Social Security's Income Inequality Problem Could Hit Retirees Hard

Social Security is facing a growing gap between the revenue it brings in and the benefits it pays out. The actuaries at the Social Security Administration estimate that the retirement program will pay out $1.5 trillion in benefits this year, but revenue from payroll taxes, taxes on benefits, and interest earned on investments will total only $1.3 trillion. That deficit is set to expand over the next six years until the trust fund runs out of money.

While there are several reasons why Social Security is facing a shortfall in revenue, there's one clear culprit that Congress has the power to address: rising income inequality. If Congress fails to act, Social Security retirement benefits could be slashed by 23% across the board as soon as 2032, according to the most recent estimates from Social Security's chief actuary.

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The income inequality problem

This isn't the first time Social Security has been on the brink of bankruptcy. The program came within days of being unable to meet its obligations in the 1980s before Congress acted to change the program. Those changes included raising the full retirement age and accelerating a scheduled increase in payroll taxes. At the time, the Social Security actuaries estimated the changes should enable the program to pay out full benefits for the next 75 years.

But now Social Security is set to deplete the trust fund within 50 years of the amendment passed by Congress in 1983. Chief Actuary Karen Glenn explained exactly what the actuaries got wrong in a Congressional testimony in March.

There are two main culprits. The first is that the economy hasn't grown as much as expected. Glenn specifically cites the 2007 to 2008 recession, which significantly set back economic growth. The other culprit, however, is significant income inequality that arose in the 80s and 90s and never corrected itself.

When Congress implemented the new payroll tax, it levied Social Security tax on 90% of all wages paid. By the end of the century, however, only 83% of wages paid were subject to Social Security taxes.

The gap stems from the fact that wages above a certain level aren't subject to Social Security tax. The maximum taxable earnings increase with wage inflation every year. In 1983, the amount was $35,700. In 2026, it's $184,500. As high earners saw their wages climb faster than average, though, Social Security participated in less of the total economic growth. Combined with slower-than-anticipated economic growth, it led to a significant revenue shortfall for the program.

As such, Congress should seek to address that shortfall with any upcoming changes to Social Security law. If they don't, all retirees will likely get hit hard by across-the-board benefits cuts. That said, some proposed solutions would still leave some retirees facing a negative impact on their finances.

What changes could be coming?

With the shortfall in revenue stemming from undertaxing high earners, it would make sense for Congress to increase those taxes when it looks to reform the program. That can come in two forms.

First, there is a straightforward increase in the wages subject to Social Security taxes. That could be as simple as increasing the maximum taxable earnings. Alternatively, it could create a new tax tier. For example, one proposal calls for taxing wages up to the current cap as well as earnings above $400,000 per year.

Second, Congress may look to increase taxes on retirees receiving significant sums of Social Security income, or income from other sources. The tax would effectively correct for the wider wage gap experienced since the last major Social Security reform. That means lower-income retirees would be saved from the negative impact caused by the wider wage gap, while higher-income retirees will have to make up for it.

Other proposals include raising the full retirement age, increasing the payroll tax rate, and changing how the annual COLA is calculated. In all likelihood, Congress will have to supplement a tax overhaul with other changes in order to ensure Social Security can last another 75 years. Those changes could have a big impact on many retirees' finances, most likely negatively affecting the take-home pay for higher-income retirees.

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