Does the tax cap make the system regressive?

Much of the sentiment to raise the cap comes from the perception that the Social Security tax is regressive.  People with earnings above the cap pay less tax proportionally to their income than people below it.  This is true because the tax is a flat rate of 12.4 percent on all earners (employer and employee share combined).  But for the vast segment of the workforce -- the roughly 95 percent of workers whose earnings fall below the cap -- the tax is a proportional one.  Some would suggest that the tax is modestly progressive within this group because the Earned Income Tax Credit (EITC)--which lowers income taxes for qualified persons--was partially intended to offset the Social Security bite on low-income workers.[4]

People also overlook the fact that Social Security taxable earnings lead to Social Security benefits, which are derived by applying a progressive formula to the earnings record on which the tax was levied.  While the highest covered earners pay lower Social Security taxes as a proportion of their income, they also receive the lowest return for their tax dollars. Thus, it can be argued that the regressivity of the tax is offset by the progressiveness of the benefits.

A recent analysis done by the Congressional Budget Office (CBO) shows that people born in the 1940s, with lifetime earnings in the lowest fifth of the income ladder, can expect to get lifetime benefits equal to twice their lifetime taxes.  In contrast, people in the highest fifth of the income ladder would get benefits equal to only 60 percent of their lifetime taxes (see following table).

It is interesting to note that because of the tax-to-benefit link, the most ardent supporters of the social insurance nature of Social Security reject the idea of taxing all earnings.  They fear two things:
that the low returns on the additional tax dollars that high earners would pay will give further impetus to allowing people to opt out of Social Security, thereby crippling the system for those who remain, and
that enormous and, in some eyes, unconscionably high benefits would be paid to people with large amounts, perhaps millions of dollars, in other income.  But to tax them further without paying those benefits would only intensify the pressures for an optional system, or for shifting to a means-tested general revenue financed system.

Comparison of Lifetime Payroll Taxes and Benefits
(Workers Born in 10-Year Period 1940-49)

Average lifetime payroll taxes    Average lifetime benefits    Ratio of lifetime taxes to lifetime benefits
All workers born from 1940-49    177,000    137,000    1.29 to 1

Lowest fifth of earners    28,000    58,000    0.48 to 1
Middle fifth of earners    175,000    142,000    1.23 to 1
Highest fifth of earners    348,000    214,000    1.63 to 1
Source: CBO, Updated Long-term Social Security Projections, March 2005.  Taxes and benefits are expressed in present values as of age 60.

Thus, whether the tax cap is fair is more complicated than simply alleging that its existence creates a regressive incidence of taxation.