Topic: Social Security

Sorry, We Can’t ‘Grow’ Our Way out of the Social Security Problem

Many economists and lawmakers — especially conservatives — argue against tax hikes as solutions to entitlement shortfalls, saying the hikes would be counterproductive. According to this argument, higher taxes would retard growth, reduce federal revenues, and worsen entitlement shortfalls. 

For example, Stephen Moore in his June 12 Wall Street Journal column “Don’t Know Much About History…” alludes to a presumed beneficial impact of faster (wage) growth on the financial problems of entitlement programs. Unfortunately, that presumption is incorrect, especially as regards Social Security.

The claim that faster wage growth would reduce Social Security’s financial shortfall is an artifact of the standard (but flawed) 75-year-ahead Social Security financial projections that count payroll taxes through that period but ignore benefit obligations those taxes would create beyond the 75th year. The projections make it look as though robust wage growth would shrink the gap between Social Security revenues and obligations. But the picture changes over a longer timeframe.

The Social Security trustees have in recent years begun publishing estimates of the present value of Social Security’s financial shortfall in perpetuity. This is the correct measure to use in assessing the impact of faster wage growth on Social Security’s financial status because it is comprehensive — it accounts for all future taxes and benefits. Unfortunately, the trustees do not provide any analysis of how sensitive the perpetuity measure is to changes in various underlying assumptions. 

Whether faster economic growth would improve or worsen Social Security’s actuarial deficit depends on the balance between two opposing forces: demographics and wage growth. 

Concerning demographics, as retirees grow more numerous relative to workers, Social Security’s finances would worsen — which is easy to see if benefits depend on current wages. 

Concerning wages, in each time period, benefits mostly depend on past wages. That’s because under current Social Security laws, once a person’s benefit level is determined at the time of retirement, its real value remains constant during the rest of the person’s retirement years because it is indexed to prices. (The real value of benefits would grow were post-retirement benefits indexed to wages instead.) Because current benefits depend mostly on past wages, faster growth in current wages won’t lead to a proportionate increase in current benefits. Benefits would begin to grow faster only after a considerable time lag. Hence, faster wage growth magnifies the financial advantage associated with this time lag and reduces Social Security’s actuarial deficit.

It has been shown that in the case of U.S. Social Security, the force of worsening demographics dominates: The system’s actuarial deficit (i.e., the ratio of the present value of the system’s financial shortfall to the present value of the payroll tax base when both are calculated in perpetuity) increases with faster wage growth — a result opposite to that obtained under 75-year-ahead calculations. 

Thus, based on a comprehensive measure, the view that faster wage growth would deliver us from our Social Security problem is misguided. But many have repeatedly cited it to argue against reforming the program, e.g., Sen. John Kerry during his 2004 presidential bid. 

The Social Security debate would be better served if we put this view in its rightful place: the trash bin.

Of course, the conclusion should not be that we should strive for slower wage growth to improve Social Security’s finances! Mr. Moore’s distaste for growth-retarding tax hikes is correct. But the negative implications of faster wage growth for Social Security’s finances do not provide any purchase for his argument. Indeed, the twin imperatives of maintaining high economic growth and resolving Social Security’s financial shortfall indicate — even more strongly — that reforms should be weighted more heavily toward future benefit cuts rather than tax hikes.

Who’s More Myopic?

Here’s a partial view of the range of issues that needs to be scaled in order to constrain the future size of the federal government. In what follows, A = widely appreciated by the public, N = not widely appreciated, and A-N = appreciated by a few.

  • Waiting to reform will mean that the median voter will be older – and tend to vote for tax hikes rather than benefit cuts as a solution to entitlement shortfalls (A).
  • Waiting to reform entitlements makes the cost of fixing them increase as a percentage of GDP – and last year, we decided to postpone Social Security reform until who knows when. Just for Social Security, each year brings an additional $600 billion in cost (official Social Security Administration estimate). Note, the economy adds only about $450 billion in additional output each year (N).
  • When analyzing the merits and demerits of reforms, we do not consider their full cost because we make policies based on short-horizon fiscal measurements – the 10-year cost of prescription drugs, for example (A-N).
  • Recently emerged needs for countering terrorism and international nuclear blackmail means the peace dividend has evaporated and cutting other government spending is less viable as a means of releasing resources for entitlement outlay needs (A-N).
  • Private saving has declined and remains low (zero percent on personal saving) precisely because of the types of entitlements we have adopted (my finding from past research on why national saving declined in the U.S.). We’re lucky to be able for borrow capital from abroad today, but all such borrowing will have to be repaid with interest – perhaps just when we need to distribute more for retiree support (A-N).
  • We just enacted a massive new and irreversible entitlement – Medicare prescription drugs – the constituency for which will grow more solid by the year (A).

Most of these issues ARE known to policymakers and federal budget practitioners within the beltway. In fact, they have been known since the early 1990s. Despite recognizing these problems, Congress has repeatedly settled into postponing action on entitlement reforms.

What does that tell you?

Those who believe that the government should come to the aid of “myopic” individuals who don’t save enough for the future, think again.

The Battle over Entitlements Isn’t Lost Yet

I thought I would step out from behind Cato Unbound’s editorial curtain and make a comment here about what’s going on over there. In particular, I’d like to offer some words of encouragement to my friends David Frum and Bruce Bartlett, both of whom are downhearted (excessively, in my opinion) about the prospects of checking and reversing the entitlement-driven expansion of government spending.

Both David and Bruce make strong cases for their pessimism. David points to the opportunities blown during the nineties, while Bruce stresses the huge increases in spending that existing commitments under Social Security, Medicare, and Medicaid will necessitate in coming years.

Good points, but not the whole story. Yes, the nineties offered what in retrospect were optimal conditions for restructuring America’s entitlement commitments and thereby winning huge victories for good policy and limited government. But to adopt the clear-eyed realism that David and Bruce urge, since when did countries ever make major systemic reforms at the optimal time? Over the past generation, we have seen bold moves around the world to unwind overreaching government and install more market-friendly policies. And almost without exception, those moves have occurred, not when favorable conditions permitted sweeping changes with a minimum of short-term pain and dislocation, but when countries had their backs against the wall. Gorbachev’s launch of perestroika and the resulting collapse of communism in the Soviet bloc, India’s dismantling of central planning, the general turn toward macroeconomic stabilization, trade liberalization, and privatization throughout the less developed world, New Zealand’s dramatic policy turnaround – all occurred when countries were in extremis and alternatives to liberal reform had been exhausted.

So while it’s disappointing, it’s not terribly surprising that we have thus far failed to face up to the fiscal unsustainability of our existing entitlement commitments. We have opted for delay because delay has been the path of least resistance, but it will not remain so indefinitely. At some point, the day of reckoning will arrive, and we will face an unavoidable choice: pay to keep the promises we have made with huge tax increases, or repudiate those promises and restructure the programs that made them. It is entirely possible that, when the time comes, we will end up choosing something much closer to the former than the latter. Certainly that is what David and Bruce seem to assume.  But I don’t think it’s inevitable. Indeed, there are sound, non-wishful-thinking reasons for believing that the limited-government side has a fighting chance.

After a steady runup from the 1930s through the 1960s, total government spending as a percentage of GDP has been stable for a generation [.pdf], knocking around the 35 percent range (see Figure VI.1 on page 163). Yet if no changes are made to Social Security, Medicare, and Medicaid, spending under those programs will increase dramatically over the coming decades – according to this CBO report, from 8 percent of GDP today to 21 percent in 2075. Which means a commensurate 13 percentage point increase in overall government spending as a share of GDP, and a mind-bogglingly large tax increase to pay for it all.

Bruce assumes that because past efforts to roll back government spending’s share of GDP have been unsuccessful, further whopping increases in that share are all but inevitable.  But how does that follow? Look at things another way: efforts to prevent increases in government spending’s share of GDP have been highly successful for over three decades. Why is it unimaginable that such success can be continued? Isn’t it conceivable that, when faced with a ruinously expensive tax increase, Americans will choose a repudiation of past promises, and a restructuring of future commitments, as the lesser of two evils?

David and Bruce seem to assume that repudiating past promises will be next to impossible. I think that assumption is unwarranted. Countries around the world have repudiated obligations under fiscally unsound public pension programs – and so did we (by increasing the retirement age and subjecting benefits to taxation) in the 1983 Social Security reform. And unsustainable corporate promises to retirees are being repudiated left and right these days, without any strong political backlash.

So there is hope. A battle is looming, and the limited-government side is very much alive. Because we have waited so long, partial repudiation of past promises will inflict pain that could have been avoided. And even with partial repudiation, the price tag of taking care of existing retirees and near-retirees will be hefty. But if we do succeed in restructuring these programs, that transition can be financed, and after digesting the rat the government snake can slim down again.

It won’t be easy. We could lose. But we are not foredoomed.

The Social Security Side-Step

In describing the contents of the Social Security Trustees’ latest annual report, most reporters have described the changes as “minor.” That impression rests, however, on a comparison of a large number with a gigantic number—the present value of Social Security’s financial shortfall over 75 years to the present value of total payrolls, also projected over the next 75 years.

Note that according to the report, an additional 2 percentage points must be added to payroll tax rates immediately and must be kept in place permanently. That’s unlikely, and precisely because we are describing the shortfall as “no big deal.”

Problem is, the cost escalates the longer we wait. How long would we wait? When it becomes as large as four percentage points? Six? No, if it becomes that large, chances are taxpayers would revolt and the system would have to face benefit cuts.

Benefit cuts? At a time when beneficiaries are more numerous and politically powerful? Unlikely. Then what?

Buried inside the report are other, larger estimates of the system’s shortfall—the “actuarial deficit” calculated without a time limit is reported to be $13.3 trillion. Including the outstanding Treasury liabilities to Social Security that must be paid for out of higher income or other non-payroll taxes, the total financial shortfall compared to benefits is a whopping $15.2 trillion. And compared to total future payrolls, this amount equals 3.7 percentage points.

Most reports attached some variant of “let’s not panic, these numbers are very uncertain” to the perpetuity estimates of Social Security’s shortfall.

Not panic? OK. But ignore? That’s effectively the message. If we don’t like the outlook, we should just ignore it. It’s not going to affect us. We’ll collect our benefits well before then, so why bother?

That’s not the advice financial planners would give to an individual or family facing uncertainty in personal finances. Rather, they would recommend purchasing insurance or hedging their portfolios by diversifying assets.

But prudence with personal assets and profligacy with public ones imply a collision course—one that’s unlikely to deliver “social security.”

Someone recently asked: Even if God told us these numbers were correct, what can we do today? After all, we can only distribute future outputs to meet future needs. This reminded me of Jacob and the Pharaohs. In that story, Jacob suggested filling the granaries well before the famines arrived—in other words, saving and investing more today.

Existing institutions—Social Security Trust Funds and such—haven’t worked in that regard. Indeed, the evidence points to the exact opposite outcome: Today’s entitlement programs are inducing us to spend more, work less, and retire earlier than ever before.
Rather than give up on a structural reform of Social Security, our efforts need redoubling.

Sometimes, Governments Lie

Year after year, federal officials speak of the Social Security and Medicare trust funds as if they were real.  Yesterday, the government announced that the Social Security trust fund will be exhausted in 2040 and that the Medicare hospital insurance trust fund will be exhausted in 2018 – projections that the media dutifully reported

But those dates are meaningless, because there are no assets for these “trust funds” to exhaust.  The Bush administration wrote in its FY2007 budget proposal:

These balances are available to finance future benefit payments and other trust fund expenditures—but only in a bookkeeping sense. These funds…are not assets…that can be drawn down in the future to fund benefits…When trust fund holdings are redeemed to pay benefits, Treasury will have to finance the expenditure in the same way as any other Federal expenditure: out of current receipts, by borrowing from the public, or by reducing benefits or other expenditures. The existence of large trust fund balances, therefore, does not, by itself, increase the Government’s ability to pay benefits.

This is similar to language in the Clinton administration’s FY2000 budget, which noted that the size of the trust fund “does not…have any impact on the Government’s ability to pay benefits” (emphasis added).

I offer the following proposition:

  • If the government knows that there are no assets in the Social Security and Medicare “trust funds,” and yet projects the interest earned on those non-assets and the date on which those non-assets will be exhausted, then the government is lying. 

If that’s the case, then these annual trustees reports constitute an institutionalized, ritualistic lie.  Also ritualistic is the media’s uncritical repetition of the lie.

The High Cost of Obstructionism

Michael’s posts below looked at the Medicare Trustees Report. The 2006 Report issued by the Social Security Trustees isn’t any better. With another year of inaction, Social Security’s problems have grown worse. The program will begin running a deficit in just 11 years. In theory, the Social Security Trust Fund will pay benefits until 2040, a year earlier than predicted last year. That’s not much comfort to today’s 33-year-olds, who will face an automatic 26 percent cut in benefits unless the program is reformed before they retire.

But even that is misleading, because the Trust Fund doesn’t contain any actual assets. The government bonds it holds are simply a form of IOU, a measure of how much money the government owes the system. It says nothing about where the government will get the money to actually pay those IOUs.

Overall, the system’s unfunded liabilities—the amount it has promised more than it can actually pay—now totals $15.3 trillion.

That’s “trillion.” With a T.

Setting aside some technical changes in how future obligations are calculated, that’s also $550 billion worse than last year. In other words, because Congress failed to act last year, our children and grandchildren were handed a bill for another $550 billion.

How long will Congress continue to duck this issue?

Hey Buddy, Can You Spare $86 Trillion?

That’s how much Congress would have to put in an interest-bearing account today to cover the gap between the Social Security and Medicare benefits it has promised, and its ability to actually keep those promises.

The trustees of the Medicare and Social Security programs released their annual reports at 3pm today.

A brief rundown:

  • The unfunded liability of the Social Security program grew by 20 percent (from $12.8 trillion to $15.3 trillion) while Congress dithered over reform proposals.
  • But the Social Security gap is still smaller than the unfunded liability of just the Medicare prescription drug program, which weighs in at a robust $16.2 trillion.
  • The total unfunded liability of Medicare topped $70 trillion (It’s actually $70.8 trillion. Round up or down to suit your taste.)
  • The trustees’ estimate of the unfunded liability of the Medicare drug program actually shrank 11 percent from their 2005 estimate of $18.2 trillion. But that reduction was more than offset by a 2 percent increase in the unfunded liability of the physician insurance part of Medicare (from $25.8 trillion to $26.2 trillion) and a 16 percent surge in the unfunded liability of the hospital part of Medicare (from $24.4 trillion to $28.4 trillion).
  • All told, Medicare’s problems are over four times the size of Social Security’s.