Analysts have proposed raising the maximum level of earnings subject to the Social Security payroll tax (the "tax max") to improve long-term Social Security Trust Fund solvency. This article investigates how raising the tax max leads to the "leakage" of portions of the additional revenue into higher benefit payments. Using Health and Retirement Study data matched to Social Security earnings records, we compare historical payroll tax payments and benefit amounts for Early Boomers (born 1948-1953) with tax and benefit simulations had they been subject to the tax max (adjusted for wage growth) faced by cohorts 12 and 24 years older. We find that 43.2 percent of the additional payroll tax revenue attributable to tax max increases affecting Early Boomers relative to taxes paid by the cohort 12 years older leaked into higher benefits. For Early Boomers relative to those 24 years older, we find 53.5 percent leakage.
Raising the maximum earnings level subject to the payroll tax is one of the policies often suggested as a means of narrowing the financial gap facing the Social Security system (for example, Senate Special Committee on Aging 2010). Increasing the cap on taxable earnings would generate greater payroll tax revenues to reduce future Social Security Trust Fund shortfalls in the face of increasing benefit obligations. The Social Security Administration's (SSA's) Office of the Actuary, the Congressional Budget Office (CBO), and the Congressional Research Service (CRS), among others, have estimated the effects of increasing the taxable maximum (or "tax max").1 Typically, they simulate the effects of changing the tax max under two polar assumptions about such a law-that either the increased taxes on earnings will result in higher benefit payments, or they will not.2 The difference between these estimates indicates "leakage"-the additional payroll tax receipts that are used to pay higher benefits, rather than to shore up the Social Security trust funds-as those who pay additional taxes because of the higher tax max are in turn credited with additional benefits. The size of this potential leakage obviously concerns those who are contemplating changes in the Social Security tax and benefit structure.
The tax max has increased in the past, first on an ad hoc basis, and since 1982 as an annual automatic adjustment determined by wage indexing.3, 4 In this article we use data from the University of Michigan's Health and Retirement Study (HRS) matched with data from Social Security administrative files to improve our understanding of how tax max changes have affected Social Security tax receipts and benefit payments. Using HRS data enables us to learn about changes in own benefits from increases in own earnings, as well as increases in spouse and survivor benefits due to increases in the taxable earnings of primary beneficiaries in couple households.5
To separate the effects of changes in the tax max from changes in earnings over time for members of a given cohort, we adjust the cap, reducing it to levels that applied to older cohorts, while holding earnings constant at the levels observed for the youngest cohort available. Because the calculation involves lowering the caps relative to actual values, we do not confront the absence of data on earnings above the taxable maximum. Thus, we avoid a problem faced by studies that project the effects of changing the tax max into the future. Moreover, if we chose to use the actual earnings of an older cohort as our base, and then to project earnings forward, we would face the further limitation of having the administrative data on earnings prior to 1978 censored by the earnings cap.
Using historical data provides another advantage. Projecting future earnings for each individual with earnings near the tax max is harder than it might first appear. Forecasting the effects of tax max increases on benefits and taxes paid is sensitive to the model underlying the projections. …