December 23, 2004

EMERGING ISSUES IN THE SOCIAL SECURITY DEBATE

At this week's "economic summit," President Bush repeated his call to create a system of private accounts in Social Security.  While the President still has not endorsed a specific plan, it apparently will include large-scale borrowing.  It also may include substantial cuts over time in the percentage of a worker's pre-retirement earnings that Social Security benefits replace.

Paying for Individual Accounts by Borrowing:
A $2 Trillion Solution to a $10 Trillion Problem?

Social Security uses the payroll taxes it collects each year to pay current beneficiaries; any payroll taxes that are diverted to private accounts will have to be replaced with other funds in order to continue payments to current beneficiaries.  Under a plan the Administration is considering (the principal plan proposed by the President's Social Security Commission, known as "Model 2"), replacing these lost funds would cost $2 trillion.

The Administration has ruled out covering this cost by raising payroll taxes or cutting benefits for current retirees.  Instead, it appears to favor borrowing the full amount needed.

Administration officials have defended the proposed borrowing by claiming that borrowing $2 trillion to set up personal accounts will solve Social Security's $10 trillion shortfall.  That claim is misleading:

  • First, it should be noted that the $10 trillion figure is the estimate of the Social Security shortfall not over 75 years, or even over several centuries, but from now into eternity.  The American Academy of Actuaries, the nation's leading professional organization of actuaries, has stated that such "infinite horizon" projections are misleading.  Over the next 75 years, the time period traditionally used to examine the system's finances, the shortfall is less than 1 percent of GDP — and much less than the cost over this period of making the 2001 and 2003 tax cuts permanent (see table).
  • Most importantly, the money borrowed to fund individual accounts does nothing by itself to reduce Social Security's long-term deficit.  Individual account plans that eliminate the long-term deficit in Social Security, such as "Model 2," do so entirely by reducing future Social Security benefits, not because of borrowing.
     

Social Security Shortfall Is a Fraction of the Cost of the Tax Cuts

 

Cost over 75 years*

Cost over
"infinite horizon"

Social Security shortfall 0.7% of GDP
(according to Social Security actuaries)
0.4% of GDP
(according to Congressional Budget Office)
$10 trillion
Tax cuts of 2001 & 2003** 2% of GDP $18 trillion
* 75 years is the standard period used for examining Social Security's long-term finances.
**Assumes tax cuts are made permanent and are not eroded by the Alternative Minimum Tax.

Should the Borrowing Be Left Out of the Budget?

To mask the effect of this borrowing — which would occur at a time when the deficit already is projected to be several hundred billion dollars each year — the Administration and some Congressional leaders are reportedly considering omitting the new borrowing from the budget so it would not show up as an increase in the deficit.

Such an effort to make trillions of dollars in costs simply disappear would not be fiscally responsible.  It would not reduce the actual damage that borrowing on that scale would do to the nation's fiscal situation.

Some argue that the borrowing can legitimately be omitted from the budget because its cost will be more than offset by large cuts in Social Security benefits once the accounts are established.  But the debt created by this borrowing will create a real, added burden on the government, which will have to repay the borrowed funds with interest.  In contrast, the supposed gains from future benefit cuts may never materialize if public opposition to the cuts becomes too strong and the cuts are scaled back or reversed before they are implemented.

The "Price Indexing" Proposal

One of the principal ideas the Administration is considering for future benefit reductions under a private account plan is sometimes known as "price indexing."  It would change the formula used to determine a worker's Social Security benefit levels in such a way that workers ultimately would receive much lower benefits than they would receive under the current formula.

Under this proposal, the gap between workers' pre-retirement earnings and their Social Security benefits would grow over time.  In other words, Social Security benefits would replace a much smaller share of the pre-retirement earnings of workers who retire farther into the future than of workers who retire sooner.

To get a sense of the magnitude of the cuts:  under the current benefit formula, a steady average wage-earner who retires in future decades at age 65 will receive Social Security benefits that replace 36 percent of his or her pre-retirement earnings.   Under the "price indexing" proposal, Social Security would replace 27 percent of the earnings of an equivalent worker who retires in 2042, and just 20 percent of the earnings of a worker who retires in 2075.

This benefit cut would apply to all Social Security beneficiaries, not just those who elected to forego a portion of their Social Security benefits in return for an individual account.

The benefit cut also would apply to people with serious disabilities who receive Social Security disability benefits and to orphans, widows, and anyone else who receives Social Security survivors' benefits.  Nor could these people necessarily rely on significant funds from their private accounts to supplement their reduced Social Security benefits, since workers who become disabled or die at a young age will not have had the opportunity to build up much in their individual accounts before they are compelled to leave the work force due to disability or death.