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Issue Summary: Social Security Reform Detailed Issue Summaries contain a quick reference to Centrists.Org policy ideas. They will be revised and updated periodically for clarity and usefulness, and as events and policy ideas change. Questions or comments? Please contact us at information@centrists.org. What the Social Security "Trust Funds" Means 2. Degree of Progressivity 4. Opportunities for Wealth Creation 6. Promised versus funded benefit levels 7. Improving generational equity The Government Pre-Fund or "Lockbox" Approach Incremental Tax Increases and Benefit Cuts Diamond-Orszag Proposal Figures: As a result of these trends, the Trustees project that the Social Security system will move from black to red as annual obligations begin to exceed annual program revenues by 2018 and by 2042, the Social Security program will be insolvent. The Congressional Budget Office (CBO) issued estimates of Social Security's long-term outlook which differ somewhat from the estimates of the Social Security Trustees. Because CBO's cost figures are slightly lower than the Social Security Trustees Report within the 2020 - 2060 period, and because CBO's outlook for revenues is slightly higher after 2040, the “magic date” in which the trust fund is projected to become insolvent was ten years later in the CBO report and the size of the deficit over the valuation period was somewhat smaller, many proponents of the “do-nothing” or “take-it-slow” approach to reform cite the CBO report as evidence that the program is not as serious as had previously been thought However, CBO's new model is really telling us the same story: Social Security benefits will jump by about 2 percentage points of GDP over the next 25 years, while revenues stay roughly flat. The difference in the estimate of exactly when the revenue and outlay lines will cross is not nearly as significant as the fact that the estimates of both CBO and the Trustees show a permanent and growing gap between revenues and outlays after the lines cross. For policymaking purposes, there is no real difference between CBO's cost and revenue outlook and those of the Social Security actuaries. The Need for Reform: As the numbers above demonstrate, the first reason for reforming Social Security is that its costs would otherwise raise government spending by about 2 percentage points of GDP. If we do not address the pressures on the rest of the budget caused by the growth in the costs of Social Security, future Congresses will be forced to cut other important government programs, raise additional taxes or issue massive amounts of new debt to meet the obligations to our senior citizens. Tolerating federal deficits of an additional 2 percent of GDP would hurt prospects for economic growth under all but the most extreme deflationary scenarios. Closing the gap through taxes would be roughly equivalent to raising payroll taxes by 4 percentage points and use revenue options that may be needed to finance Medicare or meet other fiscal priorities. Cutting federal spending elsewhere in the budget by 2 percent of GDP is unlikely given the current trajectory of defense, health care, and other federal spending. Social Security has mostly been a "pay as you go" program. Today's workers finance, with their payroll taxes, the retirements of today's senior citizens. When those workers get old, they will in turn rely on taxes from their children's generation. But increased lifespans and decreased childbearing have made this bargain hard to sustain. In 1950, there were 16 workers supporting each retiree. There are 3.3 today. By 2040, there will be only 2.1. Many Social Security reform proposals seek to address this issue by "advance funding" a portion of future benefits. Advance funding is essentially a timing deal: public expenditures now to fund personal investment accounts, in exchange for benefit reductions later. Funds in the accounts would be used to compensate for the benefit reductions. Economic growth is a much smaller factor acting upon the sensitivity of projections than are demographic estimates. The improved outlook in the “low-cost” estimates in the Trustees report is primarily a result lower-cost estimates employed in fertility rates and life expectancies. In addition, increased economic growth is a mixed blessing in terms of Trust Fund solvency because it increases out-year liabilities at the same time that it increases short-term revenues. Faster economic growth may modestly improve long-term actuarial balance of the trust fund, but it does so by swelling the trust fund with increased short-term revenues, which exacerbates the out-year budgetary pressures on general revenues. In addition, Social Security can be modernized in a way that not only ameliorates a future budget crunch, but also helps empower all workers to be savers and investors, and to take better charge of their financial future. Social Security reform can be a powerful tool to help low-income workers build assets and move up into the middle class. Social Security reforms which include individual accounts could provide new wealth for the one-half of American households who currently have no appreciable financial assets. Individuals would have a greater stake in the progress of our economy and a greater say in their own retirement income prospects. They would accumulate wealth, which they could use for their own retirement or pass on to their heirs. Another reason to reform Social Security is to adjust the system to reflect the changes in society since Social Security was created. Social Security was modeled on the single-earner, married-couple family. Although more common in the late 1930s, this type of household is not the norm today. Indeed, since Social Security's inception, sweeping social and demographic shifts have radically altered the structure of the American family. Nonetheless, Social Security law still largely reflects the realities of the 1930s. The changing demographics of American society have led some analysts to question whether the system’s redistributive elements are well targeted to deal with the threat of poverty among tomorrow’s elderly. In particular, the increasing numbers of women in the workforce – including divorcees, those who never married, and two-earner couples – are among those who may be missed by the system’s anti-poverty protections. Compared with previous decades, more women are earning higher education, entering the labor force, working more hours, and receiving wages comparable with those of men. Consequently, an increasing number of couples participate in a program that provides them with fewer benefits than it provides households with the same total earnings, yet where one spouse brings in all, or much of, the earnings. A low-income, two-earner couple receives a lower rate of return than a high-income, one-earner couple, despite the progressivity of the benefit formula. Much of this difference is due to the relative generosity of the non-working-spouse benefit, in comparison with the relatively low rate of return on an individual’s primary Social Security tax contributions. The progressivity of the basic benefit formula is often undermined in its effects by redistribution to one-earner couples from households with working women. Modernizing the Social Security system to reflect these changes could ensure both that more of the elderly are kept out of poverty and that spouses share more equally in the retirement benefits accruing from and attributable to years spent together. Links: In years when the Social Security program runs a cash surplus, the surplus is available to be allocated for unrelated spending or to buy down publicly held debt. In return for immediate access to the revenue, the federal government issues interest-bearing bonds to the Social Security Trust Fund. Many proposals contain provisions to deposit Social Security surpluses instead in personal Social Security accounts. If such a provision were adopted, the federal government, having borrowed less of the surplus, would issue fewer bonds to the Social Security Trust Fund, and assets would accumulate in the personal accounts. Although much of the debate focuses on the insolvency date (projected to be 2042 under the most recent Trustees report and 2052 under CBO estimates), insolvency is an accounting term that doesn't bear an economic reality. Trust fund solvency is a necessary but not sufficient standard for measuring the program’s health. It is necessary because the Social Security Administration is not empowered to issue checks to beneficiaries without dedicated financing. Ensuring trust fund solvency does not by itself embody a solution to Social Security’s financing challenges. Solvency measures the revenues committed to the Social Security program, but does not answer the more important question as to how those revenues are to be generated. The key date for Social Security is the year in which cash-flow benefits will exceed cash-flow payroll taxes (2018 under the Trustees estimates, 2019 under CBO estimates), and the Social Security system will have to come back to the rest of the budget for additional resources to pay promised benefits. Regardless of whether the program is “solvent,” a cash deficit requires the federal government to find additional revenue if full benefits are to be paid. The government will need to raise other taxes, cut other spending or issue new debt in order to redeem the Treasury bills held by the Social Security trust fund in order to pay benefits. Unlike the measure of “solvency,” Social Security’s cash imbalances cannot be made to appear less serious simply by changing program bookkeeping. Accordingly, many analysts believe that reducing long-term cash imbalances is a goal of equal or greater importance than attaining program solvency. Trust fund accounting is a political construction, not an economic activity. To use an economist's term, money is fungible. Tax dollars arrive in the treasury each year from many sources and are spent in myriad ways the same year. It does not matter which dollars are spent which way -- they are all just dollars, after all. What matters most to the macroeconomy is how many dollars are collected and how many are spent. The difference is the overall or "unified" federal deficit or surplus -- the amount by which the national debt owed to the public rises or falls. Ultimately, whether or not Social Security is sustainable depends not on the accounting balance in their trust funds but on the political balance between overall government spending and tax revenues and between government spending for entitlements and spending for discretionary programs. Therefore political considerations, not trust fund accounts, will ultimately determine their viability. Congress could transfer all federal revenues -- income taxes, corporate taxes, excise taxes, the works -- to the Social Security Trust Fund, deferring the fund's insolvency forever. But that would not solve the political problem that will arise when 80 million baby boomers begin drawing benefits.
The difference between these costs and dedicated revenues is Social Security's effective cash-flow surplus or deficit. Because benefit costs are currently lower than revenues, Social Security is running a surplus. However, Social Security's current surplus is expected to disappear and become a deficit after 2010 as the large baby boom generation starts to retire in large numbers. After 2030, the Social Security deficit is projected to be about 2 percent of GDP (see Figure 2).
This definition of Social Security's budget situation does not consider trust fund balances or intra-governmental interest payments or transfers. That is because Social Security is essentially a pay-as-you-go social insurance program, not an advance-funded retirement plan. Workers pay payroll taxes roughly sufficient to cover Social Security's outlays at the time. Social Security's future budget problem is simple: payroll taxes will not be high enough to cover future benefits. Cost (+) or Savings (-) From Social Security Reform Proposals (As A Percent of GDP)
Source: Centrists.Org, based on information from Social Security Administration. In this example, all four proposals successfully close Social Security's funding gap in the long run. However, the Graham proposal includes significant transition costs, which would otherwise burden current taxpayers. An individual’s wage contributions to the system do not directly fund his or her own benefits, but are used principally to pay benefits to current retirees. When the individual reaches retirement age, the benefits paid are indirectly related to wage contributions through a set of complex benefit formulas. The system as a whole redistributes income between Americans. Plans which include individual accounts should be target changes in the defined benefit system at middle and upper income workers who are able to tolerate a higher level of risk in individual accounts and therefore have a greater opportunity to benefit from the prospects for higher returns from individual accounts. In addition, the formulas for funding personal accounts should be progressive -- if Social Security reforms imply switching from a progressive defined benefit formula toward a combination of defined benefits and income from personal accounts, reformers should ensure that those accounts mimic the progressivity of the benefits being replaced. Proponents of Social Security personal accounts should use reasonable assumptions about the rates of return workers are likely to achieve, and should not promote the accounts as likely to lead to a large increase in national savings and investment. Some proponents of Social Security private accounts insist that because private investments will have a high rate of return, the accounts are essentially "free money," creating wealth that would not otherwise have been created. In particular, proponents of large Social Security accounts claim that rates of return on those accounts will be so high that the government can be assured that all workers will be better off, and can guarantee the current Social Security promised level of benefits without risk. Moving around existing savings and maintaining current government benefit promises can only redistribute the tax burden, not alleviate it. If the government continues to formally guarantee the level of benefits provided under current law, it can produce no other means of providing for them than direct or indirect taxation of the private economy. If the Social Security program continues to guarantee benefits equal to 6.1% of GDP in the year 2030, then it must tax sufficiently to pay that amount. No matter how this is done there is no way around an effective tax increase of that magnitude if the federal government is committed to guaranteeing benefits at the level promised under current law. Social Security calculations that sound too good to be true are usually based on the tenuous assumption that Social Security reform will dramatically increase national savings and investment, and raise the national tolerance for risk. Proponents of Social Security accounts should not depend on such "leverage" in their calculations or the likely impact of reforms. 4. Opportunities for Wealth Creation. Personal accounts that can be held as assets in a family are an important part of Social Security reform. Social Security reform should establish the opportunity for all Americans to build a nest egg for retirement and benefit from the market forces to increase their Workers at all income levels would be able to leave the remaining assets in their account to their heirs upon death. Similarly, if a worker dies before reaching retirement, all assets in a worker’s individual account would be part of their estate. The ability to bequeath assets would be especially beneficial for low-income workers who have shorter life expectancies. It is possible to give Americans control over their retirement income while also providing government safeguards that address legitimate risk concerns. Individuals who control their own retirement assets, including the freedom to invest in risk-free Treasury securities or the stock market, will voluntarily decide how to handle their individual accounts. Accounts that are notionally owned by workers, but which are not actually under workers' control and which must be distributed in full when a worker retires do not pass the test of wealth creation. 5. Sustainability. Another important measure of the Social Security program’s health is its sustainability. The program has attained sustainability if it has been placed on a path where the revenues generated by the program are projected to henceforth be permanently sufficient to fund subsequent annual benefit obligations. The program is not sustainable if its outlay obligations perpetually grow faster than the revenues collected to support them. The self-financing nature of the Social Security program distinguishes it from other welfare programs and unearned entitlements. If the program is unsustainable without permanent infusions of non-Social Security revenues, then its ethic as a self-financing contributory system cannot be maintained. If a Social Security reform program is solvent but not sustainable, then it could revert in the year after enactment into insolvency again. This would be the case if the system is projected to run permanent deficits at the end of the valuation period. Then the passage of time would bring deficit years into the valuation picture, while surplus years recede into the past. This is why some analysts have suggested utilizing "infinite horizon" calculations for Social Security reforms instead of relying on truncated time periods. In the 2004 Trustees report, the Trustees wrote: ".....overemphasis of summary measures (such as the actuarial balance The difference between a plan that leaves in place a strong and growing Trust Fund at the end of seventy-five years, and a plan that extends solvency for a finite period of time but leaves the system with a depleted Trust Fund at the end of the valuation period, is fundamental and significant. The issue should not be seventy-five years versus one hundred years or a short time period; it should be whether a reform plan offers a complete solution that puts the Social Security system on a permanent, sustainable fiscal course. Reform proposals achieve sustainability range from reducing projected benefits to raising the payroll tax. The Diamond-Orszag plan, for example, would be sustainable because it would increase future payroll tax rates to match benefit increases. Individual account plans such as the Graham and Kolbe-Stenholm proposals achieve sustainability by providing for advance funding of a portion of future benefits obligations through personal accounts. 6. Promised versus funded benefit levels. Comparing the benefits of any Social Security plan to the benefits promised under current law is extremely misleading, because current law makes promises we can’t keep without substantially raising payroll taxes. It is not meaningful to compare any balanced, fully funded reform plan with the insolvent, un-funded current system. The right comparison is to compare what a reform plan can offer with what current law can actually buy, or to compare balanced reform plans to one another. Otherwise the incentives in the standards of comparison will simply be to promise higher benefits, provide no financing, and thus promise an impressive return. 7. Improving generational equity. While it is important that Social Security reform protect the interests of current retirees, it is just as important that we address the concerns of younger generations who doubt that the Social Security system will be there for them. The Social Security system has always been based on an implicit generational contract that workers will pay taxes to fund benefits for current retirees in the expectation that they will receive similar benefits when they retire. This generational contract is threatened by the growing skepticism among younger workers about the future of the Social Security system. Requiring workers to pay taxes to support a system that they do not expect to benefit from will create discord that can only jeopardize the political legitimacy of the Social Security program. The Social Security system, as a whole, transfers income from younger generations to older ones as a consequence of Social Security’s “pay as you go” structure. As the ratio of workers continues to drop (it will be roughly 2:1 within a generation), this means that each subsequent generation of Americans receives a worsening deal than the one previous to them. Under Social Security’s current pay-as-you-go structure, annual tax burdens would continue to rise to fund the benefits of a growing retiree population. Advance funding addresses this issue by moving some of the cost of funding benefits into the present, and leaving less of future benefit financing to be met from commitments of future tax dollars. Social Security reform should modernize the Social Security system to ensure that it can earn the support of younger generations that will be necessary to preserve the program. Responsible Social Security reform will give younger generations much greater confidence in the Social Security system by reassuring them that the Social Security program will be there for them when they retire by putting the system on a long-term, sustainable fiscal path and given them ownership of and control over a portion of their retirement income. The Role of Individual Accounts in Social Security Reform: Individual accounts can be an important component of a comprehensive reform plan, but they do not provide a painless solution to the financial challenges facing Social Security. Centrists believe that personal accounts are not a magic bullet that will save Social Security on their own, but coupled with progressive reforms to the benefit structure, they offer workers a much better deal than current law can afford. Individual accounts offer a more effective method to save current payroll taxes to pre-fund a portion of future benefits. Past efforts to pre-fund Social Security's future liabilities via trust funds or other accounting mechanisms have failed to work in an economic sense, because Congress tends to spend the money in trust funds or "off-budget" accounts anyway. In a sense individual accounts are the ultimate lock-box, ensuring that current payroll taxes are truly saved for future retirement benefits. Individual accounts are often described as taking money away from the Social Security system. In reality, they represent a different approach to saving current payroll taxes to fund future retirement income. The total assets of the system would remain the same, but a portion of the system assets held in Government IOUs would be replaced by individually owned accounts. Individual accounts explicitly reduce future liabilities with prefunded accounts by replacing a portion of guaranteed benefits that the government is required to honor in the future with individual accounts funded with current revenues. The costs associated with individual accounts are not new costs, but simply shifting existing costs forward by funding future retirement income today. Without individual accounts, the entirety of the burden of funding tomorrow’s retirement income benefits would fall exclusively on tomorrow’s taxpayers in the form of increased taxes for general revenues or reductions in other government programs. Tough choices will be necessary to eliminate the deficit facing Social Security whether or not individual accounts are included in a reform plan. Including individual accounts in a reform plan does not require deeper benefit reductions than would otherwise be required, but neither does it make such reductions unnecessary. However, individual accounts can help make the task easier for policymakers and limit the impact on future beneficiaries. The benefits from the higher returns earned by accounts could offset some of the reductions in promised benefits that will be necessary to restore solvency with or without individual accounts. Analysis conducted by the independent Social Security Actuaries and the Congressional Research Service have found that reform plans which include individual accounts provide a better deal than plans which restore solvency through tax increases or benefit reductions alone. The proposal by Senator Lindsey Graham, which was introduced in November 2003, is an example of a Social Security reform proposal that includes individual accounts as part of the solution. This proposal would significantly reduce Social Security's net costs in the long run, protect low-income workers, and give all workers an opportunity to use the wealth in their personal accounts to build and pass on assets. Of course, under normal assumptions about the rates of return in personal accounts, the bulk of the accounts' accumulated assets would be necessary to replace retirement income as defined benefits were cut. Many higher-income beneficiaries would have to save more just to keep pace with currently promised benefits. (It is important to remember that currently promised benefits assume Social Security will run large deficits; current benefit promises may not be achievable in any case.) However, if rates of return were high, or if a retiree could manage to live on the reduced defined benefit, the accounts could create a permanent store of wealth.
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