Money Management and the Economy

Wednesday, October 6, 2010

Five Solutions to Social Security

As I discussed in Friday's article, there is a concerted political campaign to "wean us off" social security, as one of the program's congressional opponents put it. Central to that campaign is the notion that the program is going "bankrupt" and future generations will not receive any benefits. While that argument has little merit, there is some reality to the underlying problemt. Lets look at the reality.

The real problem facing Social Security is demographic. That huge group of baby boomers born after World War II is approaching retirement. This means they are ready to leave the workforce and start collecting social security. That demographic bubble means more people will be receiving benefits and relatively fewer people will be paying for them.

This problem has been anticipated for a while. The solution hit on 25 years ago was to switch to having current workers pay more in social security taxes than the costs of paying benefits to current retirees. The extra money was put into the Social Security trust fund to be used when the demographics shifted and current workers were paying less than was needed for current benefits.

The extra money paid into the Social Security trust fund was "loaned", with interest, for other government expenses. This allowed the government to avoid borrowing that money elsewhere. One way to look at it is the Social Security trust fund bought government bonds rather than the government selling them to China. Another way to look at it is that the government used the money to pay for other programs. And still another way to look at it is that the government used social security taxes to keep other taxes low, including providing the currently debated temporary tax cuts.

Regardless of how you want to look at how the trust fund has been used, as of this year Social Security taxes will no longer cover current benefits. That means other taxes are now going to have to pay the difference. In essence its time to pay back the money taken from the trust fund.

This causes two problems. The first is that the government got used to having the excess social security taxes to spend. So it needs to replace that revenue by either borrowing more money elsewhere, raising taxes or cutting spending or some combination of those.

The other is that for about the next 30 years it will have to come up with additional funds to pay social security. Again the choices are borrowing money elsewhere, raising taxes or cutting spending. This is in addition to having to replace the revenue it no longer receives from excess social security taxes. Essentially its a double-whammy.

There is a third problem beyond repaying the money saved for future social security benefits, which is that we didn't save enough. In 20-30 years the money saved will be gone and current taxes are projected to cover only 75% of the promised benefits.

So that's the problem. Here are the potential solutions:

Solution 1: Raise Social Security Taxes

The most obvious solution is to raise social security taxes. The current rate for social security taxes is about 6% for both employers and employees. Since that will pay 75% of benefits in 30 years, the tax rate will need to be raised to 8% in order to cover the benefits with current taxes. What that means is that if we raise the rate by one-tenth of one percent each year for the next 20 years there will be enough money coming into Social Security to pay all the promised benefits.
To put that in perspective, someone paying social security taxes on the maximum of $100,000 would see their social security taxes go up by $100 each year. Of course it adds up. After 20 years, they will be paying $2000 more each year, as will their employer.

Slowly increasing the rate prevents disrupting the economy. That extra $100 is unlikely to have much impact on either employment or spending decisions. It also means the trust fund will last longer, so the actual increase may not need to be even .1%. And, of course, the trust fund lasting longer means the rest of the federal budget doesn't have to pay it back as fast.

Solution 2: Raise the Cap on Wages Covered

Right now people do not pay social security taxes on wages over $100,000 (approximately). Wages over that amount also do not get counted in determining benefits. One of the reasons that not enough was saved in the trust fund is that as income disparities have grown, more and more wages have been exempt from having to pay social security taxes.

According to this analysis by the congressional research service , eliminating the cap would entirely solve the shortfall if individual benefits were not extended as a result. Even if benefits were extended to the people paying taxes on all their wages, removing the cap would almost eliminate the gap between the cost of benefits and tax receipts. This is because, as a group, the extra benefits high wage earners receive would not equal the taxes on their additional income.

Solution 3: Extend Payments to the Social Security Trust Fund

As mentioned above, by the time the trust fund is paid back, the annual repayments are projected to cover 25% of the cost of social security benefits. This means that 25% of the cost of benefits will be coming from the federal government's general fund, whether it is borrowed or tax revenue. To understand the impact of that on the federal budget, think of what happens to your family budget when your final house payment has been made. Suddenly a major annual expense is gone. The same thing will happen to the federal government.

There are a number of ways that new surplus could be spent. But one way to deal with social security deficit is simply to extend the existing payments to the Social Security Trust Fund in the form of loans against future revenue. Just as the general fund borrowed money when the social security trust fund had a surplus, the trust fund can borrow money from the general fund to meet its cash flow problem. At some point, as the baby boomers die off, the trust fund will begin to generate more revenue than benefits. At that point it can pay back the general fund.

Of course that assumes that the numbers work. We are already stretching our ability to predict the future when we assume there will be a shortfall in the future. Trying to project what is going to happen to the economy and demographics of the United States 50 years from now is almost pure speculation. So this solution would raise taxes or borrow to repay the trust fund to cover benefits as needed. The decision to extend those payments from the general fund would be made in 20 or 30 years, closer to the point at which the social security trust actually runs out of money.

The solutions above all look at how to preserve social security without cutting promised benefits. They are essentially revenue solutions. The other side of the coin is to reduce the cost of Social Security. There are two ways to accomplish that:

Solution 4: Reduce benefits for all Recipients

There are numerous ways too reduce benefits. One is to simply wait until the trust fund runs out and then cut benefits to to match current revenue. Current projections tell us that would be a 25% cut. Just as increasing taxes gradually would reduce the pain, so would reducing benefits gradually. If you reduce benefits by 1% each year from the currently projected benefits then in 25 years they will be equal to tax receipts. The current average social security payment for a couple is $22,000. To achieve a 1% reduction would would mean cutting retired recipients income by $220 each year and by $5500 over 25 years. That is in current dollars, the actual amounts will need to be adjusted for inflation.


Solution 5: Reduce the number of recipients

The obvious way to reduce the number of recipients is to raise the retirement age. There is a lot of logic to this. People live longer and many people are productive long past the traditional retirement age of 65. In fact, currently we require most people to retire later than 65 in order to get full benefits and delaying retirement even further results in still higher benefits.

Another suggestion is to "means test" social security, reducing or eliminating benefits for people whose income is over a certain level. One way to look at this is the flip side of raising the income limit for taxes.

Whatever the solution. What is clear is that social security is not in a crisis. There is plenty of time to consider options for making sure it remains a solid foundation for most people's retirement.

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