Social Security is a vital social insurance program that provides benefits to replace the lost earnings of disabled or retired workers and their survivors. As of June 30, 2023, nearly 67 million individuals receive monthly benefits. Without Social Security, almost 22 million more individuals would be in poverty.
According to the 2023 Social Security Trustees Report, Social Security is facing a financial shortfall and is projected to be unable to pay full retirement and survivor benefits in 2033. Without action, Social Security’s Trust Funds will be depleted, and only 77 percent of benefits would be payable using ongoing program revenues.
Social Security’s Trust Funds are primarily financed by the Federal Insurance Contribution (FICA) payroll tax, which is regressive due to the cap on earnings subject to the tax. Under current law, only earnings up to $160,200 are subject to the payroll tax, which is 6.2 percent of earnings for employees and employers, each, for a combined 12.4 percent.
However, some “in lieu of wages” compensation is excluded from the FICA tax under current law, further eroding the taxable wage base that funds Social Security benefits. These non-taxed items are predominantly fringe benefits.
Between 1969 and 2019, the portion of total compensation that was comprised of earnings decreased by an average of 0.14 percent per year. That equates to a 7 percent decline in taxable wages over that fifty-year period. Bureau of Economic Analysis data indicate that the largest single contributor to this shift from earnings to fringe benefits was from employer-sponsored group health insurance. Increased social insurance payroll taxes and a slight increase in employer payments for retirement plans played a smaller role during that period.
Economists generally believe that employers set compensation at a certain level, and any increase in one element is offset by a decrease in other parts of the total compensation package. Therefore, an increase in the cost of employer-provided health insurance reduces the amount of earnings the worker receives. Because only earnings are subject to the payroll tax, as compensation has shifted to a higher portion being paid as fringe benefits instead of earnings, the lower the contributions to the Social Security program have been.
Unfortunately, this trend has only increased, and is projected to increase even further over the years as a larger portion of worker compensation is made up of fringe benefits not subject to the payroll tax (e.g., funds to cover employer-provided health insurance, funds for employer matching and nonelective contributions to retirement plans, and cafeteria plans such as contributions up to a certain amount for health spending under a Flexible Spending Account).
Under the Social Security Trustees intermediate assumptions, about 18 percent of total compensation is currently not subject to the payroll tax—a proportion that is expected to increase to almost 25 percent by 2097—because more compensation is being paid as fringe benefits not subject to the payroll tax instead of being paid as wages.
These exclusions may cost about $2.0 trillion over a ten-year period. CBO estimated that in just 2019, $195 billion was foregone in payroll tax expenditures to both Social Security and Medicare due to the exclusion for employer sponsored health care plans and the exclusion for employer contributions to pension and retirement savings plans. CBO notes that “The payroll tax expenditure is created because employer contributions to pension and retirement savings accounts are not subject to the payroll tax. Employee contributions are subject to the payroll tax and therefore do not contribute to the estimate of the payroll tax expenditure.”
These exclusions primarily benefit higher earners, who are already benefiting from not having all of their earnings subject to the payroll tax. As is shown in the figure below, 65 percent of the tax benefits accrue to the top two income quintiles. Approximately one-third of those tax expenditures go to those in just the top income quintile, compared to only 4 percent going to the lowest income quintile.
CBO determined that 28 percent of the benefit from the payroll tax exclusion on health care plans went to the top income quintile, while 4 percent went to the bottom quintile. This imbalance reflects the lack of access to employer-provided health insurance available to the lower income quintiles.
CBO also determined that 45 percent of the benefits from tax expenditures for pensions/retirement savings went to the top income quintile, while 2.9 percent went to the lowest income quintile. As with employer-sponsored health insurance, access to employer-provided pensions or retirement savings plans is also highly skewed towards higher income individuals, who then benefit from the payroll-tax-excluded employer contributions to these plans.
To help improve Social Security solvency, these fringe benefits should not be subsidized by the Social Security Trust Funds through forgone payroll tax revenues. If Social Security were reimbursed for these lost revenues, it would cover approximately 41 percent of the long-term financial shortfall. Just reimbursing Social Security’s Trust Funds for the payroll tax revenues lost to employer premiums on health insurance would cover about 31 percent of the long-term financial shortfall. Reimbursing the Social Security Trust Funds for voluntary salary reduction plans, such as cafeteria plans and Flex Spending Accounts, so that they are treated like 401(k) plans would cover nearly another 10 percent.
If Social Security were reimbursed for these lost revenues, it would cover approximately 41 percent of the long-term financial shortfall.
No one wants to discourage employers from providing these benefits, but using a regressive tax expenditure that benefits the highest income, and harms the Social Security Trust Funds in doing so, runs counter to the intent of the program. There is arguably a social benefit to having exclusions from tax for certain types of savings. However, there is no reason that these social benefits should be paid for by the Social Security Trust Funds.
To maintain the tax exemptions that we hope induce employers to provide these fringe benefits, but keep Social Security’s financing harmless, we should reimburse the Social Security Trust Funds through general revenues equal to the payroll tax revenue losses that serve these larger public goals. General revenues, which are funded via the progressive income tax, are a more appropriate source of funding for fringe benefits which primarily benefit the higher income bracket. Lower-income workers, who will depend more on Social Security benefits in retirement, should not face Social Security benefit reductions to achieve solvency, when a large portion of the long-term financing challenge can be addressed by placing the burden of the cost of these fringe benefits where they belong: with general revenues.