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Saving Social Security

A gimmick-free plan for long-term solvency

Peter A. Diamond and Peter R. Orszag

8 Social Security is one of America's most successful government programs. For more than 60 years it has helped millions of Americans avoid poverty in old age, upon becoming disabled, or after the death of a family wage earner. And through its payout structure Social Security protects against the possibility that one's career may not turn out as well as planned. Despite its successes, however, the program faces two principal problems.

First, for years we've known that Social Security faces a long-term deficit: its finances are not projected to be sufficient to pay all the benefits promised under current law over the next 75 years. Analysts widely agree that it would be better to eliminate this projected deficit sooner rather than later.

Second, there is also broad agreement that benefits should be increased for some particularly needy groups—such as those who have worked at low pay over long careers and widows with low benefits—and that disabled workers should receive some protection from benefit cuts.

Much more controversy surrounds the discussion of how to fix the problems: the right mix of tax increases and benefit reductions that should be used to restore long-term balance to the program and whether some payroll-tax revenue should be diverted into individual accounts rather than financing the program as a whole. In his State of the Union address, President Bush called for the creation of voluntary individual accounts within Social Security, although the administration has still not embraced any specific plan to do so. But diverting revenue from Social Security without replacing it makes the program's financial problems worse and threatens its future. With large federal deficits, the lost revenues cannot be made up from the rest of the budget, nor does the president seem willing to raise some other taxes to replace them.

We believe it is unwise and unnecessary to destroy the program in order to save it. Here we describe the current program and its projected deficit, present our plan to restore actuarial balance, and explain why—contrary to Bush-administration proposals—individual accounts financed out of existing payroll-tax revenue are a bad idea.

Causes of the Long-Term Deficit

Social Security's trust-fund assets and tax revenue are projected to be sufficient to pay all the benefits scheduled under current law until 2042. When the trust-fund assets are exhausted, payroll-tax revenue would continue to be available, so fears of receiving no benefits from Social Security are wildly exaggerated. Indeed, even with no reform ahead of time, the flow of revenues in 2042 would suffice to pay roughly three quarters of the benefits scheduled in current law, with a slowly declining fraction thereafter.

Many factors contribute to the long-term deficit in Social Security. We link our reform to three important contributing factors: improvements in life expectancy, increases in earnings inequality, and the burden of the legacy debt resulting from Social Security's history.

Life expectancy at age 65 has risen by four years for men and five years for women since 1940, and it is expected to continue rising in the future. Increasing life expectancy raises the value of Social Security benefits to workers, because benefits last as long as the recipient is alive. By the same token, though, increasing life expectancy adversely affects Social Security's financial condition, because beneficiaries then collect benefits over a longer period.

A second factor affecting Social Security's financing is earnings inequality. Over the past two decades, earnings have risen most rapidly among workers who already have the highest earnings. This affects Social Security's financing because the Social Security payroll tax is imposed only up to a maximum taxable level ($87,900 in 2004). Between 1983 and 2002, the percent of aggregate earnings above the maximum taxable level increased from 10 to 15. Furthermore, the extent to which people with higher earnings and more education tend to live longer than those with lower earnings and less education has also increased. This increasing gap in life expectancy exacerbates Social Security's financing shortfall and makes the system less progressive on a lifetime basis, since higher earners will collect benefits for a greater number of years and thus enjoy greater lifetime benefits than lower earners.

A third important influence on the future finances of Social Security reflects the past. The benefits paid to almost all current and past cohorts of beneficiaries exceeded what could have been financed with the revenue they contributed, including interest. This history imposes a "legacy debt" on the Social Security system. That is, if earlier cohorts had received only the benefits that could be financed by their contributions plus interest, the trust fund's assets would be much greater today. If those expanded assets existed, they would be earning interest that could contribute to benefits.

A reasonable estimate of the program's legacy that needs to be financed by those younger than 55 years old is $11.5 trillion. This legacy debt is not a debt in the traditional sense of that word, but the term crystallizes the need to allocate the cost of the assets that are not there across future cohorts. In particular, relative to a world in which the legacy debt didn't exist, future generations will have to bear some combination of higher taxes and lower benefits. The key question is how those higher taxes and lower benefits will be distributed among future generations and among different people within each generation. Any plan that restores actuarial balance distributes this cost in some way. The challenge is to select a way that seems fair.

A Balanced Reform Plan

Our plan has three components, each of which addresses one of the factors listed above that contribute to the long-term deficit. Each component of our reform plan includes adjustments to both benefits and revenue to help close the long-term deficit.

The first element concerns the problem of life expectancy. Many observers have recognized that it makes sense to adjust Social Security automatically for the effects of increased life expectancy. Previous proposals, however, have taken the extreme view that all of the adjustment should occur through reductions in benefits. Instead, we propose a balanced approach in which roughly half the life-expectancy adjustment occurs through changes to benefits and the rest through changes to payroll taxes. (Like the other components of our plan, our life-expectancy adjustment does not affect benefits for workers who are 55 years old or older in 2004. It also does not change the early entitlement age of 62 nor the full benefit age under Social Security.)

The second component of our plan addresses earnings inequality, also combining revenue and benefit adjustments. First, we propose gradually raising the maximum taxable earnings base until the share of earnings that is above the base—and hence escapes the payroll tax—has returned to roughly its average level over the past 20 years. The share of earnings not subject to the payroll tax would slowly decline until, in 2063, it is returned to roughly halfway between its current level and its level in 1983. Second, to make Social Security somewhat more progressive, and thereby offset the effects of disproportionately rapid gains in life expectancy among higher earners, we propose a benefit reduction that affects only relatively high earners. Currently, about 15 percent of workers newly eligible for Social Security benefits have sufficiently high earnings that a portion of those earnings falls in the highest tier of the Social Security benefit formula. Our benefit adjustment for income inequality includes a gradual reduction in that highest tier of the benefit formula.

The third component of our plan focuses on the legacy debt stemming from Social Security's history. Our goal is to distribute its cost more fairly, in part by attempting to stabilize the ratio of the legacy debt to taxable payroll from one generation to the next (just as a sensible goal for the federal budget is to stabilize the ratio of public debt to the economy). We propose to reform the financing of the legacy debt through three changes:

First, all newly hired state and local government workers would be covered under Social Security starting in 2008, to ensure that eventually all workers bear their fair share of the cost of the nation's generosity to earlier generations. While most state and local workers are covered by Social Security, about four million of them are not. Their nonparticipation means that those workers escape any contribution to the financing of the legacy debt. Moreover, Social Security provides some protections that are not currently available to such workers, particularly those with only part of their career outside Social Security.

Second, we would impose a legacy tax on earnings above the maximum taxable earnings base, thereby ensuring that very high earners contribute to financing the legacy debt in proportion to their full earnings. The legacy tax above the base would start at 3.0 percent and increase along with the universal charge, described next.

Third, we would impose a universal legacy charge on future workers and beneficiaries, roughly half as a benefit reduction for all beneficiaries becoming eligible in or after 2023, and the rest as a very modest increase in the payroll tax from 2023 onward. We start these changes after the last of the changes legislated in 1983 has taken effect. This universal legacy charge would gradually increase over time to help stabilize the ratio of the legacy debt to taxable payroll.

This approach to financing the legacy debt reflects a reasonable balance between current and distant generations, between lower earners and higher earners, and between workers who are currently covered by the program and workers who are not. It is meant to keep the full cost of servicing the legacy debt from simply being pushed further into the future for our children and grandchildren to pay.

As an alternative to some of our proposals for benefit reductions or revenue increases, policymakers could dedicate revenue from another specific source to Social Security. For example, the estate tax could be reformed rather than eliminated entirely, as the Bush administration has proposed, and some or all of that revenue could be dedicated to Social Security.

Our three-part proposal would restore long-term balance to Social Security over the next 75 years and produce a modestly growing ratio of the Social Security trust fund to annual costs at the end of that period (see graph at right). It would also provide resources for the improvements to benefits detailed below.

Strengthening Our Social Insurance

Our plan would shore up Social Security for three particularly vulnerable groups:

  • Workers with low lifetime earnings receive meager benefits under Social Security despite the progressive benefit formula. We propose a benefit enhancement for workers with long careers at low wages, so that minimum-wage workers with at least 35 years of covered and steadily rising earnings would receive a benefit level equal to the poverty line in 2012 and above it thereafter.
  • Widows typically suffer a 30 percent drop in living standards around the time they lose their husband. We propose to increase the benefits of elderly survivors. For those with low benefits, the increase would be financed out of the rest of the program. For higher-income couples, the increase in the survivor's benefit would be financed by reducing the couple's own combined benefits while both are alive. The goal is to leave a survivor with three fourths of what the couple had received in benefits.
  • Disabled workers and the young survivors of deceased workers are not well-off on average. Our proposal does not rely on any net reduction in benefits for these vulnerable beneficiary groups as a whole over the 75-year projection period. Our plan does, however, redistribute disabled and young-survivor benefits toward those who receive benefits for a longer time over their lives.

In addition, we would augment the program's protection against unexpected inflation. Currently, there is no protection against unexpectedly high inflation in the years between ages 60 and 62. For example, a repeat of the inflation rates of 1980 and 1981 (14.3 percent and 11.2 percent) would reduce the real benefits for a cohort by almost 25 percent. Extending indexing in a no-cost fashion protects against this risk.

Implications

What do all these various changes imply for the benefits that individual workers will receive and for the taxes they will pay? Workers who are 55 years old or older in 2004 will experience no change in their benefits from those scheduled under current law. A 45-year-old average earner (in 2004) is projected to experience less than a one-percent reduction in benefits under our plan. And a 25-year-old with average earnings would experience less than a nine-percent reduction in benefits. (Benefits for such workers would still be higher, even after adjusting for inflation, than those of the older workers because the effect of ongoing real wage growth on benefits is much larger than the modest decreases in our plan.) Higher earners would experience somewhat larger reductions in benefits than the average, and lower earners would experience smaller reductions.

These modest reductions in benefits are also in keeping with the tradition set in 1983. For example, the 1983 reform reduced benefits by about ten percent for those 25 years old at the time of the reform, a slightly larger benefit reduction than under our plan for average earners age 25 in 2004.

Our plan combines its modest and gradual benefit reductions with a modest and gradual increase in the payroll tax rate. The combined employer-employee payroll-tax rate is projected to rise from 12.4 percent today to 12.45 percent in 2015, 13.2 percent in 2035, and 14.2 percent in 2055. This gradual increase in the payroll-tax rate helps ensure that Social Security continues to provide an adequate level of benefits that are protected against inflation and financial market fluctuations, and that last as long as the beneficiary lives.

Individual Accounts?

Our plan does not—as President Bush has proposed—include individual accounts. The reason is that although tax-favored individual accounts such as 401(k)s and IRAs already provide an extremely useful supplement to Social Security, they are simply inappropriate for the basic tier of income during retirement, disability, and other times of need. Those nearing retirement need a reliable source of income that offsets inflation and lasts as long as they live. This is particularly important for the one third of the elderly who get at least 90 percent of their income from Social Security. Individual accounts do not provide this type of security. The assets in the accounts are subject to financial-market risks. Furthermore, despite whatever ivory-tower proponents might like to believe, it is unlikely that real-world individual accounts would require that benefits keep pace with inflation, last as long as the beneficiaries are alive, or protect surviving spouses as well as the current system.

Individual accounts are thus inferior as a foundation of retirement-income security to the current benefit structure even if the accounts were genuinely funded. However, recent individual account plans typically do not provide genuine funding-instead, they simply assume that money will be provided from the rest of the budget. Despite growing concerns about the magnitude of the budget deficit, for example, the plans proposed by the President's Commission to Strengthen Social Security would substantially expand the deficit for an extended period, adding over $1 trillion to the budget deficit. Without real funding, individual accounts do not accomplish anything for the economy. And the "magic asterisk" approach of simply assuming that trillions of dollars will be provided from the rest of the budget, despite the nation's substantial fiscal gap, puts the future of Social Security itself at risk. That is, if payroll-tax revenue is taken from Social Security and no alternative funds are provided, Social Security's financing problems would be exacerbated and new risks created for workers and retirees.

Conclusion

Social Security reform is controversial, as it should be. After all, Social Security plays a critical role in the lives of millions of Americans and in the federal budget. Reforms to such an important program should generate political interest and debate. Nonetheless, we hope that the balance of our basic three-pronged plan demonstrates that Social Security can be mended without resorting to the most controversial and problematic elements included in some other recent reform plans, without accounting gimmicks, and without simply assuming the availability of funds from the rest of the budget that are not likely to be there. <

Peter A. Diamond is an Institute Professor at MIT. His article is adapted from Saving Social Security: A Balanced Approach (2004), with the permission of Brookings Institution Press.

Peter R. Orszag is the Joseph A. Pechman Senior Fellow in Economics Studies at the Brookings Institution and a co-director of the TaxPolicy Center.

Originally published in the April/May 2004 issue of Boston Review.



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