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Rising Income Inequality Could Deplete Social Security's Cash Sooner Than Expected

Social Security has been a financial rock for our retired workforce for nearly 80 years. Today, it's responsible for providing a payout to more than 43 million retired workers, 62% of whom lean on their monthly stipend for at least half of their income.

However, it's also a program facing an unprecedented financial challenge, with a cash shortfall of $13.2 trillion looming between 2034 and 2092, according to the latest annual report from the Social Security Board of Trustees. This cash shortfall implies that the existing payout schedule isn't sustainable over the long term, which is defined as the next 75 years.

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How, exactly, does a social investment like Social Security go from record annual net cash surpluses just over a decade ago to being on the verge of big trouble in 2019? The answer lies with a growing number of demographic changes that aren't working in the program's favor. Examples include the ongoing retirement of baby boomers, which is lowering the worker-to-beneficiary ratio, lower fertility rates, which also threatens to lower the worker-to-beneficiary ratio, and lengthening life expectancies over many decades. When initially conceived in the 1930s, Social Security was designed to provide a benefit to seniors for a few years after retirement. Nowadays, it's a program that the average 65-year-old will lean on for two decades.

These represent some of Social Security's biggest problems. But the biggest of all might just be growing income inequality.

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Growing income inequality is a problem in more ways than you probably realize

Growing income inequality in the U.S. is probably something you're familiar with. If you're an investor, you're likely aware of the crazy multiples CEOs are sometimes paid compared to the average workers in their companies. But it's not just between CEOs and their employees that this gap is apparent. According to the Economic Policy Institute, the average income of the top 1% was 26.3 times higher than the average household income of the bottom 99% in 2015. With earnings growing at a faster pace for the well-to-do relative to lower- and middle-income families, opportunities for advancement remain harder to come by for these low- and middle-income households.

This income disparity also leads to problems with the Social Security program. For starters, the wealthy have no financial constraints when it comes to receiving preventative care or prescription medicines. The same can't be said for the poor, who may not have access to the same quality of medical care as the rich. This has led to a defined gap in longevity between the rich and poor, allowing the rich to pocket a higher Social Security benefit check for an extended period of time.

Unlike the average working American, the wealthy are also able to avoid paying into the Social Security system on every dollar they earn. In 2019, earned income between $0.01 and $132,900 is subject to the 12.4% payroll tax rate, with earned income above this amount exempt. Data from the Social Security Administration finds that between 1983 and 2016, the amount of earnings exempted from taxation has risen from about $300 billion to $1.2 trillion. And at $1.2 trillion, that's close to $150 billion in potential payroll tax revenue that's escaping the system.

Image source: Getty Images.

Social Security's $2.9 trillion in cash could be gone sooner than pundits expect

Now, here's where things get really scary.

According to the Social Security Board of Trustees report, the program's numerous demographic changes, including income inequality, are expected to lead to widening net cash outflows. In plain English, Social Security will expend more than it collects each year, possibly beginning in 2019; and the amount it expends compared to what it collects is going to widen as time passes. By 2034, the $2.9 trillion that Social Security has built up in net cash surpluses since its inception is forecast to be completely gone. If the program's asset reserves are exhausted and Congress fails to raise additional revenue or cut expenditures, a big cut to benefits of up to 21% may await.

However, the estimates presented by the Trustees take a middle-of-the-road approach (the intermediate-cost model). One of the variables considered is the taxable ratio -- i.e., how much earned income is subject to the payroll tax relative to all earned income. The assumption in the intermediate-cost model, which is the most widely accepted, is a taxable ratio of 82.5%. That's pretty much where we are today.

But the trend has clearly been to a lower taxable ratio over time. In 1983, close to 90% of all earnings was subject to the payroll tax, but by 2016, it had dipped to below 83%. Based on estimates in the Trustees report, if this taxable ratio falls by another 150 basis points to 81%, which seems quite plausible based on the long-term trend, Social Security's $2.9 trillion in cash would disappear by 2033, not 2034.

Image source: Getty Images.

Growing income inequality places a greater burden on working Americans

Just as worrisome, a lower taxable ratio would also increase the long-term (75-year) actuarial deficit. The actuarial deficit describes how much the payroll tax would have to increase today to offset the expected cash shortfall that lies ahead, through 2092. Under the intermediate-cost model where the taxable ratio is 82.5%, the actuarial deficit is 2.84%. This means the payroll tax would have to rise from 12.4% to 15.24% today to completely account for the projected long-term cash shortfall, as well as leave enough money in the trust fund to cover 100% of costs come 2093.

But if the taxable ratio falls to 81% and less earned income is subject to the payroll tax, the actuarial deficit rises 17 basis points to 3.01%. Ultimately, this just means that it's going to cost American workers (and businesses) even more to fix Social Security.

Long story short, if Social Security is going to be shored up for future generations, lawmakers are going to have no choice but to tackle rising income inequality sooner rather than later.

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