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Fixing Social Security in Two Simple Steps

October 05, 2015

In 2010, payments from the Old Age, Survivor, and Disability Insurance trust fund – more commonly known as Social Security – exceeded tax revenues for the first time. More distressingly, the Office predicts that after 2016, expenditures will regularly exceed contributions in perpetuity. As the population continues to grow older, benefits paid will grow, and the pace at which Social Security runs a deficit will increase – to the extent that the Congressional Budget Office (CBO) projects the fund to be completely exhausted by 2031. However, there are two simple policy changes that will ensure Social Security’s solvency for generations to come: eliminating the maximum taxable income, and restructuring the Social Security trust funds into funded pension plans.

The Problem

Social Security Tax Revenues and Outlays 

(Image: Social Security Flows, Current and Projected, as a Percentage of GDP. Source: Congressional Budget Office Report)

Social Security faces a structural and existential threat. The program is funded by a trust fund that accepts payments from a 12.4% payroll tax, split evenly between workers and employers. The amount of an individual’s taxable income is capped; benefits, which are scheduled as a percentage of average lifetime income (the percentage diminishes as income increases), are in turn subject to a cap. However, as the fund is currently structured, this payment mechanism is insufficient to cover the benefits paid to retirees and others eligible for social insurance transfers. One option would be to simply raise the payroll tax, as Congress has repeatedly done in the past. But such a solution would merely be a band-aid; what Social Security needs is cure.

Two Key Reforms

The first and most basic reform for Social Security is to eliminate the maximum income subject to the payroll tax, currently set at $118,500 for 2015, without eliminating the corresponding cap on maximum benefits. In 2010, when the CBO analyzed this proposed policy change, they found that it “would extend the trust fund exhaustion date beyond the 75-year projection period,” ensuring its solvency in perpetuity.

The main argument against this plan seems to be the perceived fundamental unfairness of it: why should the rich have to contribute more to Social Security if they do not get more out of it? Well, the reality is that the economy is already structurally biased in favor of the wealthy: since 1950, the top 1% of income earners have seen their share of (pre-capital gains) aggregate income increase from 11.4% to 19.34% in 2012. Meanwhile, average worker productivity has increased massively while average wages have stagnated. Thus, market forces are currently redistributing productivity gains from the median worker (the laborers) into wage increases for the rich (usually the managers). As a result, a more redistributive public pension program is not in fact unfair. Rather, it would help to ameliorate current unfair wage disparities.

Along those lines, this policy could produce another positive consequence: higher wages for the average worker. Currently, the taxable income cap creates an effective federal subsidy for high-earning workers. For example: take the hypothetical situation of Sarah, a manager making $120,000 a year, and Mark, a laborer making $50,000. If a firm has an additional $5,000 raise to hand out, they have three options. They could give it to Mark and pay the employer component of the Social Security tax – 6.2% or $310, bringing the total cost of the raise to $5,310. They could factor in the additional tax and give Mark a raise of $4,708, which including the 6.2% tax brings the total cost of the raise to $5,000. Or they could give Sarah the whole $5,000 raise and not have to pay an additional tax. This is the problem with the taxable earnings cap: it either increases the cost of giving a raise to lower earners, or reduces the raise they get, while incentivizing firms to instead give the raise to high earners. If this subsidy were eliminated, firms may invest more money in increasing the depressed wages of their lower- and median-income workers. Lastly, since Social Security is redistributive – as wages increase the replacement rate falls – increasing wages for the median worker coupled with decreasing replacement rates means increased net income for Social Security itself, further buttressing its financial solvency.

However, there is one other important reform to make: transforming the Social Security Trust Funds into a more fully funded pension program. Currently, Social Security is a “pay-as-you-go” system: income from tax revenues goes directly to finance payouts, with surpluses being deposited into the Social Security trust funds to be withdrawn when the program starts running a deficit. The money in the trust funds is used to purchase US Treasury bonds, and receives interest from those bonds.

What the trust funds should do, however, is invest a higher percentage of current tax income directly into the fund so that it can immediately begin earning interest. Payouts, meanwhile, should be financed by a mixture of current receipts and the maturation of existing Treasury bonds in the fund.

To see how this would help Social Security finances, it is instructive to look at real world data. In 1984, Social Security’s total receipts were $186.6 billion. Net expenditures were $180.4 billion, meaning a net of $6.2 was deposited into the trust fund. At the same time, a 30-year Treasury bond purchased at the end of 1984 yielded an 11.54% annual return, and the federal government ran a federal funds deficit (not including surpluses from federal trust funds) of $218.3 billion, financed through bond sales. If all of Social Security’s receipts were deposited into the trust fund, in 2014 they would cash out at $4.94 trillion in 2014, or far more than enough to cover 2014 Social Security expenses of $859 billion.

This approach also has an unintended positive consequence: reducing private sector crowd out. The concern with a government consistently running debt is that its debt securities (Treasury bonds and notes) will be purchased by actors who would otherwise invest in private financial markets, essentially crowding out private investment. However, if Social Security (which does not invest in the private market) were able to buy massive amounts of government debt, it would prevent private actors from purchasing public securities and direct their investments towards the private sector.

There are a few concerns with this policy, however. One potential issue is that the government may simply not run enough of a deficit to issue enough bonds for Social Security to buy. This, however, is not a massive issue, as Social Security does not have to invest every penny of the trust fund into the bond market. As one can see in the previous example, interest from the 1984 bonds vastly exceeded payouts to Social Security recipients in 2014. In 1984 the trust fund could have invested less than a fifth of its total receipts into the bond market, and it would have still financed all 2014 payouts.

Another issue is that making bonds available to the private sector to purchase is not necessarily a bad thing in the way that economic models of crowd out may imply. The backing of the full faith and credit of the United States makes Treasury bonds an extremely safe investment, especially relative to other financial products (though such products likely deliver a higher return), and thus it may be valuable to keep them as an option for those who want to insulate their portfolios against market shock and financial crises. However, as discussed above, Social Security does not necessarily have to invest all of its revenues into Treasury securities. The government may conduct studies to determine the optimal amount of public debt available as bonds to the private market, and allocate funds accordingly.

A third issue with this approach concerns how to phase it in. The best approach would arguably use the reserves in the Social Security trust funds to finance benefits over the next few years, while at first using revenues to purchase shorter term Treasury notes that mature in fewer years and can be used to finance payouts after the first few years of the restructured program. Actuaries and economists at the Congressional Budget Office would have to make estimates as to what proportion of payments to invest in short term notes, long term bonds, and direct payouts, but it is certainly not beyond their capability to ascertain these actuarially fair ratios. Further, if this policy were enacted in concert with the above proposal to eliminate the maximum taxable income, Social Security’s budget would receive a windfall of additional revenues that would give it more financial flexibility.

 

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  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

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