Could an Employer Compensation Tax Save Social Security?

Most taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. proposals to increase Social Security trust fund revenue have focused on raising the payroll tax rate or lifting the payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. cap to increase the amount of wages subject to the payroll tax. Less attention has been given to other kinds of base broadeners, such as adding fringe employer benefits to the payroll tax base, which have the potential to raise substantial revenue.

Under current law, one of the largest tax exclusions is for employer-sponsored health insurance (ESI), which is excluded from both income and payroll taxes. Other types of fringes, such as commuter benefits, education assistance, employer contributions to employee retirement plans, and stock options, are also excluded from both.

One novel idea to tax fringes has been proposed by the Committee for a Responsible Federal Budget (CRFB): the employer compensation tax (ECT). The ECT would replace the current employer-side payroll taxes, 6.2 percent for Social Security and 1.45 percent for Medicare, with a 7.65 percent payroll tax on all compensation, including compensation above the taxable maximum ($192,300 in 2027). Self-employed workers would pay half their payroll tax under the current Self-Employed Contributions Act (SECA) tax rules and the other half under the ECT.

Tax Foundation modeled the ECT as part of our Options for Reforming America’s Tax Code 3.0: A Policymaker’s Guide to Tax Reform Trade-Offs (Option 41). We find that the ECT could raise $2.5 trillion from 2027 through 2036. The top quintile of taxpayers would experience the largest decrease in after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings., 1.5 percent in 2036, largely due to applying the employer-side payroll tax to income above the taxable maximum. This makes the ECT a progressive reform overall.

Table 1. How Employer Compensation Tax (ECT) Would Change Payroll Tax Base

Source: IRS; Committee for a Responsible Federal Budget, "An Employer Compensation Tax for Social Security and Medicare."

The ECT would also come at a significant cost to the US economy. We estimate that the ECT would reduce long-run GDP by 1.1 percent. After accounting for this reduction in economic growth, revenue over the next decade would fall to $1.4 trillion on a dynamic basis. Incorporating changes in interest costs, the publicly held debt-to-GDP ratio would decrease in 2056, from its baseline value of 176 percent to 168 percent.

Applying the ECT to compensation above the taxable maximum would also somewhat decouple the relationship between taxes paid while working and benefits earned in retirement. Currently, Social Security replaces income in retirement up to the taxable maximum: workers do not pay payroll taxes on income above $184,500, but they also do not receive benefits based on income earned above that threshold.

One way to partially restore that link would be to only apply the ECT to compensation below the taxable maximum. This would not fully preserve the tax-benefit link, as fringes would still not be counted as part of the benefit calculation, but would be more consistent with current policy. Alternatively, policymakers could count fringes as part of the benefit calculation, but this would blunt the revenue-raising impact of the proposal.

The ECT would make the tax code more neutral in some ways and less neutral in others. By removing the payroll tax exclusion for all fringes, the tax code would not favor certain types of employee compensation over others (although the distortions from the income tax exclusion would remain). It would also reduce the asymmetrical tax treatment between employer and employee contributions to retirement accounts. For example, employee contributions to both traditional 401(k) plans and Roth 401(k) plans face payroll taxes, while employer matching and nonelective contributions are excluded.

The ECT could also create new arbitrage opportunities for self-employed workers. Although most fringes for self-employed workers are already non-deductible, removing the payroll tax cap on half of the payroll tax base might encourage some businesses to reclassify their wage income as business income. Applying SECA to cover the active component of partnership and S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT).  income could help address this.

With Social Security insolvency rapidly approaching and policymakers exploring changes to benefits and taxation, Congress could look to base-broadening reforms like the ECT as a guide for how to think about taxing compensation and broadening the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates..

Share this article