Reforming the Social Security Earnings Cap: The Role of Endogenous Human Capital

Old age Social Security benefits in the US are funded by a 10.6% payroll tax up to a cap, currently set at $118,500. Despite calls from policy circles to eliminate the cap on taxable earnings, there has been little work examining the likely outcomes of such a policy change. I use a life-cycle human capital model with heterogeneous individuals to investigate the aggregate and distributional steady state impacts of several policy changes to the earnings cap. I find: (1) Eliminating the earnings cap generates large reductions in aggregate output and consumption, between 2.1- 3.1%. (2) The role of endogenous human capital is first order: when I do not allow the life-cycle human capital profiles of workers to adjust across policy regimes, the change in economic aggregates is roughly cut in half. (3) While eliminating the earnings cap increases revenues from the payroll tax by 12%, the decline in output lowers tax revenues from other sources, so that total federal tax revenues never increase by more than 1.2%. (4) Eliminating the earnings cap produces modest welfare gains for about 2/3 of workers, while about 1/3 of workers experience welfare losses, which are typically large. (5) Lowering the earnings cap to a level near the mean of earnings increases aggregate output by 1.3%, and also increases welfare for the vast majority of workers.