Common Sense on Social Security

A Centrist Strategy for Social Security Reform



Social Security: Breaking the Stalemate

Section 3. Closing the Gap: Six Options

In the face of a Social Security financing gap that expands with frightening speed after 2014, Americans are presented with an extraordinary challenge. How can such a gap possibly be closed? Six sets of options have been proposed.

Option One. Federal Subsidies. Suppose nothing were done. Benefit schedules remain as they are, as does the payroll tax. By 2034, as Social Security runs out of money, a permanent federal subsidy is established. From that time on, Social Security's annual financing shortfall is covered with money appropriated from the federal budget.

Stated so baldly, the subsidy option is universally disliked. Yet the notion of a federal subsidy doesn't die easily. It has been floated in several different guises. Senator Robert Kerrey (D-Neb) wants federal funds used to create Personal Retirement Accounts (PRA's) for every newborn. (While many different names have been suggested for such accounts, in the interests of simplicity this article will refer to all of them as PRA's, or Personal Retirement Accounts.) Harvard economist Martin Feldstein favors Personal Retirement Accounts with federal tax credits used to compensate employees for the full cost of their PRA contributions. Congressmen Bill Archer (R-TX) and Clay Shaw (R-FL) have incorporated the Feldstein tax credit strategy into their own Social Security bill, the Archer-Shaw proposal. And President Clinton has proposed a substantial but temporary federal subsidy to beef up the Social Security Trust Fund. In one form or another, a temporary federal subsidy may well wind up as part of the eventual solution.

Option Two. Cutting Benefits. The financing gap might also be narrowed by trimming Social Security benefits or raising the retirement age. A variety of benefit-cutting techniques have been proposed. Eligibility formulas can be tweaked to reduce the benefit amount set for each new retiree. The formula that controls the Consumer Price Index (CPI) can be fudged if Congress wants to reduce the annual Cost-Of-Living Adjustment (COLA) for all retirees, a step whose cumulative impact is the harshest for the very old. (Such an adjustment to the CPI would affect all taxpayers, not just retirees. The IRS raises its tax bracket cutoff points every year, based on movement in the CPI. Slowing down the CPI would reduce the size of the annual bracket adjustment, leaving an ever-increasing number of Americans with incomes higher than the cutoff points. In other words, the proposed CPI slowdown could generate ongoing tax increases for millions of Americans.) The normal retirement age can be raised, cutting the number of years that one spends in retirement, and penalizing more heavily those who retire early. Most of the suggestions, unfortunately, single out specific groups and ask them to bear the heaviest load. Many of the proposed adjustments would fall with special force on the poorest and most elderly retirees. Others would have their greatest impact on higher income retirees.

If lasting solvency is to be achieved, a modest reduction in the benefit schedule is virtually unavoidable. The fairest way to trim the schedule is reduce, slightly, a factor known as the replacement rate. Today's Social Security benefits are meant to replace, on average, 42% of the individual's pre-retirement monthly salary. Over the next few decades, as wages and salaries double in value, it would not be unreasonable to trim the replacement rate by a modest amount, to an average of 38% or 39%. The real value of the benefit would still be twice as high as it is today. If phased in over three or four decades, such a reduction would scarcely be felt, and it is certainly the fairest method for scaling back Social Security's benefit schedule.

Option Three. Raising the Payroll Tax. Employees currently pay 6.2% of salary in taxes to Social Security. Employers match that, for a combined payroll tax rate of 12.4%. If the payroll tax were used to close the entire gap, the tax rate would have to rise to almost 19% by 2075. Nobody likes this option. Politicians on all sides are determined to hold the combined rate at 12.4%.

Option Four. Expanding the Tax Base. Senator Moynihan (D-NY) has proposed a substantial increase in the earned income cap, now set at $72,600. When the cap was first established, 90% of all wage and salary income fell below the cap, while only 10% exceeded the cap. In recent years, as those with the highest incomes have benefited most from an expanding economy, the ratio has shifted. 15% of all earned income now exceeds the cap. By raising the earned income cap, Senator Moynihan's proposal would restore the 90-10 split and expand the size of Social Security's tax base by roughly 5%.

Senator Moynihan has also recommended extending Social Security's coverage to all those state and local government employees not currently covered. Though he'd start by covering the new-hires only, such a change would ultimately expand Social Security's tax base by approximately four percent. (And, after a three-decade delay, its long-run benefit obligations would expand by nearly the same amount.)

A modest tax is now levied on the Social Security benefits received by higher income retirees. Although most of the proceeds are recycled back into Social Security, some of the money is forwarded along to Medicare. Some proposals would end the Medicare diversion and recycle all such funds back into Social Security.

Taken together, these three tax base expanders are capable of moving Social Security about one-fifth of the way closer to lasting solvency.

Option Five. The Savings Option and its Three Variations. The ancient fable of the ant and the grasshopper has a simple moral. Those who save put themselves in a stronger position than those who don't. Retirement advisers preach a similar message. The earlier one starts saving, the greater the boost from compounding.

It has been suggested that such advice also makes good sense for Social Security. Social Security has enjoyed a sixty-year run as an unfunded, pay-as-you-go retirement program, initially meant to serve a relatively small number of retirees in an otherwise youthful America. But conditions have changed. With the American population maturing, perhaps the time has come for Social Security to be reconfigured as a properly capitalized, mature retirement system.

With a cash flow gap that ultimately widens to 2 1/3% of GDP, a portion of this gap could be closed, if Social Security were adequately capitalized, by using the interest and dividend earnings on capital. How much total capital would be needed? That depends. For starters, imagine a pool of capital worth 50% to 90% of GDP. The weaker the earnings on capital, the larger the pool must be. The more reluctant Congress has been to close the financing gap by other means, the larger the pool must be. With a financing gap so daunting, one must be prepared to think in GDP-sized magnitudes.

The savings option is available in three flavors: decentralized, centralized, and blended.

a) Decentralized. Conservatives hope to use PRA's (Personal Retirement Accounts) as Social Security's preferred savings vehicle. They'd like Social Security to sponsor Personal Retirement Accounts for every employee; they want to trim Social Security's regular benefit schedule; and they believe the assets accumulated in 170 million separate PRA's will go a long way to offset those cuts.

b) Centralized. Liberals favor a strategy in which Social Security accumulates capital in its own Trust Fund, invests it for higher returns, and utilizes the earnings on capital to close as much of the financing gap as possible.

c) Blended. A centrist strategy does both. It accumulates capital not only in PRA's but also in a souped-up Trust Fund. Are PRA's too risky? A blended strategy uses the Trust Fund to help in overcoming a range of PRA-related risks. Is a centralized Trust Fund too risky? A blended strategy leverages the decentralized advantages of PRA's to mitigate Trust Fund risks.

Everyone on Capitol Hill concurs on one point. It is virtuous to save for the future. If Social Security benefits are to be protected, most elected officials agree that a hefty savings program of some kind is essential. The sticking points are risk and fear. Republicans have not been able to overcome a widespread apprehension of PRA's, and Democrats have been similarly unsuccessful in quieting fears raised by the notion of a stock-rich Trust Fund.

Option Six. Adjusting the Social Security Forecast. Many economists believe that Social Security's GDP growth forecast is more pessimistic than it needs to be. In Social Security's Intermediate Cost estimate (commonly treated as its "Most Likely" case), the GDP growth forecast is quite low, which reflects an estimated productivity growth rate of less than one percent a year. Historically, though, productivity growth has averaged two percent a year, and, as economist Dean Baker points out, productivity growth continues to average two percent a year in most of the world's industrial economies. In planning for Social Security's future, it would not be unreasonable to forecast productivity growth rates closer to 2% a year, and to forecast a correspondingly higher growth rate for GDP as well.

If the GDP growth rate isn't as anemic as Social Security's forecasters think it will be, the close-in financing pressure on Social Security won't be quite as great. Why? In a faster growth economy, Social Security's source of funds - taxable payroll - grows just as rapidly as GDP. On the other hand, the growth in Social Security's obligations to beneficiaries lags slightly behind the GDP growth rate. A more realistic forecast of the GDP growth rate would push Social Security's expected insolvency date about ten years further into the future.

At the same time, Social Security's inflation forecast also seems unrealistic. It pegs inflation at 3.3%, though 2.3% is somewhat more likely. Forecasting higher inflation narrows the anticipated gap slightly. Higher inflation generates higher tax collections almost instantly, while there's a lag of nearly two years before high inflation triggers higher benefit payments. Reducing the inflation forecast, however, has the reverse effect. In a low inflation economy, tax collections grow more slowly, while obligations are due immediately. High inflation helps Social Security's cash flow, low inflation hurts it. Trimming the inflation forecast from 3.3% to 2.3% pulls the expected insolvency date closer by one year.

A more sensible forecast would incorporate not only 1% faster GDP growth but also 1% slower inflation. Together, these adjustments push the expected insolvency date nine years further out, to 2043. Faster GDP growth, one must note, is not an unalloyed blessing. The sooner GDP gets big, the bigger Social Security's ultimate pot of capital has to get. And the more costly it will be. Faster GDP growth paradoxically makes Social Security's near-term insolvency problem easier to solve and its lasting solvency problem more difficult.


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Common Sense on Social Security
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Revision Date April 13, 2006