Amid all the chatter about tax cuts the incoming Republican administration is expected to shepherd through a Republican Congress, it's easy to lose sight of a tax increase. Social Security payroll tax is set to rise for some workers due to a 7.3% increase in the maximum taxable earnings cutoff from $118,500 to $127,200.
Social Security payroll tax differs from federal income tax, which is levied on practically all income (that isn't stashed away in tax havens) and applies higher rates to higher earners. Old age, survivor and disability insurance (OASDI) – as the Social Security portion of payroll taxes is known – is only paid on the first $127,200 in earnings, and the tax rate on income below that threshold is a steady 6.2% for all income levels (12.4% for the self-employed, who must pay the employee and employer contributions). For the approximately 161 million workers making less than that cap every year, this year's change doesn't apply.
For the other 12 million, however, the maximum annual employee contribution to OASDI will rise by $539.40 to $7,886.40.
The increase is so steep this year partly because there was no increase last year, since rules prohibit raising the maximum taxable earnings level without also providing a cost-of-living adjustment (this year's adjustment is 0.3%). The maximum taxable earnings level is tied to the National Average Wage Index, which rose 3.6% in 2014 – without a corresponding rise in the earnings cutoff – and 3.5% in 2015. The result is the largest bump in OASDI-taxable earnings since 1981. (See When Do I Stop Paying Social Security Tax?)
High earners who chafe at this development can take comfort in the fact that the increase makes it marginally more likely that Social Security will be able to pay their benefits. According to the Social Security Board of Trustees' 2016 annual report, the program's costs will exceed its income beginning in 2020. By 2034, it will be necessary either to slash all benefits by 21%, raise the payroll tax rate by 3.58 percentage points, or some combination of the two approaches. The demographic squeeze is a well-known contributor to this grim outlook: there were 3.2 to 3.4 workers contributing to Social Security's coffers per beneficiary from 1974 to 2008; by 2035 the ratio is expected to fall to 2.2. (See also, How Old Will You Be When Social Security Goes Broke?)
But there is another, less well-known reason for Social Security's troubles. The rise in income inequality has not been kind to a program that only taxes a limited chunk of income. The percentage of workers who make more than the cutoff has not changed significantly – it is currently around 6% – but the proportion of the nation's income that is subject to OASDI taxes has fallen from 90.0% in 1983 to 82.7% in 2014, as a greater share of the nation's income goes to that cohort.