Social Security’s Tough Transition

December 14, 2004 • Commentary
This article appeared in the New York Post on December 14, 2004.

Social Security touches most Americans. Nearly 80 percent of U.S. families pay more in Social Security payroll taxes than federal income taxes. At the same time, more than half of seniors receive a majority of their retirement income from Social Security.

As the debate over the program’s future goes forward, here are a few things to keep in mind.

Reform Can’t Wait. Although Social Security is running a surplus today, that will change very soon. In less than 15 years, Social Security will be running a deficit, spending more on benefits than it will take in through taxes. After that, at least in theory, it would draw on the Social Security Trust Fund until 2042, after which the Trust fund would be exhausted, and Social security could only pay about 75 cents out of every dollar of promised benefits. In reality, the Trust Fund contains no assets. The bonds it holds are simply IOUs, promises that at some date in the future the government will tax someone in order to pay benefits. Social Security currently faces unfunded liabilities of more than $11.9 trillion.

Why the problem? Social Security taxes are not invested or saved for retirement, but are used to pay for those already retired. This works when there are many people paying in and only a few taking money out. However, fewer workers are supporting more retirees today. Social Security, as we know it, is unsustainable.

Limited Options. President Clinton explained the limited options for reform: raise taxes, cut benefits or invest privately.

Tax increases and benefit cuts would have to be large. By 2030, the additional tax burden increases to $1,543 a year per worker, and continues to rise thereafter. That would mean an increase in payroll taxes of roughly 50 percent, or an increase in income or other taxes. Some people have also suggested taking the cap off the amount of income subject to the payroll tax. This would be the largest tax increase in U.S. history, but would fall far short of the money needed to keep Social Security solvent. By some estimates, removing the cap would provide only seven additional years of solvency to the program.

The second alternative is to cut benefits. Current estimates suggest that benefits may have to be reduced by as much as a third. There are several ways that this might be done — none likely to be politically popular.

Individual Accounts. The final alternative is to allow younger workers to privately invest a portion of their Social Security taxes. The portion is still undecided, but could range from just 2 percent of wages to as much as the worker’s half of the tax (6.2 percent of wages). This would give workers ownership and control over their retirement funds, and allow them to take advantage of compound interest.

Individuals would not be expected to be sophisticated investors. Investments, at least at first, would be in safe, broadly diversified funds, and given the long‐​term investment horizon, there would be remarkably little risk. There has never been a 20‐​year period during which U.S. capital markets lost money. And unlike under the current system, the money in these accounts could be passed on to their heirs at death.

Transition Costs. Some claim private accounts would cost $2 trillion or more. But they would reduce the unfunded liabilities of Social Security by as much as half — though we would have to pay those costs now instead of waiting until they come due in the future.

Details To Come. President Bush has not yet endorsed a specific reform proposal. There are several plans being considered by Congress. These vary in terms of the size of the accounts, the investment options allowed, the types of guarantees they offer and how they would finance the short‐​term transition costs, whether through borrowing or some new source of revenue. A final plan will probably be hammered out next spring.

In the end, Congress will have to make some tough choices to finance transition costs today, but we will all be much better off later if it does.

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