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The Unfinished Work
By Charles Blahous
Hoover Institution PressCopyright © 2010 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
A Memorandum to the President and Congress
TO: PRESIDENT OBAMA AND CONGRESS
FROM: CHUCK BLAHOUS
RE: SOCIAL SECURITY
AS YOU WELL KNOW, you have assumed great public responsibilities at a time of dire challenges to our nation's economy and to the individual well-being of millions of Americans. Our citizens have looked to you for solutions to long-intractable national challenges, many of which have absorbed your energies during your first several months in office. To move us beyond years of political gridlock and policy paralysis in these and other areas, your most creative and inclusive thinking will be required.
One of the most profound responsibilities you have accepted is for the financial sustainability and effective functioning of Social Security, the federal government's largest and arguably its most important domestic program.
Meeting this responsibility will not be easy. Social Security faces substantial challenges in the decades ahead. Moreover, Americans care deeply about Social Security while holding a wide variety of conflicting, impassioned views about how to render the program strong and beneficial going forward.
Compounding these challenges is that, in the Internet age, Americans are turning increasingly to disparate sources for the basic factual predicates of the Social Security discussion. It is forbiddingly difficult to foster a policy agreement among those making different value judgments when they cannot even agree on the facts and on the problem to be solved.
Despite enormous efforts over the years — by bipartisan advisory councils, congressional bodies, and Presidents George W. Bush (whom I served) and Bill Clinton — to objectively define and quantify Social Security's challenges, agreement even on these factual predicates remains elusive. An equitable Social Security solution will be unattainable unless you bring stakeholders together around a common understanding of the facts and of the need to take action to address them.
This challenge, though difficult, must be met if Social Security is to serve future generations as it has served us. Toward this end, the following memorandum presents some basic factual background about Social Security — about how it affects program participants and about the demographic, economic, and political factors that threaten its future efficacy. These issues will be probed in greater depth in the chapters that follow.
What Americans Pay for Social Security
Social Security's official name is the "Old-Age, Survivors, and Disability Insurance" program. Most working Americans (and their employers) are required to pay into it, and after ten years of such contributions are eligible for an array of benefits.
Social Security's primary source of revenue is a 12.4 percent tax levied on workers' wages. Unlike the federal income tax, the Social Security payroll tax admits of no exemptions and no deductions. It is levied on the first dollar of earnings. Ostensibly, the worker pays 6.2 percent and the employer pays 6.2 percent, but economists generally agree that both ends of the payroll tax come from workers' wages and that we can best think of the Social Security payroll tax as a full 12.4 percent tax on the worker. In effect, one out of every eight dollars workers earn is provided to the government to operate Social Security.
The 12.4 percent tax is actually split into two pieces: a 10.6 percent assessment to fund retirement and survivors' benefits and a 1.8 percent assessment for Social Security's disability insurance program.
There is a limit to the application of the payroll tax to wage income. It is currently levied on the first $106,800 of a worker's wages and not beyond. This reflects Social Security's design as a contributory entitlement program: the more you pay in, the more benefits you receive. This ethic has long distinguished Social Security in the public's mind from welfare programs.
In a welfare program, higher-income individuals may pay in while receiving nothing out, while poorer Americans may receive something out while paying nothing in. Social Security does not function this way. Accordingly, exposing more income to the Social Security payroll tax would result in additional benefits for those who need them least, unless deliberate action is taken to deny benefits based on these additional contributions.
The payroll tax is the largest — but not the only — source of Social Security revenue. Social Security benefits are also subject to the income tax. Part of the resulting revenue is provided to the Social Security program.
Together, these revenues currently add up to more than $700 billion paid annually into Social Security: $677 billion in payroll taxes and another $24 billion in benefit taxation. These figures give a sense of how heavily invested are Americans in Social Security and how great a role it plays in their economic lives. In 2006, an Urban Institute study found that for two-thirds of Americans, their payroll tax payments (including both Social Security and Medicare) exceeded their income tax payments.
The large annual contributions made by Americans to Social Security have in recent decades been more than enough to fund payments to the program's beneficiaries. This is, however, starting to change, as the following information will detail. But first, let us examine what Americans receive for these payments into Social Security.
Social Security Benefits
Americans tend to think first of retirement benefits when thinking of Social Security. Indeed, Social Security pays more retirement (technically "old-age") benefits than any other kind. But Social Security provides many other categories of benefits as well.
In its 2009 report, Social Security's Board of Trustees estimated that the program would spend $683 billion for the year. Out of all benefits paid, roughly 62 percent would be worker retirement benefits. The Social Security retirement benefit formula is complex, but the basics are as follows. The Social Security Administration keeps track of each worker's wages subject to the Social Security payroll tax each year. These past earnings years are then indexed into today's terms, using a method that reflects how national wages have grown in the interim. This wage growth adjustment enables a determination as to which years were effectively the worker's highest thirty-five years of earnings. These thirty-five years are then averaged to produce an average indexed monthly earnings (the AIME) for the worker, in today's terms.
Once each worker has an average earnings profile, this number is converted into a Social Security benefit. The benefit formula is progressive, meaning that it delivers higher returns on the first dollars each worker earns than on the last dollars earned by the highest-wage workers. As one example, the first $100 of a worker's average monthly earnings will produce $90 in monthly benefits in retirement, whereas the last $100 of taxable earnings of a high-wage worker will only produce $15 in monthly benefits.
All of this calculating determines the benefit that a worker receives if he or she claims benefits at the Normal Retirement Age (NRA). The NRA is currently sixty-six and is scheduled to gradually rise to sixty-seven for people born in 1960 or later. A worker can claim benefits earlier, as early as age sixty-two, but by doing so he or she receives a lower annual benefit to adjust for the longer period of time that benefits will be collected. Similarly, the worker can delay a benefit claim for up to three years after NRA and thereby receive a higher annual benefit via the Delayed Retirement Credit (DRC). No matter at what age a worker retires, the benefits are adjusted each year thereafter for price inflation through a Cost-of-Living Adjustment (COLA) based on that year's change in the Consumer Price Index.
Whether or not one masters all of these technical elements, there are three aspects of Social Security benefits that can and should be borne in mind.
One is, again, that the benefit formula is progressive. Lower-wage workers (all other things being equal) receive a higher return on their investment than higher-wage workers. Thus, while both high-wage and low-wage workers earn credits for their contributions, Social Security generally redistributes income from high wage to low. There is some tension and opacity in a system that has the dual features of redistributing income while maintaining a contribution-benefit connection for high earners. Policymakers continually debate how much income redistribution the system should impose to protect low earners, as well as what is a sufficient return to higher-income workers to ensure their continued political support.
Another important factor is that benefit earnings stop where tax assessments stop. Workers earn benefits only on their wages that were subject to the Social Security tax. They do not earn benefits on wages that were not so taxed. Again, this reflects the program's design to provide a floor of income protection based on taxpaying work.
Thus, the system literally cannot "see" most of the earnings of a Bill Gates, nor does he earn any benefits based on most of his earnings. As a result of such earnings being invisible to the system, a worker with a calculated AIME equivalent to $62,000 annually is actually in the top 19 percent of all workers. Such counterintuitive figures sometimes create great confusion as to how many people would be affected by a proposed benefit change.
The third factor of note is that the initial benefit formula (in addition to the worker's wage history, which we've already discussed) is wage-indexed. I will explain this in depth later, but essentially what this means is that each class of retirees is provided with initial benefits higher than those paid to those retiring the previous year, assuming that national wages have increased in the meantime, as they usually do. This feature of Social Security was not included in the system originally implemented by President Franklin D. Roosevelt and the Congress of 1935. It was enacted in its current form in 1977. If it did not exist — if, for example, initial benefits simply grew with price inflation — Social Security would not now face a projected shortfall at all.
If 62 percent of Social Security payments are to retired workers, what about the other 38 percent? The largest shares of the remainder are paid to disabled workers (16 percent) and surviving spouses (aged widows and widowers, 13 percent). In addition to these, there are a number of other beneficiaries: non-working spouses, child survivors, and children of retired and disabled workers, among others.
These auxiliary benefits are all generally linked to the basic retirement benefit in some fashion. A surviving spouse, for example, will generally get the higher of the two benefits received by each half of the couple when alive. A disabled worker's benefit is also based on the retirement benefit formula, with the wrinkle that the number of years used to determine his or her average earnings is determined by the age of disability rather than the age of retirement. The overriding principle to recognize is that the retirement benefit formula generally drives benefit levels for other beneficiaries, such as the disabled and survivors, as well.
Social Security is fully able to meet today's benefit payments. Even with our current economic difficulties, no one is seriously worried about whether the federal government can meet its Social Security obligations next year.
That, however, will soon change. The first symptoms of the change are already starting to be felt, and will intensify in the coming years.
Social Security's challenge is one of the easiest issues to grasp, once shorn of superfluous detail, in all areas of federal policy. One remarkable aspect of the public Social Security debate is how such arcane concepts as "solvency," "actuarial balance," and Social Security Trust Fund accounting can obscure simple realities and make a truly straightforward issue seem very complex.
It is not at all complex. The simple reality is this: more people are now heading into retirement than ever before and will under current law be collecting higher benefits for a longer period of time. This means that higher costs will face our children and grandchildren than we have ever been asked to shoulder.
On October 15, 2007, Kathleen Casey-Kirchling, born on New Year's Day, 1946, became the first baby boomer to claim Social Security benefits. With Ms. Casey-Kirchling in the lead, the enormous baby boom generation began to head into retirement. Thereupon began a surge of benefit claims that will swell Social Security costs steadily and dramatically over the next couple of decades.
In 2009, roughly 52 million people were drawing Social Security benefits of one kind or another. It is expected that over the next twenty-five years this number will grow to over 88 million, an increase of more than 70 percent. As a result, the cost of paying Social Security benefits is expected to roughly double, even after adjusting for inflation, over that same time span: from just over $680 billion to over $1.4 trillion — for one program alone.
This cost surge is not a faraway phenomenon. It is already starting to happen. In 2008, the number of new retired worker beneficiaries shot upward by more than 11 percent relative to 2007, itself a record-setting year. In both of the first two quarters of 2009, there was a further 20 percent rise in new retiree beneficiaries relative to the same quarters of 2008.
Over this and the next presidential term, the total number of retirees on Social Security is projected to grow by roughly 24 percent while the number of workers contributing taxes grows by only 7 percent. The long-anticipated tidal wave of Social Security beneficiaries has finally reached the shore.
One reason for the surge in the number of retirees is, among other factors, that Americans are living longer than ever before. What causes it to play out so rapidly, however, is that the generation just now heading into retirement is the enormous baby boom generation born between 1946 and 1964. Those baby boomers, in turn, had fewer children than their parents did.
All of these factors combine to produce a situation in which there will soon be far fewer workers paying Social Security taxes to support each beneficiary. Today there are roughly 3.1 workers paying taxes to support each person receiving Social Security benefits. By 2030, that ratio will be 2.2 per recipient.
Let's put these figures another way. Today, one hundred workers must pay enough in taxes to support thirty-two Social Security beneficiaries. One hundred workers in 2030, however, will need to support forty-six beneficiaries (figure 1.1).
The principal manifestation of this rise in the number of beneficiaries is that, as Social Security is currently constructed, the cost of paying benefits will absorb a sharply increasing share of each taxpaying worker's wages.
In 2008, benefit costs equaled a little bit more than eleven cents of each taxable dollar earned by workers. The leftover portion of the 12.4 percent payroll tax was provided to the federal government to otherwise spend, in exchange for bonds issued to the Social Security Trust Fund. More on this later.
In 2009, due in part to a struggling economy, the cost of paying benefits rose to more than 12 percent of each worker's taxable earnings. Within the next twenty years, under current law, the cost of Social Security will rise to more than 16.5 percent of each worker's taxable earnings, as shown in figure 1.2.
Meanwhile, workers will simultaneously be asked to pay for similarly sharp increases in the cost of Medicare. All told, the next generation of workers will be asked to part with the equivalent of roughly one-third of their taxable wages to support these two programs alone. Everything else that the various levels of government tax workers to support — from national defense, roads and bridges, and state education expenses to the massive federal health care expansion enacted in early 2010 — would be levied on top of these unprecedented individual program costs.
The combination of these trends would result in enormous adverse implications for the economic experience of future generations, or — to put it more starkly — whether our children and grandchildren will be permitted an after-tax standard of living comparable to what we have enjoyed.
By 2016, under 2009 projections, annual Social Security costs will exceed the tax revenue the program generates. This date is likely to appear even sooner when the 2010 trustees' report is released. This means that our already cash-strapped federal government will need to find additional revenues to fully pay benefit obligations. Though the deficits will start small, they will exceed $100 billion (in today's dollars) by 2021 and $200 billion by 2026 under the 2009 projections that I will continue to cite here. It bears repeating that these are not total Social Security costs, but just the annual deficits that must be financed beyond the 12.4 percent payroll tax.
Excerpted from Social Security by Charles Blahous. Copyright © 2010 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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