Uncapping the Payroll Tax Would Raise the Top Marginal Tax Rate on Wages to Above 60 Percent in Some States

By Kyle Pomerleau of AEI.

"Social Security’s trust fund is nearing insolvency. The latest trustees report projects that the Old-Age and Survivors Insurance Trust Fund will run out in late 2032. If this occurs, benefits paid will be limited to payroll tax revenue, resulting in a roughly 22 percent benefit cut. Some lawmakers have suggested eliminating the payroll tax cap to help close the gap. This would raise revenue, but it would push top marginal tax rates on wages to over 60 percent in some states. 

Social Security is financed with a 12.4 percent payroll tax on employee wages and a matching tax on self-employment income. The tax is split evenly between the employee and employer. The payroll tax is “capped,” meaning that it applies only to the first $184,500 in wages and salaries (in 2026). 

Several proposals would eliminate or alter the cap. Two proposals would introduce a “donut hole” by applying the payroll tax to earnings above either $250,000 (Social Security Expansion Act) or $400,000 (Social Security 2100 Act). A proposal by Sens. Elizabeth Warren (D-MA) and Bernie Moreno (R-OH) would apply the payroll tax to all earnings. 

Eliminating the payroll tax cap would raise the top marginal tax rate on labor earnings. The top marginal tax rate is the combined federal, state, and local tax that a top earner pays on each additional dollar of wage and salary income. 

For example, a top earner in Massachusetts faces a top marginal tax rate of 49.5 percent. This includes the top individual income tax rate of 37 percent, the 2.9 percent Medicare payroll tax, the 0.9 percent Additional Medicare Tax, and Massachusetts’s top income tax rate of 9 percent.¹ Eliminating the cap would raise the top marginal tax rate in the state by 8.7 percentage points to 58.2 percent. 

The top marginal tax rate would depend on where a taxpayer resides. The top marginal tax rate would rise to 63.1 percent in New York City, 63 percent in California, and 59.7 percent in Washington, DC. In states without an income tax, the top rate would rise to 49.4 percent. This would be the highest top marginal tax rate on wages since the Tax Reform Act of 1986.

Lawmakers should proceed with caution. 

First, higher top marginal tax rates reduce the incentive to work. This is because eliminating the cap would reduce the after-tax wage that an individual earns. For example, top earners in Washington, DC, would experience a 17.4 percent reduction in their after-tax wage rate if the cap were eliminated. Using the Congressional Budget Office’s estimate that the labor supply elasticity (or responsiveness) of high-income workers is 0.17 (net of the income effect), this would imply a reduction in hours worked of 3 percent for those facing the top marginal tax rate. 

Second, eliminating the cap would exacerbate the incentive for business owners to reclassify their income. Owners of partnerships and S corporations can split their income between profits and wages. The tax code creates an incentive to pay more income out as profits because profits are taxed at a top federal income tax rate of 29.6 percent (37 percent reduced by the 20 percent deduction for pass-through business income) compared to the top federal tax rate on wages of 40.2 percent. Eliminating the cap would widen that gap from 11 percentage points to 19.8 percentage points. 

Third, eliminating the cap would reduce revenue from other taxes. Because the employer-side payroll tax is borne by workers in the form of lower W-2 wages, raising it shrinks the base of the income and employee-side payroll tax. The Joint Committee on Taxation estimates that for each dollar raised by the payroll tax, the federal government collects only 86 cents. Furthermore, the reduction in hours worked would mean that total taxable income would fall, offsetting an even larger share of the initial tax increase. 

Finally, eliminating the cap would delink taxes from benefits. One of the virtues of the current Social Security system is that benefits and taxes are at least loosely linked. The more an individual works, the more they pay in payroll taxes, but also the more they accrue in future benefits, up to the cap. This limits the work disincentive effect because future benefits partly offset taxes at the margin. Eliminating the cap without expanding benefits would make the tax on earnings above the cap a pure tax, with no offsetting benefit. 

Lawmakers are right to be concerned about the future of Social Security. Reform will require changes to both spending and revenue. It matters, however, how those changes are structured. Eliminating the cap on the payroll tax would come with important economic trade-offs. 

---

[1] The top marginal tax rate is calculated on total labor compensation, including the employer-side payroll tax. Assumes Massachusetts’s paid family leave payroll tax remains capped."