Social Safety Nets

One of the most controversial functions of government in a modern market economy is the redistribution of income and wealth.  Just about everything the government does redistributes wealth between groups in society.   The competing groups are not simply rich vs. poor; the gaining and losing groups may consist of owners and workers in different industries, consumers of different kinds of goods and services, owners of different types of property, or individuals in different age cohorts or geographic regions.

Most of the redistribution is indirect.  A large share of the federal budget is devoted to a category called “income support” that consists of direct redistribution of funds to individuals.  State and some local governments also play an important role in redistribution to individuals.

The Social Safety Net

There will always be some individuals who are not able to earn a living in markets.  This could be due to age or disability.

Private Charity:  Some feel that private charity could and would take care of these individuals in the absence of government safety nets.  Institutions such as the family, the church, civic organizations, private charities, etc.

They argue that the existence of the government safety net creates a much larger problem than actually exists because incentives are distorted.  Without the distortion of incentives, the number of people needing help would decrease considerably and the number of people willing to provide it would increase.

Government:  Others feel that the government should step in.  The challenge then becomes one of ensuring that those who cannot earn enough to support themselves are provided for while at the same time retaining strong work incentives and limiting outlays for support for such households to an acceptable level of expenditure.

We will address two major U.S. social welfare programs, one exclusively federal and one primarily state-supported, that account for most federal and state direct redistribution to individuals – the collection of programs known as “welfare” and the social insurance programs that cover retirees and their survivors and persons with disabilities. 

Social Security

• Established 1935 Social Security Act (the OAI) – supposed to provide only old age insurance.  Survivor benefits added in 1939 (OASI) and disability benefits were included in 1954 (OASDI) and then in 1965 Medicare was included (OASDHI).
• OASDHI (Old Age, Survivors, Disability and Health Insurance)
• Public defined benefit plan supported by payroll tax (earmarked tax)
  • 7.65% employee, 7.65% employer
  • 6.2% for OASDI up to salary of $90,000
  • 1.45% for Medicare – applies to income above maximum
  • You earn $30,000 this year.  You pay $2,295 in Social Security taxes (.0765 x 30,000) and your employer pays the same amount.  The total Social Security tax is $4,590 (15.3% of your salary).
• Still primarily a system providing retired persons with benefits both in cash (in the form of pensions or annuities) and in kind (Medicare).  Benefits based on
  • age of retirement
  • # years worked – must work a number of years to be eligible
  • income earned
  • COLAs every year based on CPI (since 1972)
• Social Security is pay-as-you-go financing – does not operate like private insurance.  Over most of its operation, the tax revenues collected in each year were immediately paid out as benefits to currently retired persons.  There was no fund accruing in each taxpayer’s name; the only way the taxpayer could receive benefits when he or she retired was from taxes levied on workers employed at that time.  Also known as an un-funded system.
•  An important implication of pay-as-you-go social security is that it can provide pensions that represent a rate of return on taxes paid equal to the rate of growth of the tax base.  If the tax base falls relative to the pay-outs, the system is in trouble.  The tax base grows with working population but also with productivity. 
  • So retirees today paid with payroll taxes collected today.
  • Reform in 1983 (raised retirement age, expanded coverage, taxed some benefits, changed index) – the social security system has begun to accumulate a sizable trust fund, at least for OASI.  About 15% larger than the benefits paid out each year, with the excess accumulating in a fund.  Still a far cry from full-funding. Basically still an un-funded system.

The Trust Fund:  Social security payments in excess of those needed to fund social security payments to current retirees are held in the social security trust fund.  The growing Social Security trust fund, now about $1.5 trillion, is invested in interest-paying U.S. Treasury securities, or, essentially, lent to the rest of the government. This sometimes leads to charges that Congress is "spending" Social Security funds. But there isn't any safer investment.

Problems with Social Security

• The fundamental problem is demographic:  as U.S. population ages, too many people collecting benefits relative to how many are paying benefits

Originally over 8 payers-to-retirees

 In 1945 only 8% of those over 65 received benefits, but today more than 94% receive benefits (most who don’t have benefits under other federal retirement programs). 

A larger portion of the population is elderly. 

The level of real benefits per retired person has risen.

In 1960, there were 5 workers for every Social Security beneficiary.  Today there are slightly more than three.  In 30 years, there will be only two.  That means fewer tax-paying workers to support more benefit-receiving retirees

currently payroll tax revenue exceeds benefits by about 15%

surplus invested in Treasury IOUs

after 2015 or so benefits will exceed revenues

draw on Treasury IOUs

after 2042 or 2052 (depending upon whose estimates one uses) assets exhausted.  If changes aren’t made, benefits at that point would have to be cut about 30% so they don’t’ exceed revenue devoted to the program.

A typical worker born during the 2000s is promised about $24,300 (in today’s dollars) in initial Social Security benefits at retirement, the Congressional Budget Office estimates, but there would be money to pay only $18,300.

Source:  WSJ, Feb. 1, 2005, PB1.

So What’s the Urgency?

Although Social Security can pay promised benefits for many years, changing retirement programs abruptly is a bad idea.

Workers need time to save more from their paychecks if government benefits are to be reduced, and they deserve notice about changes to the retirement age.  Bush plan – promises that current retires will be basically untouched; the same for workers older than 55.

But the longer the government delays, the bigger the eventual tax increases or benefit cuts have to be. And putting off changes until the baby boomers are collecting benefits risks unpleasant political conflict between generations.

Over 75 years, the usual metric for Social Security, the agency's actuaries say the government has made promises that cost about $3.7 trillion (in today's dollars) more than projected tax revenue. Any such projection relies heavily on assumptions about life spans, economic growth, wages and immigration. Some critics say the Social Security actuaries are too pessimistic, particularly in forecasts about the pace of economic growth and immigration. Others counter that the trustees' expectations about life spans underestimate medical progress; if they're wrong on that, the hole is bigger.

POSSIBLE SOLUTIONS

1.       Increase payroll tax - How big a tax increase would stabilize Social Security?

Social Security today depends on the payroll tax, income taxes collected on benefits paid to the highest-income elderly and interest on agency's holdings of government bonds. The system could be financed by other federal taxes. An immediate 15% increase in the payroll tax -- from today's 12.4% on wages to about 13.9% -- would stabilize the system for 75 years, according to Social Security's trustees (four government officials and two outsiders).

The tax rate would have to go much higher if the increase were phased in over several years. Today's payroll tax applies only to the first $90,000 of wages, a ceiling adjusted annually for inflation. That's about 85% of all wages.

2.        Increase ceiling - An alternative to higher tax rates is taxing 90% of wages -- that is, moving the ceiling to $140,000 over a decade -- which would solve about 40% of Social Security's problem.

3.       Decrease benefits - How much would benefits have to be cut to stabilize the program for 75 years?

The Social Security trustees say it would take an immediate and permanent reduction in benefits of 13%. If the changes were phased in gradually, the cuts would have to be bigger. And fixing the program so it would be sustainable after 75 years would take even bigger changes.

There are lots of ways to reduce benefits promised by current law. The formula used to calculate a retiree's initial benefit could be altered. The annual cost-of-living adjustment could be reduced.

4.        Increase the age of eligibility for full benefits -- which is rising gradually for workers born after 1938 and will reach 67 for workers born after.

5.        Benefits for upper-income retirees could be reduced. (Today, benefits of the highest-income retirees are subject to federal income taxes.)

6.         Investing Social Security surplus in assets other than Treasury IOUs. 

7.        Individual accounts - Individuals direct their investment to a restricted list of broad stock or bond funds.  These funds are converted into annuities upon retirement which supplement benefits from a pay as you go system.

8.        Privatize Social Security accounts (more like a 401k) – basically 5 would be included here.  There are proposals ranging from all mandatory to none mandatory.

What is President Bush proposing?

Nothing specific yet. He has ruled out raising taxes and insists on private accounts. Aides make clear that he will also seek other reductions in benefits from levels promised in current law, arguing that the promises made in current law are unaffordable.

The White House has praised an option crafted by a commission he appointed in his first term. This plan would:

a.        Allow workers under age 55 to voluntarily divert four percentage points of payroll taxes into private accounts -- up to $1,000 a year -- in exchange for smaller benefits in the future.

b.        In addition, it would reduce Social Security benefits promised to all future retirees by tweaking the formula by which wages are used to compute initial retirement benefits. And to help people at the bottom, it would sweeten benefits promised to some low-wage and disabled workers and widows.

c.        Benefits to those with private accounts will be decreased further to reflect taxes diverted to private accounts.

d.        At retirement, workers get access to the money in their private accounts.  Workers collect more or less than they would under the current system depending upon how their funds perform.

e.        Funding shortfall:  the government would have to find $1 trillion to $2 trillion over a decade to replace tax revenues diverted to private accounts and to pay existing retirees.

What would private accounts do to stabilize Social Security's finances?

In the short run, they would cause a problem. Social Security depends on taxes paid by today's workers to pay today's retirees. If those taxes are diverted to private accounts, then the government has to find another way to cover those retirees' benefits. Mr. Bush proposes to borrow the money, perhaps $1 trillion or $2 trillion over 10 years.

Over the long run, private accounts are a wash, at best, for the system. Diverting payroll taxes to private accounts would reduce the flow of tax money into the system in exchange for reducing government benefits when workers with private accounts retire. That's why the White House, to the consternation of some Republicans, says the president will seek other money-saving changes to the program.

But for individuals, accepting smaller government benefits in exchange for the right to divert some payroll taxes to a private account could be a winner -- depending on the performance of the stock and bond markets. If the markets do well, growing private accounts could offset some of the likely cuts in government benefits

If markets do poorly, workers would be expected to absorb the losses, though there could be pressure for the government to provide a safety net.

Are there other sorts of private accounts?

Many Americans already have Individual Retirement Accounts or 401(k) retirement accounts. Several Democrats would expand those, creating private accounts alongside Social Security without diverting payroll taxes into them.

What are the other leading alternatives to Mr. Bush's proposal?.

Economists Peter Diamond and Peter Orszag offer a detailed plan to raise payroll taxes to 14.2% (split between employer and employee) by 2055, increase the base on which taxes are levied, lift the age for the full retirement benefit, and trim benefits for higher-income recipients while increasing them for low-income workers.

Robert Pozen, a former Fidelity Investments vice chairman who served on Mr. Bush's Social Security commission, embraces the structure of the plan that the Bush administration praises -- but he would make it more generous to lower-income workers and less so to higher-income workers.

Sen. Lindsey Graham, a South Carolina Republican, would offer workers under age 55 a choice: Stay in today's Social Security program and pay two percentage points more in payroll taxes or accept lower benefits or divert four percentage points of payroll taxes into a personal account in exchange for accepting lower benefits. Full-time workers who took the private-account option would be guaranteed a retirement benefit 20% above the poverty line.

Two other Republicans, Rep. Paul Ryan of Wisconsin and Sen. John Sununu of New Hampshire, would allow workers to divert an average of 6.4% of wages (10% on the first $10,000 of wages and 5% on wages above that) to private accounts in exchange for accepting lower benefits. They say they would guarantee that all workers would get at least as much from combined government benefits and personal accounts as Social Security promises today. To pay for all this, they vow to restrain the growth in other government spending and count on a tax windfall from the added saving and corporate investment generated by private accounts.

And the Macroeconomics of it?

If one believes in Say’s law – the economy is productivity driven.  Then diverting funds away from government securities into private capital is a good thing for productivity and job growth.

The question one might ask is:  does the existence of social security give people an incentive to save less?  If yes, is that good or bad?

On the other hand, if one believes that spending drives the economy, then this diversion isn’t such a big deal.