The Common Sense of Social Security Reform

By far the most important issue is to put in place, sooner rather than later, reforms that gradually and cumulatively bring projected future benefit growth in line with projected future revenues without a tax increase. Waiting several decades to deal with the issue raises the prospect of a 50 percent increase in payroll taxes. Alternatively, benefits could then be cut abruptly, which would be wrenching for future retirees’ finances.

Perhaps the best place to start a rational discussion of these issues is to straighten out the language used to describe Social Security and the proposed reforms. When is a contribution really a tax? A guarantee almost certain not to be realized? And a cut actually an increase? All of these misappropriations of language obfuscate the facts about Social Security. The critics claim the Bush plan will necessitate massive cuts in “guaranteed” benefits of 40 percent or more. This is absurd. In contrast to the conventional spin, nobody’s benefits need to be cut and nobody’s taxes need to be raised. Current tax rates, given projected economic growth, are sufficient to deal with the demographic deluge.

The current benefit formula, as carried forward in the long-term Social Security projections, implies that real Social Security benefits per recipient will double in the next few decades. This occurs because (1) The initial benefit level for Social Security is indexed to wages rather than prices; because wage growth generally exceeds price growth, future benefits rise by roughly the rate of productivity gains. (2) People will be living longer, which increases the present value of total lifetime Social Security benefits. (3) The change in the consumer price index (CPI), which indexes Social Security benefits post-retirement, overstates inflation by 80–90 basis points per year, despite some valuable improvements made by the Bureau of Labor Statistics (BLS).

The claims that “guaranteed” benefits will be cut and promises broken are relative to projecting the current benefit formula forward indefinitely. This is misleading on several counts. The Social Security Administration sends future beneficiaries an annual review clearly stating that the current system cannot pay such benefits; in a few decades, under current law, there will only be 74 cents in taxes coming into the Trust Fund, from which benefits must be paid, for every dollar of projected benefits.

Further, Congress has often changed benefits in the past, most recently by taxing them, and is certain to do so in the future. The Supreme Court has ruled that no one is entitled to the benefits; they are not legally owned assets. In fact, most younger workers are not expecting to receive them. There is thus nothing “guaranteed” about the benefits; they involve immense economic, demographic, and political risk.

The president says there will be no changes for retirees or near retirees—no cuts or broken promises there. The most widely discussed proposal— indexing by prices rather than wages—would still leave ample room for substantial benefit growth for those in midcareer, via life expectancy rising more rapidly than retirement ages and by the price index, even after some improvement, overstating inflation. Many younger workers say they expect the system to be bankrupt and gone by the time they retire. Only in Washington would higher real benefits in the distant future for people who do not expect to receive them (or for those not yet born) be considered a “benefit cut” or a mechanical and unsustainable projection of a benefit formula put in place more than a century before, a promise of benefits to the not yet born for the year 2080.

There is an obvious set of commonsensical reforms that would strengthen and modernize Social Security, improve incentives, and eliminate the future funding uncertainty for families and the economy. First, we should switch from wage indexing to price indexing but raise benefits more rapidly for those with low earnings. This would eliminate most of the long-term insolvency but in a manner that leads to rapidly rising real benefits for people with low incomes and slower-rising benefits for people with higher incomes.

Next, we should prospectively increase the retirement age in several decades slightly beyond that in current law yet maintain a strong early-retirement option. Combined with a partial improvement in the CPI (the BLS implementing its vastly superior chained-CPI, which would eliminate 30–40 basis points of the bias), these reforms will easily deal with the long-run solvency issues. And they will finally fully deliver what is Social Security’s most important mission, as stated at its inception by President Franklin D. Roosevelt: providing “protection against poverty-ridden old age.”

Finally, as the president has argued, we should add an individual accounts component to Social Security whereby younger workers can choose to put a modest portion (up to a limit) of their payroll taxes into a broadly diversified, low-cost index fund. Like the other reforms, it should be phased in gradually over time. There is an especially strong case for individual accounts for the half of the population that owns virtually no assets, a point often made by Senator Moynihan.

Many critics of individual accounts denounce the idea of borrowing to finance them. Although I share concerns about large deficits in prosperous peacetime, there is a fundamental difference between borrowing to finance individual accounts and borrowing to fund government current consumption. The individual accounts acquire real assets. So, although there is borrowing by the government, on the one hand, it finances investment in real assets, like borrowing to buy a home, not to throw a party. Is there really such an aversion to private capital that only government spending counts?

Individual accounts will increase saving and offer potentially higher returns to young participants. But some people will adjust their other saving, so the amount of saving in the individual accounts will be more than the total amount of incremental saving. It will, however, be much harder for the government to get its hands on the funds and spend them, as it has done with Social Security surpluses for decades under administrations and Congresses of both political parties. Thus, despite the borrowing, individual accounts may be more, rather than less, likely to increase national saving. The required diversification in low-cost index funds and the long-term nature of the investment considerably mitigate the risk attendant to investment in higher-return equities.

The biggest concern with individual accounts is one its opponents seldom raise: The growing future political power of the elderly may eventually result in at least a partial cancellation of the offset against individual account income, thereby turning the ex ante “carve out” into an ex post “add-on.”

Thus, think of the reform as consisting of two parts: (1) Deal with long-run solvency by partial price indexing, slightly increasing the retirement age in the distant future, and modestly improving the consumer price index. (2) Modernize Social Security by adding an individual account component. Nobody gets their benefits “cut” in part 1. It is very unlikely that anybody’s benefits would be less in part 2 than they would have been if the system described in part 1—call it the sustainable traditional Social Security system—had been in place. Most younger workers likely will receive more from the sum of their individual account income and traditional Social Security than they would have received from the unsustainable current system.

Put the other way around, suppose we have the Social Security reform described above (partial price indexing, older retirement age, more accurate CPI) in place. Does anyone really believe it would make sense to dramatically increase benefits for future retirees and finance the expansion with a 50 percent increase in the payroll tax, especially given the impending larger problem in Medicare? That is what the opponents of Social Security reform are really peddling. Keeping the current system in place and raising taxes later just taxes future workers to pay ever larger inflation-adjusted benefits to well-off future retirees; prevents the bottom half of the wealth distribution from owning assets; and eventually wreaks havoc on the economy.

If we wait and make large tax increases or benefit cuts abruptly, wrenching adjustments will be required for beneficiaries, taxpayers, and the economy. Thus, reform really is urgent. Enacting these sensible reforms now will strengthen the economy, spare future retirees and taxpayers severe disruption in their personal finances, and ensure that Social Security plays an important and appropriate role in future retirement income security.