Social Security

The first social security program originated in Germany in 1889 under Chancellor Otto von Bismarck. By 1935, when President Franklin Delano Roosevelt signed the U.S. Social Security law, thirty-four European nations operated some form of old-age retirement plan based on transfers from workers to retirees. The U.S. Social Security system remained a retirement and survivor benefit program until 1957, when Congress began changing it significantly. The only previous changes had been increases in benefits and in taxes. In 1957, Congress broadened the program to include disability Insurance benefits for severely disabled workers. In 1972, Congress approved automatic cost-of-living adjustments (COLAs) and in 1977 changed the benefit formula to provide a constant percentage of work income. Then, in 1983, in response to a funding crisis, Congress raised the payroll tax rate to its current level, increased the retirement age, and started to tax benefits.

In spite of and, in some cases because of, these changes, the system faces serious challenges in the future. In 1945, the United States had more than forty workers per retiree, so a minimal tax on workers could support all retirees. However, the system that began with few receiving benefits had to mature, and this maturation process meant that more and more individuals would become eligible for benefits. Thus, this idyllic world could not last. The combination of increased life expectancy from sixty-one years for those born in 1935 to seventy-six for those born in 2004, increased benefits, and falling birthrates has reduced the number of workers per retiree to three. By 2030, only two workers will be available to support each retiree.

U.S. Social Security comprises two distinct programs, each covering a separate population and each with its own method of financing. Old Age and Survivor Insurance (OASI) provides two types of benefits: retirement benefits for retired workers and benefits to the spouses and children of deceased workers. Disability Insurance (DI) provides benefits for disabled workers and their dependents on the same basis as retirement benefits are determined.

Social Security retirement benefits are based on average indexed monthly earnings for the thirty-five highest earnings years prior to retirement. The benefit formula is set up to favor lower-income workers. For example, in 2004, someone with average monthly earnings of $624 received a benefit that replaced 90 percent of earnings. Someone whose average monthly earnings were $3,760 received a benefit that replaced 42 percent of earnings, while someone with monthly earnings at the then-taxable maximum of $7,325 received a benefit that replaced only 28 percent of earnings. Early retirement—retirement between age sixty-two and the full-benefit age—results in a deduction from full benefits based on the actuarial assumption that early retirees will collect benefits for a longer period of time. The full-benefit age was sixty-five until 2000, when it began a two-month-a-year rise. It reached sixty-six in 2005, where it will remain until 2017; it will then rise by two months each year until it reaches sixty-seven in 2022.

Social Security’s survivors’ benefits are granted to the children and spouses of individuals who worked for at least ten years. Children and surviving spouses with children under sixteen years of age each receive an amount equivalent to 75 percent of the deceased’s benefits, subject to a family maximum. Older surviving spouses are also eligible for benefits.

Disability benefits are granted to individuals who worked for at least ten years prior to disability, although younger workers with fewer than ten years of work may qualify for some benefits. Benefits are determined by a worker’s earnings, ability to work in previous employment, ability to adjust to another job, and the expected duration of the disability. Children and spouses of disabled workers may also be eligible for benefits.

Many people believe that the FICA taxes they pay are placed in an account in their name at the Social Security Administration. In fact, these funds arrive at the U.S. Treasury and are used for current retirees’ benefits and other government expenditures. If, at the end of the year, revenue from FICA taxes exceeds total benefits paid, which it has every year since 1983, the Treasury issues special government bonds to the Social Security Administration. These bonds prove that the Treasury used Social Security’s money for other purposes and promise that when FICA revenues are too small to pay benefits, the Treasury will redeem the bonds. These bonds are, in essence, an IOU from the federal government to itself. It matters little whether the IOUs amount to zero, $100 billion, or $10 trillion.

The OASDI’s revenues are expected to be relatively stable, growing from 12.71 percent of payroll in 2004 to 13.39 percent in 2080, with the modest rise attributable to increased revenues from the taxation of Social Security benefits. Costs will rise rapidly from 10.8 percent of payroll, when the first of the baby boomers become eligible for early retirement in 2008, to 17 percent in 2031, when the last of the baby boomers reach normal retirement age. Even after the last baby boomer retires, costs will continue to rise steadily for the indefinite future. While the program’s current tax revenues are expected to exceed its costs until 2018, in every subsequent year thereafter, the program will face a funding deficit that will continue to grow in dollar terms and as a percentage of payroll.

Traditionally, media reports have summarized Social Security’s financial health by reporting two numbers, the seventy-five-year actuarial deficit and the year of Trust Fund exhaustion. For 2004, these two numbers were 1.89 and 2042. The 1.89 actuarial deficit means that if the OASDI tax rate were raised in 2004 from its 2004 level of 12.4 percent of payroll to 14.29 percent of payroll, Trust Fund exhaustion would occur exactly seventy-five years later—in this case, 2078. Even if this payroll tax increase were enacted immediately, however, the system would go into deficit in 2023, just five years later than is currently forecast. Furthermore, there would be large deficits after 2078. The last time the Social Security system was brought back into actuarial balance was 1983, when a combination of an increased tax rate, gradual increase in full retirement age, and partial taxation of benefits reduced the actuarial deficit from 1.82 to −0.02. However, the government anticipated in 1983 that the actuarial deficit would be high again twenty years later.

The relevance of the 2042 Trust Fund exhaustion date is that the Treasury is not legally obligated to fund benefit payments that exceed Social Security revenues once there are no Trust Fund bonds to redeem. That date is artificial, though. Starting in 2018, paying benefits will require transfers from the rest of the federal budget. While the Trust Fund is an asset to Social Security, it is a Treasury obligation, not a Treasury asset, and provides no revenue to the Treasury for the payment of benefits. Thus, the redemption of Trust Fund assets will require some combination of increased federal taxes, reduced federal expenditures on other programs, or increased debt sales to the public.

Because Social Security is popular, it is difficult to change; without change, however, the program is financially doomed. As the Social Security trustees repeatedly point out, by 2018, Social Security will no longer be able to contribute to the Treasury revenue that, in 2003, equaled 7 percent of total income tax revenues. In fact, by 2024, the payment of Social Security benefits will require a transfer from the Treasury of more than 7.5 percent of total income tax revenues; by 2042, this transfer will grow to more than 15 percent of total income tax revenues.

Further, if Congress chooses to cover the looming deficits by raising the existing payroll tax, the tax rate required to pay benefits will grow from its current level of 12.4 percent of payroll to 17.8 percent of payroll by 2042 and to 19.4 percent by 2080, the end of the trustees’ normal seventy-five-year horizon. Given that current Social Security replaces on average 42 percent of earned income, if in the long run there are two workers per retiree—the level expected by 2030—the required tax rate will be 21 percent. To the extent people view payroll taxes as pure taxes rather than as generating future benefits, such taxes reduce the supply of labor and result in a deadweight loss to the economy. At best, the current tax rate, if invested at the 3 percent rate assumed by the trustees, would just yield the benefits currently promised. Thus, the current payroll tax could be viewed by participants as buying them their promised benefits. However, the ultimate 21 percent payroll tax could not be so viewed and would result in a real reduction in the nation’s output.

If currently scheduled Social Security benefits are paid, other government spending will have to be reduced or income taxes increased by almost 15 percent of projected income tax revenue. The Medicare program faces similar financial shortfalls. By 2030, maintaining currently scheduled Social Security and Medicare benefits would require all the payroll taxes and other revenues earmarked for these programs, plus more than 50 percent of all projected income tax revenues. This burden would fall on future workers, who would have to pay much higher payroll taxes.

To put the Social Security problem in perspective, the trustees calculated that the debt the system owed its current participants (those fifteen years old and older) at the close of 2003 was thirteen trillion dollars. If the government continued paying scheduled benefits and collecting only scheduled taxes from current participants, all new entrants to the workforce would have to pay off this thirteen-trillion-dollar debt in their lifetime. This is the equivalent of saddling each newborn with a substantial mortgage for which he will receive nothing in return.

With the Medicare debt added to the Social Security debt, new entrants to the workforce owe current participants almost forty-two trillion dollars. Because these debts are so enormous, they cannot and will not be honored. If the government solves the problem well and soon, the solution will be less painful. The required changes will cost something, but doing nothing will cost even more and will pass that cost on to future generations.

Even if benefits currently scheduled for the future are paid, the participants in Social Security will have received a rate of return on their taxes that is near zero. This low rate of return has formed the basis for increasing calls for reform. In 2001, President George W. Bush established the President’s Commission to Strengthen Social Security (CSSS), of which I was a member. The CSSS considered alternative ways of dealing with the thirteen-trillion-dollar debt and suggested adjusting the benefit formula and allowing workers to invest part of their FICA taxes in individual retirement accounts. Thus, part of each worker’s FICA would be deposited to an account in his or her name and would not become part of general Treasury revenue.

Currently, benefits are scheduled to increase with the increase in real wages. The CSSS benefit formula adjustment would fix the real purchasing power of benefits at the level that would be achieved in 2009. The individual accounts would replace future benefit increases, so that the benefit structure would remain virtually unchanged. These changes would pay off about $4.4 trillion of the $13 trillion Social Security debt, largely through a significant reduction in the level of future promised benefits. Even with this reform, however, future generations would be saddled with $8.6 trillion in extra debt. Several other reforms are being considered, ranging from retaining much of the current pay-as-you-go financing to completely privatizing the system. To the extent that we replace a system in which individuals depend on future generations to pay for their retirement with one in which each generation saves for its own retirement, the U.S. capital stock will grow. Further, contributions to private accounts, even if equal to current tax rates, would correctly be viewed by participants as buying direct benefits and would have little negative effect on labor supply. Thus, the reform path that is ultimately chosen will have long-run implications for capital growth and income growth, and, ultimately, will determine which generation bears the burden of financing retirement.