having promised the money to America's workers, will be unable to pay. Short of major reforms, raising taxes or cutting benefits are the only ways to close this funding gap.

Right now, workers pay a 6.2 percent tax on their wages up to $90,000 to fund Social Security. Employers pay an additional 6.2 percent tax. This division in the payroll tax is artificial, however, as employers regard their part of the payroll tax as an expense of hiring, just like wages and other benefits: In other words, it is money that the employer is willing to spend on his workers. Though workers see only a 6.2 percent deduction on their pay stubs for Social Security, they really pay the whole 12.4 percent tax in terms of foregone wages.

Social Security's Trustees estimate that increasing the payroll tax by 1.89 percentage points, to 14.29 percent in total, would be sufficient to make Social Security's Old Age, Survivors, and Disability programs solvent.[1] This is the sort of "small change" that opponents of reform paint as a reasonable solution to Social Security's developing crisis.

The average worker might disagree. If payroll taxes were increased by 1.89 percentage points, a worker earning $35,000 would forego an additional $662 in pay every year. Raising payroll taxes by 1.89 percentage points would cost this worker, on average:

• As much as he spends on gasoline over three months;
• As much as he spends in two and a half months on clothing;
• As much as he spends in one month on food for consumption at home; or
• As much as he spends in two months on food outside of the home.[2]

In other words, this "small change" in the payroll tax would have a major impact on most workers' household budgets.

Using the Global Insight U.S. Macroeconomic Model, economists at The Heritage Foundation's Center for Data Analysis simulated a 1.89 percentage point increase in the payroll tax.[3]

It should be no surprise that a tax increase of this magnitude would increase the cost of labor in the economy and thereby have an impact on jobs. The CDA study found that a 1.89 percentage point increase in the payroll tax would reduce potential employment by 277,000 jobs per year, on average, over the next 10 years relative to the baseline.

There are spillover effects on economic growth as well. Increasing the payroll tax would reduce U.S. gross domestic product (GDP), a broad measure of economic activity, by $34.6 billion per year, on average, over the next 10 years.

Overall, raising the payroll tax would have a major impact on U.S. households. On average, every American would have $302 less in disposable income per year for each of the next 10 years, amounting to over $1,200 per year for a family of four. Personal savings would also decline in the aggregate by $46.9 billion per year, on average, over the next 10 years. Ironically, this decline in savings would make worse the very problem that Social Security is intended to fix-workers retiring with insufficient savings.

Raising the payroll tax rate is only one variant of the revenue enhancement approach to reform. Other proponents of tax increases argue that the amount of wages subject to the tax should be increased. This increase in what is called the maximum taxable income would, indeed, increase revenues.

However, the amount of the increase falls far short of expectations. Using SSA's own projections, Heritage analysts found that eliminating the cap would generate only enough revenue to delay the date of the system's insolvency by eight years, from 2017 to 2025. Under the current law, by 2041, the OASI program would receive only enough revenue to pay 74 cents on every dollar in promised benefits.[4]

Yet the cost of eliminating the cap would be substantial. It would result in the largest tax increase in the history of the United States,[5]subjecting millions of American families to a massive hike in their payroll taxes and further reducing the already dismal rate of return to Social Security.[6]It would also negatively affect America's economic prospects, slowing U.S. output growth and eliminating hundreds of thousands of employment opportunities.

Specifically, eliminating the cap on taxable wages would:

• Result in the largest tax increase in U.S. history, raising $607 billion (in nominal dollars) over five years and just over $1.4 trillion over 10 years.[7]
• Fail to save Social Security from bankruptcy. Social Security would start paying out more in benefits than it collects in taxes in 2025, only eight years later than under the current system. (See Chart 1.)
• Increase the top effective federal marginal tax rate on labor income to over 50 percent, its highest level since the 1970s.
• Reduce the take-home pay of 9.8 million workers by an average of $4,206 in the first year alone after the cap is removed.
• Weaken the U.S. economy by reducing the number of job opportunities and personal savings.

By fiscal year (FY) 2015, the number of job opportunities lost would exceed 965,000, and personal savings (adjusted for inflation) would decline by more than $55 billion.

But the problem is even more fundamental: Social Security's very structure is such that even all this sacrifice would not be enough to save it. Currently, the system is in a cash-flow surplus, which means that it takes in every year more money in taxes than it pays out. But these extra funds don't really accumulate. Instead, the government spends them and issues the Social Security Trust Fund special bonds, which are really just IOUs to pay back the money at a later date.

According to Social Security's Trustees, the system is set to have a negative cash flow beginning in 2017. To pay out promised benefits, it will have to cash in the government's IOUs, and the money to pay them will have to come from somewhere-either higher general revenue taxes (e.g., income taxes), lower government spending, or, ironically, more government debt. Because of the way the Trust Fund operates, raising payroll taxes would only delay the date when Social Security's cash flow goes negative. Future tax increases or benefit cuts would still be on the table.

Opponents of real Social Security reform are right, but also deeply misleading, when they say that the current system can be saved by making only small changes: The changes may indeed be small, but the numbers involved are enormous. Raising the payroll tax or the maximum taxable income limit enough to fully fund Social Security would put a damper on savings, jobs, and economic growth to the great detriment of working Americans. And raising taxes enough to take Social Security's cash-flow problem off the table would require even more sacrifice.

Endnotes