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Can Removing the Tax Cap Save Social Security?

Shantanu Bagchi ()

No 2014-05, Working Papers from Towson University, Department of Economics

Abstract: The maximum amount of earnings in a calendar year that can be taxed by U.S. Social Security is currently set at $118,500. In this paper, I examine if removing this cap can solve Social Security's future budgetary problems. Using a calibrated general-equilibrium life-cycle consumption model, I show that under a realistic longevity improvement, removing this cap leads to Social Security benefits declining by less than 3%, compared to almost 15% when the cap is held fixed at its current level. Households for whom the cap expires respond by working and saving less, which reduces labor supply, capital stock, and output, and also reverses some of the initial expansion in Social Security's revenues. Elimination of the cap also makes Social Security more progressive, which has positive insurance effects for households with unfavorable earnings histories, but the higher marginal tax rates impose larger distortions on households that are no longer subject to the cap, which reduces overall welfare.

Keywords: Social Security; tax cap; mortality risk; labor income risk; incomplete markets; general equilibrium. (search for similar items in EconPapers)
JEL-codes: E21 E62 H55 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2014-09, Revised 2016-05
New Economics Papers: this item is included in nep-dge, nep-ias, nep-mac, nep-pbe and nep-pub
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Downloads: (external link) First version, 2014 (application/pdf)

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