Econ 21SI Saving Social Security Proposals for Reform WEEK 2 Student Initiated Course Instructor: Sean Arenson Faculty Sponsor: Prof. John Shoven Stanford University, Spring Quarter, 2006 Tuesdays, 4:15-5:30PM, Bldg 200 Rm 217 econ21si.stanford.edu
Econ 21SI Last Week • A Brief History of Social Security – Convergence of industrialization, terrible economic conditions, and popular political movements led to passage of Social Security Act in 1935 • How Social Security Works Today – Pay-as-you go system – Functions based on insurance principles – Provides coverage against poverty in retirement, disability, and death • What is the Social Security Crisis? – Promised benefits exceed expected revenues
Econ 21SI Next Week • Prof. John Cogan on “The Economic and Political Role of Personal Accounts in Reforming Social Security” • Readings posted: Article by Cogan & Mitchell in Journal of Economic Perspectives and Op-Ed by Cogan in Wall Street Journal
Econ 21SI This Week • What is the Social Security Crisis? (cont.) • Major Options for Reform
The Social Security “Crisis”
The Social Security “Crisis” What’s the problem? • Simply: Promised benefits exceed expected funding • Currently, Trust Fund surplus of $1.8 trillion • 2005: $600 billion revenue, $500 billion outlays • Future outlays increasing due to several factors – Retirement of baby boomers – Longer life expectancy • Future revenue stagnant – No population growth
The Social Security “Crisis” Increasing Life Expectancy
The Social Security “Crisis” Increasing Dependency Ratio
The Social Security “Crisis” Pay-Go System Flaw • Pay-Go System: t * N w * W = N b * B • t = (N b /N w ) * (B/W) • tax = dependency ratio * replacement rate • Currently: dependency ratio about 0.2 and replacement rate about 0.45. t = 0.2 * 0.45 = 0.09
The Social Security “Crisis” Pay-Go System Flaw • By 2035, dependency ratio about 0.4 • t = 0.4 * 0.45 = 0.18 • But payroll tax not scheduled to increase
The Social Security “Crisis” Pay-Go System Flaw • Pay-Go a “Ponzi Scheme,” or a Nobel Prize winner? • Ponzi (1919) promised investors 100% return within 90 days. Paid claims with new investments. Eventually, shut down by gov’t – last round of investors lost money • Paul Samuelson – “Consumption Loan Model” Each generation “loans” retirees money, following generation pays back loan with interest coming from real wage growth and population growth. Nobel Prize - 1970
The Social Security “Crisis” Pay-Go System Flaw Intergenerational transfers led to windfalls for early recipients, but slowed population growth has left burden on future recipients
The Social Security “Crisis” Long Term Deficit
The Social Security “Crisis” Extreme Benefit Cut Alternatives • Cut benefits to those currently under 55 by 25% across the board • Wait until 2041 and cut all benefits (including current retirees) by 30%
The Social Security “Crisis” Extreme Tax Increase Alternatives • Immediately increase payroll tax by 2% (to 14.4%) • Wait until 2041 and increase payroll tax by at least 5%
The Social Security “Crisis” These are NOT viable solutions! • Such extreme solutions are merely band-aids! They do nothing to fix the underlying flaws in the program • “Terminal Year Problem”
The Social Security “Crisis” Terminal Year Problem Two Percent Payroll Tax Increase: Only a Temporary Fix There is Still A Design Flaw 22.00 20.00 Percent of Covered Payroll 18.00 16.00 14.00 12.00 10.00 2005 2015 2025 2035 2045 2055 2065 2075 Year
The Social Security “Crisis” Menu of Options • Cut benefits • Increase revenues • …and that’s it… these are the ONLY ways to restore solvency • Personal Accounts DO NOT in and of themselves address solvency
The Social Security “Crisis” Types of Benefit Cuts • Explicit benefit cut – modify benefit calculation – Ex: Change bend-point replacement from 90-32-15 to 90-21-10 • Index PIA to prices rather than wages – Alternative: “Hybrid Indexing” • Increase FRA – Possibility: Index to increase in life expectancy • Increase number of years included in benefit calculation – Ex: Best 40 years included
The Social Security “Crisis” Types of Benefit Cuts 75 Years 2080 Replace Wage Indexing with Price 100% 116% Indexing Hybrid Indexing 72% 70% Index Retirement Age to life 25% 25% expectancy improvements Reduce Benefit formula gradually 85% 57% from 90,32,15 to 90,21,10
The Social Security “Crisis” Types of Revenue Increases • Explicitly increase payroll tax – Ex: Increase to 14.4% • Increase maximum taxable base – Ex: Increase to $150,000 • Relax immigration laws • Create “add-on” individual accounts • General revenue transfers (“magic asterisk”)
The Social Security “Crisis” Types of Revenue Increases 75 Years 2080 Raise the OASDI Payroll Tax from 12.4% to 14.4% 104% 34% Raise the Payroll Tax Cutoff to $150,000 40% 14%
The Social Security “Crisis” Viable Plans • There are several plans that will restore solvency • “Personal Security Accounts 2005” – Schieber & Shoven – Two-tiered system with flat “traditional” benefit and large mandatory individual accounts • Diamond-Orszag Plan – Raise taxes and reduce benefits equally, concentrate burden on middle and high income participants • President’s Commission Plan #2 – Cut promised benefits (no tax increase) and introduce voluntary individual accounts
The Social Security “Crisis” What is the best plan? • That depends on who you ask! • Key roadblock to reform – differences in values, not lack of solutions
Proposals for Reform
Proposals for Reform What constitutes a viable plan? • Restores solvency over 75 year horizon • To some extent, solves terminal year problem • Does not affect benefits for those currently over 55 • Retains important social functions of Social Security • Involves painful choices between benefits reductions and revenue increases
Proposals for Reform How long can we wait? • Longer wait means fewer, more painful options – Can’t leverage few years of surplus remaining – Lose opportunity to spread pain among generations • All proposals calculated based on enactment today • Reality: no one expects reform before 2009, and perhaps even 2013
Proposals for Reform Scheduled vs. payable benefits • Scheduled benefits are benefits statutory – Rising in real terms – Meaningless without reform • Payable benefits assume no reform – Benefits payable based on projected availability of funds – No deficit under payable benefits • Proposals for reform generally cut scheduled benefits and aim to increase payable benefits
Proposals for Reform Diamond-Orszag Plan • Goals: Restore solvency and update social insurance features • Approach: Examine sources of imbalance and outdated features and address each with balance of benefit cuts and revenue increases
Proposals for Reform Diamond-Orszag Plan Increasing Life Expectancy • Longer lives mean higher average lifetime benefits - higher costs • Idea: How would individuals react to longer life in absense of Social Security? – Increase saving during working years – Work longer – Spend less during retirement
Proposals for Reform Diamond-Orszag Plan Increasing Life Expectancy • Longer career already encouraged by benefit formula (not actually true!) • Increase saving corresponds with increase payroll tax • Spend less during retirement means reduce benefits
Proposals for Reform Diamond-Orszag Plan Increasing Life Expectancy • Increasing life expectancy unpredictable – dynamic adjustments required • Office of Chief Actuary should calculate cost to Social Security from annual improvements in life expectancy and divide costs between benefit reductions and tax increases • Preferable to simply indexing benefits to age? • Reduces 75-year actuarial deficit by nearly 30%
Proposals for Reform Diamond-Orszag Plan Increasing Earnings Inequality • Maximum taxable base indexed to average wage growth, but income of wealthiest growing faster • 1983: 10% of all earnings above max 2004: 15% of all earnings above max • Proposal: Gradually raise max base to exclude only 13% of earnings by 2063 • Amounts to tax on top 6% of earners
Proposals for Reform Diamond-Orszag Plan Burden of the Legacy Debt • Legacy debt is the difference between a funded system and a pay-go system • Currently legacy debt is $11.6 trillion • Legacy debt incurred due to generosity to previous generations. Therefore, all should share in funding it
Proposals for Reform Diamond-Orszag Plan Burden of the Legacy Debt • Universal coverage brings 6 mil state and local workers into program to share in legacy debt • 3% tax on income above max taxable base – Very controversial – tax not tied to benefits • Universal legacy charge in the form of benefit reduction of 0.31%/year and tax increase of 0.26%/year beginning in 2023
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