Politics - Social Policy Essay Review

CHAPTER 14

Government and Society

68

''Providing Social Security Benefits in the Future: A Review of the

Social Security System and Plans to Reform It"

David C. John

There is wide agreement that Social Security requires major reforms if it is to con­ tinue to provide economic security to retirees. The baby boom generation has begun retiring, and the amount of money paid out in benefits exceeds the amount paid into the system in payroll taxes. Very soon, the program will start drawing down a Trust Fund that has been funded by surplus contributions over previous decades, although paying off the obligations in that fund will require additional revenues, since the Trust Fund is made up of special Treasury securities that the government, in effect, owes to itself. By 2035, the Trust Fund will be exhausted, at which point payroll tax revenues will only be enough to pay 79 percent of scheduled benefits.

Clearly, something must change. At the heart of the debate over what to do are two contrasting perspectives of what the Social Security system should accom­ plish, both deeply rooted in American political culture. Should we view Social Security as a national guarantee of basic income for retirees, no matter what? Or should Social Security be an individualistic program that permits people to succeed—or fail—based on the choices that they make? Put another way, is Social Security a social welfare program or an investment program? David C. John of the Heritage Foundation, writing about the proposals in 2004, weighs into this debate by outlining some principles for what Social Security reform should look like from a conservative perspective. John is a strong proponent of Personal Retirement Accounts (PRA), which would allow workers to invest a portion of their Social Security taxes in individual accounts that they alone would control. However, as

he notes, none of the proposed reforms address the "transition problem." That is, because Social Security is a "pay as you go" program—the payroll taxes paid by today's workers fund the Social Security benefits of today's retirees—if today's workers are allowed to take a portion of their payroll taxes and put it in a PRA, it means there will be even less money to pay for the current obligations for today's retirees than under the current system, at least for the next several decades. John writes, "neither the current system nor any of the proposed reforms comes close to closing the gap."

Social Security is the best-loved American government program, but how it works and is financed is almost completely unknown. Most Americans have a vague idea that they pay taxes for their benefits and

that their benefits are linked somehow to their earnings. Many also know that the program is in trouble and needs to be "fixed" sometime soon to deal with the retirement of the baby boomers. Beyond this, their knowledge of the facts is severely limited and often colored by rumors and stories.

Most politicians exploit this lack of knowledge and limit their state­ ments on Social Security to platitudes and vague promises. To make mat­ ters worse, reformers tend either to be content with similar platitudes or to speak in such detail that few outside the policy world can understand what they are saying. The simple fact is that today's Social Security is extremely complex, and any reform plan that is more than fine words will be similarly complex.

This paper attempts to simplify the reform debate by comparing vari­ ous plans (including the current system) side by side. Each of the six sec­ tions of this paper compares how the current system and the reform plans handle a specific subject. Only reform plans that have been scored by Social Security's Office of the Chief Actuary are included in this compari­ son, using numbers contained in the 2003 Report of the Social Security Trustees. * * *

While looking at just one or two sections of special interest may be tempting, this approach would probably be misleading. For the best effect, each section should be considered together with the other sections in order to form a complete picture of the plan. Using simply one section by itself to judge an entire plan will not yield an accurate result.

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Seven Important Rules for Real Social Security Reform

Information in this side-by-side comparison is based on Social Security's scoring memos for each plan and conclusions that can be drawn from information contained in those memos. While there are many good points in the reform plans examined in this analysis, this is not an endorse­ ment of any proposal by the author or The Heritage Foundation. Instead, this comparison provides details of specific plans. However, it would be wise for reformers to follow a set of general principles to ensure that any

464 David C. John

Social Security reform both resolves Social Security's problems and pro­ vides workers with greater retirement security. Those principles are listed below.

This comparison of plans makes no effort to examine whether the Social Security reform plans included in it meet or violate any or all of the principles.

Principles for Social Security Reform

• The benefits of current retirees and those close to retirement must not be reduced. The government has a moral contract with those who currently receive Social Security retirement benefits, as well as with those who are so close to retirement that they have no other options for building a retirement nest egg. If the benefits of younger workers can­ not be maintained given the need to curb the burgeoning cost of the program, then they should have the opportunity to make up the differ­ ence by investing a portion of their Social Security taxes in a personal retirement account.

• The rate of return on a worker's Social Security taxes must be improved. Today's workers receive very poor returns on their Social Security payroll taxes. As a general rule, the younger a worker is or the lower his or her income, the lower his or her rate of return will be. Reform must provide a better retirement income to future retirees without increasing Social Security taxes. The best way to do this is to allow workers to divert a portion of their existing Social Security taxes into a personal retirement account that can earn significantly more than Social Security can pay.

• Americans must be able to use Social Security to build a nest egg for the future. A well-designed retirement system includes three elements: regular monthly retirement income, dependent's insurance, and the ability to save for retirement. Today's Social Security system provides a stable level of retirement income and does provide benefits for depen­ dents. But it does not allow workers to accumulate cash savings to ful­ fill their own retirement goals or to pass on to their heirs. Workers should be able to use Social Security to build a cash nest egg that can be used to increase their retirement income or to build a better economic future for their families. The best way to do this is to establish, within the framework of Social Security, a system of personal retirement accounts.

• Personal retirement accounts must guarantee an adequate minimum income. Seniors must be able to count on a reasonable and predictable minimum level of monthly income, regardless of what happens in the investment markets.

• Workers should be allowed to fund their Social Security personal retirement accounts by allocating some of their existing payroll tax dollars to them. Workers should not be required to pay twice for their

benefits—once through existing payroll taxes and again through addi­ tional income taxes or contributions used to fund a personal retirement account. Moreover, many working Americans can save little after pay­ ing existing payroll taxes and so cannot be expected to make additional contributions to a personal account. Thus Congress should allow Amer­ icans to divert a portion of the taxes that they currently pay for Social Security retirement benefits into personal retirement accounts.

• For currently employed workers, participation in the new accounts must be voluntary. No one should be forced into a system of personal retirement accounts. Instead, currently employed workers must be allowed to choose between today's Social Security and one that offers personal retirement accounts.

• Any Social Security reform plan must be realistic, cost-effective, and reduce the unfunded liabilities of the current system. True Social Security reform will provide an improved total retirement benefit. But it should also reduce Social Security's huge unfunded liabilities by a greater level than the "transition" cost needed to finance benefits for retirees during the reform. Like paying points to obtain a better mort­ gage, Social Security reform should lead to a net reduction in liabilities.

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The Social Security System and Plans for Reform

The Current System

Social Security currently pays an inflation-indexed monthly retirement and survivors' benefit, based on a worker's highest 35 years of earnings. Past earnings are indexed for average wage growth in the economy before cal­ culating the benefit. The benefit formula is progressive, meaning that lower-income workers receive a benefit equal to a higher proportion of their average income than upper-income workers receive. The program is expected to continue to collect more in payroll taxes than it pays out in ben­ efits until about 2018.

Unused payroll taxes are borrowed by the federal government and replaced by special-issue Treasury bonds. After the system begins to pay out more than it receives, the federal government will cover the resulting cash flow deficits by repaying the special-issue Treasury bonds out of gen­ eral revenues. When the bonds run out in about 2042, Social Security ben­ efits will automatically be reduced to a level equal to incoming revenue. This is projected to require a 27-percent reduction in 2042, with greater reductions after that.

The DeMint Plan

Representative Jim DeMint (R-SC) has introduced a voluntary personal retirement account (PRA) plan that would establish progressively funded voluntary individual accounts for workers under age 55 on January 1,2005.

466 David C. John

The amount that goes into each worker's account would vary according to income, with lower-income workers able to save a higher percentage. For average-income workers, the account would equal about 5.1 percent of income.

The government would pay the difference between the monthly bene­ fit that can be financed from an annuity paid for by using all or some of the PRA and the amount that the current system promises. The sum of the annuity and the government-paid portion of Social Security would be guaranteed at least to equal benefits promised under the current system, and 35 percent of PRA assets would be invested in government bonds to help pay for any Social Security cash flow deficits. This proportion would be reduced gradually in the future. General revenue money would be used to pay for additional cash flow deficits.

The Graham Plan

Senator Lindsay Graham (R-SC) has proposed a plan that would give workers under age 55 (in 2004) three options. (Workers above the age of 55 would be required to remain in the current system and would receive full benefits.)

Under Option 1, workers would establish PRAs funded with part of their existing payroll taxes, equal to 4 percent of pay up to a maximum of $1,300 per year. Workers' benefits would be reduced by changing the benefit indexing formula from the current wage growth index to one based on consumer prices. Over time, this change would reduce benefits for workers at all income levels, but the effect on lower-income workers would be eased by a mandated minimum benefit of at least 120 percent of the poverty level for workers with a 35-year work history. The government-paid monthly benefit would be further reduced to reflect the value of the PRA. This reduction would be calculated using the aver­ age earnings of government bonds so that, if the PRA earned more than government bonds, the total monthly benefit would be higher. Option 1 also raises survivor benefits to 75 percent of the couple's benefit for many survivors.

Option 2 is essentially the same as Option 1, but without PRAs. The government would pay all benefits for workers who choose this option. Option 2 includes both the basic benefit reduction and the minimum ben­ efit requirement.

Option 3 pays the same level of benefits promised under current law, but workers who select this option would pay higher payroll taxes in return. Initially, the payroll tax rate for retirement and survivors bene­ fits would increase from 12.4 percent of income to 14.4 percent of income (counting both the worker's and the employer's shares of the tax). In subsequent years, the tax rate would continue to climb in 0.25 percent increments.

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The Smith Plan

Representative Nick Smith (R-MI) has proposed a voluntary PRA plan that would create personal retirement savings accounts funded with an amount equal to 2.5 percent of income, paid out of existing payroll taxes. This would increase to 2.75 percent of income in 2025 and could become larger after 2038 if Social Security has surplus cash flows. Retirement and survivors' benefits would be reduced by an amount equal to the value of lifetime account contributions plus a specified interest rate.

The Smith plan would also make many changes in Social Security's benefit formula, mainly affecting middle-income and upper-income work­ ers. These changes would eventually result in most workers receiving a flat monthly benefit of about $550 in 2004 dollars. It would also gradually increase the retirement age for full benefits and require that all newly hired local and state workers be covered by Social Security. The Smith plan transfers $866 billion from general revenues to Social Security between 2007 and 2013 to help cover cash flow deficits and allows additional gen­ eral revenue transfers when needed after that.

The Ferrara Plan

Peter Ferrara, Director of the International Center for Law and Economics, has proposed a plan that would create voluntary PRAs that would be funded according to a progressive formula that allows lower-income workers to save a higher proportion of their payroll taxes than upper- income workers. Average-income workers could save about 6.4 percent of their income. Workers would be guaranteed that the total of their PRA- generated benefits and government-paid monthly benefits would at least equal the benefits promised under the current system.

Any Social Security cash flow deficits that remain would be financed through general revenue transfers equal to a 1 percent reduction in the growth rate of all government spending for eight years, the corporate income taxes deemed to result from the investment of personal account con­ tributions, and issuing about $1.4 trillion in "off-budget" bonds. Under the Ferrara plan, these bonds would be considered a replacement for the existing system's unfunded liability and thus would not increase the fed­ eral debt.

The Orszag-Diamond Plan

Peter Orszag, Senior Fellow at the Brookings Institution,* and Peter Diamond, Institute Professor of Economics at the Massachusetts Institute of Technology, have developed a plan that does not include any form of

‘Peter Orszag was President Obama's Budget Director at the Office of Management and Budget until July 20'“ He now is at the Council on Foreign Relations [Editors].

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PRA or government investment of Social Security trust fund money in private markets. Instead, it gradually changes the benefit formula to reduce benefits for moderate-income and upper-income workers and requires that all state and local government workers come under Social Security. It would also gradually reduce benefits by raising the age at which workers could receive full benefits. Workers could still retire earlier, but at lower benefits. Benefits would increase for lower-income workers, widows, and the disabled.

In addition, the plan would gradually increase the payroll tax for all workers from the current 12.4 percent of income to 15.36 percent of income in 2078. It would also raise the earnings threshold on Social Security taxes—thus requiring higher-income workers to pay additional payroll taxes—and impose a new 3 percent tax on income above the earnings threshold. Workers would not receive any credit toward benefits for income covered by this new tax.

* * *

1. Personal Retirement Accounts

What Is This, and Why Is It Important?

Allowing workers to invest a portion of their Social Security taxes is the only alternative to raising Social Security taxes or reducing Social Secu­ rity benefits. However, personal retirement accounts are not all equal. The money that goes into the PRAs could come from diverting a portion of existing Social Security taxes or from some other source.

Similarly, the size of the accounts (usually expressed as a percentage of the worker's pay) is important. While larger accounts would temporarily increase the amount of additional funds required to pay benefits to retir­ ees, they would also accumulate a pool of money faster than smaller accounts and finance a greater portion of benefits in future years. This can reduce the amount of additional tax dollars needed in future decades.

Finally, how the PRAs are invested is important. Even though they show steady growth over time stocks and commercial bonds are gener­ ally more volatile than government bonds. Investing a portion of the PRAs in government bonds makes the accounts slightly less volatile while providing some of the additional dollars needed to pay benefits to current retirees.

2. Retirement and Survivors Benefits

What Is This, and Why Is It Important?

Other than creating personal retirement accounts that allow workers to self-fund all or a portion of their Social Security retirement benefits, most reform plans deal with the program's coming deficits by either changing

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the level of retirement benefits promised or finding ways to increase pro­ gram revenues. This section examines how various reform plans treat promised retirement benefits.

Social Security uses a complex formula to calculate an individual worker's retirement benefits. Subtle changes in this formula can cause a large change in benefits over time. For instance, changing how past income is indexed to a constant purchasing power will have only a minor impact for the first several years. However, the effect is cumulative and after sev­ eral decades will result in major changes in benefits.

Similarly, seemingly minor changes in "bend points" or other aspects of the benefit formula can, over the long term, cause major changes in bene­ fits for upper-income and/or moderate-income workers. It is even possible to use the benefit formula to approximate an increase in the full retirement age without actually raising it. Thus, a plan could still allow workers to quality for "full retirement benefits" at 65, 66, or 67 but award them full retirement benefits (as defined under the current system) only if they wait to retire until a later age.

The first question that any plan must answer is whether it would pay the full level of benefits promised under the current system. If so, it must deal with how to pay the cost, since the current system cannot afford to pay for all of the promised benefits. Other important questions include whether the plan proposes benefit changes (usually reductions) if workers do not choose to have a personal retirement account, protects lower- income workers (who more often have an interrupted work history) by instituting some sort of minimum benefit level, and/or addresses the low benefits for certain lower-income, widowed, and disabled workers under the current system.

3. Payroll Taxes

What Is This, and Why Is It Important?

Increasing Social Security payroll taxes would be one way to pay pro­ jected cash flow deficits. This method is closer to the self-funding that has characterized the system so far, but raising payroll taxes has significant drawbacks. Alternatives to payroll tax increases include instituting some form of personal retirement account to increase the return on taxes, reduc­ ing benefits, and using significant amounts of general revenue money to cover Social Security's cash flow deficits.

Currently, all workers pay 5.3 percent of their income to pay for Social Security retirement and survivors benefits. In 2004, this tax will be paid on the first $87,700 of an employee's income.* Employers match this tax for a total of 10.6 percent of each worker's income. In addition, both employer and employee pay an additional 0.9 percent of the worker's income (1.8

This threshold is indexed and changes every year. It was $127,200 in 2017 [Editors].

470 David C. John

percent total) for Social Security disability benefits. Thus, the employer and employee pay a total Social Security payroll tax of 12.4 percent.

Additional payroll taxes could be collected in three ways:

• The overall tax rate could be increased. However, this imposes higher taxes on all income groups and could reduce employment in the econ­ omy by making it more expensive to hire additional workers.

• The tax could be imposed on income levels above the threshold, cur­ rently at $87,700. In the short run, this would increase revenues, but since retirement benefits are paid on all income taxed for Social Secu­ rity, it would also eventually increase the amount of benefits the system would have to pay each year and offset the amount raised through the higher taxes.

• Payroll taxes could be disconnected from the benefit formula. This could take the form of a new tax paid on income above the current $87,700 earnings threshold, collecting taxes on income up to the $87,700 level but counting only income up to $60,000 or some other level toward benefits, or some combination of the two. In either case, this type of tax would break the link between taxes and income that has existed since Social Security began in 1935. To date, neither the right nor the left has been willing to break this link for fear that it would be the first step toward turning Social Security into a welfare system. Both sides have worried that such a move—or even the perception of such a move—would under­ mine the program's widespread support among the American people.

4. Social Security's Unfunded Liability

What Is This, and Why Is It Important?

Both the current Social Security system and every plan to reform it will require significant amounts of general revenue money in addition to the amount collected through payroll taxes. This additional money is neces­ sary to reduce the difference between what Social Security currently owes and what it will be able to pay.

In the reform plans, the transition cost represents a major reduction from the unfunded liability of the current program. Even though the reform plans are expensive, all of them would require less additional money than the current system. However, both the amount and the tim­ ing of this additional money would vary depending on the plan.

The amount of additional money that is needed can be measured according to two different systems. Both measurements give valuable information.

Present value reflects the idea that a dollar today has more value to a person than that same dollar has sometime in the future. It gives an idea of when the additional money is needed by giving greater weight to money needed in the near future than to an equal amount needed further

in the future. In addition to showing the amount of money needed, a higher present value number indicates that money is needed sooner rather than later. [The present value of the unfunded liability ranges from $929 billion in the Orszag-Diamond plan to $7.6 trillion in the Ferrara plan.]

The sum of the deficits indicates the total amount of additional money that will be needed. This measure gives $100 needed today the same weight as $100 needed in 15 years. This measure adds up only the future cash flow deficits; it does not include cash flow surpluses because the government does not have any way to save or invest that money for future use. Using both of these measurements gives a better picture of the situation than using just one. [The sum of the deficits of the unfunded liability ranges from $7.1 trillion in the Graham plan to $16.4 trillion in the Ferrara plan.]

Paying for the current system or any of the reform plans will require Congress to balance Social Security's needs against those of the rest of the economy. In general, as more additional dollars are needed for the current system or a reform plan, less money will be available for other govern­ ment programs and the private sector.

As this burden on the general federal budget increases and persists. Congress would find it increasingly more difficult to come up with that money, and it would become increasingly less likely that such a plan would really be paid for on schedule. This is especially true for the cur­ rent system, which will incur the massive deficits to pay all of the prom­ ised benefits.

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5. Paying for Social Security's Unfunded Liability

What Is This, and Why Is It Important?

Both the current Social Security program and all of the proposed reform plans will require large amounts of general revenue money to cover the annual cash flow deficits. Exactly when that money is first needed, how many years it will be needed, and the total amount that will be needed varies from plan to plan. Avoiding use of general revenue money would require either reducing Social Security benefits enough to eliminate the annual deficits or imposing new taxes to generate sufficient revenue. Nei­ ther the current system nor any of the proposed reform plans comes close to closing the gap.

Some plans do specify sources for the needed general revenues, but these are handicapped by the fact that no Congress can bind the hands of a future Congress. Thus, even if Congress did pass a plan that specified the source of the needed general revenues, a future Congress could change the plan by a majority vote. The only way to avoid this uncertainty would be for Congress to pass and the states to ratify the plan as a constitutional amendment—which would be prohibitively difficult.

472 David C. John

In short, both the current system and all known reform plans would have to find the necessary general revenues from some combination of four sources: borrowing additional money collecting more taxes than needed to fund the rest of the government, reducing other government spending, or reducing Social Security benefits more than is called for under either current law or any of the reform plans.

The most important thing to remember is that the existing Social Security system and the reform plans all face this problem. This is not a weakness that is limited to PRA plans or any other reform plan. The only question is when the cash flow deficits begin and how large they will be.

Current Law Current law makes no provision for funding Social Security's unfunded liability. The program has no credit line with the U.S. Treasury, and when its trust fund promises are exhausted, current law will require it to reduce benefits.

The DeMint Plan While some press releases connected with Representative DeMint's plan suggest that some of its general revenue needs could be generated by reducing the growth of federal spending, no language specifying where the general revenues would come from is included in his legislation.

The Graham Plan Senator Graham's plan includes a commission that would recommend reductions in corporate welfare and redirect the savings to reduce his plan's unfunded liability. At best, a reduction in corporate welfare would generate only part of the needed general revenue. The commis­ sion would produce a legislative proposal that would then be consid­ ered by Congress.

Because the commission would be created by the same legislation that implements Graham's Social Security reforms, its recommendations could not even be considered until after the plan is enacted. As a result, passage of the Graham plan does not guarantee that these revenues would be available. Regardless of what the commission recommended, a future Congress could reject the proposed cuts in corporate welfare. In that case. Congress would have to come up with another method to raise the needed

revenue.

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The Smith Plan

Other than the proposed benefit changes that would partially reduce Social Security's unfunded liability, the Smith plan does not specify how it would pay cash flow deficits.

The Ferrara Plan

The Ferrara plan includes three mechanisms designed to create the needed general revenues.

First, it would mandate a 1 percent reduction in the growth of all fed­ eral spending (including entitlements such as Social Security) for at least eight years and redirect that revenue to Social Security. Since Congress cannot legally force a subsequent Congress to follow a set course of action, the only enforcement mechanism available is a constitutional amendment. As a result, the Ferrara plan simply appropriates to Social Security the amount of revenue that would result if Congress were to reduce spending growth. In practice, a future Congress could choose not to reduce spending growth and, instead, just let the deficit grow larger or generate the neces­ sary revenue in some other way.

Second, the Ferrara plan would transfer to Social Security the amount of corporate income taxes that could potentially result from the invest­ ment of personal accounts in corporate stocks and bonds. This is not a new or higher tax. This transfer is intended to reflect the taxes that would be paid at the current 35 percent corporate tax rate. Since SSA does not conduct dynamic scoring, this transfer is based on the static assumption that two-thirds of the stocks and bonds held through personal accounts reflect domestic corporate investment.

Third, the Ferrara plan would borrow about $1.4 trillion in special off- budget bonds. However, there is no practical way to create off-budget bonds that would not count against the federal debt. Even if there were, such a move would reduce the amount of transparency in the federal budget.

The Orszag-Diamond Plan

While the Orszag-Diamond plan includes both some benefit reductions and benefit increases for widows, the disabled, and low-income workers, the two elements of the plan are roughly equal. It reduces Social Security's unfunded liability using tax increases contained in the plan, including an increase in the payroll tax rate, a gradual increase in the amount of income subject to Social Security taxes, and a new 3 percent tax on any salary income not subject to Social Security taxes.

474 David C. John

6. Making Social Security a Better Deal for Workers

What Is This, and Why Is It Important?

In the long run, a reform plan should do more than just preserve the cur­ rent Social Security system with its many flaws. While a key requirement of any reform plan is to provide a stable, guaranteed, and adequate level of benefits at an affordable cost, it should do more.

The current system fails to allow workers to build any form of nest egg for the future. Instead, it is the highest single tax for about 80 percent of workers. In return, each worker receives a life annuity that ends with the death(s) of the worker, the surviving spouse (if there is one), or young children (if any). In today's world, where two-earner families are increas­ ingly the norm, the current system even limits survivor benefits to the higher of either the deceased spouses benefits or the surviving spouse's benefits. Whichever account is lower, no matter how long that spouse worked, is marked paid in full and extinguished.

At a minimum, a reform plan should allow workers to pass on some of what they earned and paid in Social Security taxes to improve their spouse's retirement benefits. It should also allow workers the flexibility to use their entire account for retirement benefits or take a smaller retire­ ment benefit and use the balance to pay for a grandchild's college educa­ tion, start a small business, or pass on money to a later generation.

In judging whether each proposed reform would be better for America's workers, readers may differ sharply. However, while most summaries and studies examine Social Security reform from the viewpoint of federal budget impact, tax rates, and the survivability of the system, few consider the overall impact of reform on the workers it was designed to benefit in the first place. Social Security should not be reformed or "saved" for its own sake, but only if it more effectively provides the benefits workers need at a price they can afford.

Discussion Questions

1. The payroll tax of 6.2 percent that workers pay into Social Secu­ rity is only applied to the first $127,200 of income in 2017, and increases each year based on inflation. This makes the payroll tax regressive, since someone making $20,000 a year pays a larger per­ centage of their income (6.2 percent) than someone making $200,000 a year (3.9 percent, since only the first $127,200 is taxed). Is this a valid reason for raising the payroll cap, or even eliminating it altogether?

2. Are the broad objectives initially established for Social Security— income security for old age, risk sharing across the population and across generations—still appropriate today? Are individuals better

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able to plan for and manage their retirement today than in the 1930s or even the 1990s? What do you see as the major advantages and disadvantages of the current Social Security system and proposals for partial privatization?