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20 September 2011

From the Progressive Policy Institute: Fixing the National Ponzi Scheme Called "Social Security"

The New Deals Crowning Achievement Has Fallen and It Can’t Get Up

By Robert J Shapiro,
THE NEW DEMOCRAT, September / October 1995

At a time when politicians of all stripes hotly dispute the effectiveness and legitimacy of virtually every federal activity, a collective silence surrounds the government’s single largest program, Social Security. It’s no mystery why: Nothing else that government does enjoys as much support, because nothing else delivers so much cash to so many people.

Social Security is not merely popular; it is the grand monument of New Deal liberalism. But a half-century of economic and social changes have made the old program fiscally unsustainable and, in certain respects, insupportable as sound social or economic policy.  

If Franklin D. Roosevelt’s moral vision is to survive, progressives will have to modernize his enterprise: We must stop channeling public monies into huge windfall cash retirement benefits for virtually everyone, and create a new model of mandatory private savings supplemented by public provision for lower-income people.

Clearly, some mandatory arrangement for retirement security is necessary. Without it, millions will find themselves unprepared for their retirement years, and private insurance annuity markets could not profitably cover those who are both most likely to need coverage and least able to afford it. To its credit, the Social Security program can claim a genuine achievement: By channeling enormous sums to all retirees, it sharply cut poverty among the elderly. In 1960, more than one-third of all elderly Americans lived below the poverty line, a poverty rate more than half again as high as that for everyone else. Today, less than 13 percent of elderly people are poor, a smaller share than for the rest of America.  

"For Democrats, the path back to power lies not in recreating the failures of the European welfare state but in finding new ways to make the party’s traditional values of limited government and responsible individualism workable again."

Despite this success, Social Security shares all the serious defects of the modern welfare state. As an unfunded system of windfall cash transfers from current workers to retirees, often amounting to hundreds of thousands of dollars per retiree, it is fiscally unsustainable over time.  It also appears to endanger the economy’s health, eroding savings and investment by creating a universal entitlement for everyone to consume over their lifetimes more than what they produce. Finally, many of the system’s actual operations are unsound as social policy, since they transfer enormous cash resources from lower and middle-income workers to generally more affluent retirees, with the largest transfers going to the richest.

Even its success in reducing poverty is suspect, for reduced poverty among retirees is achieved in part at the cost of higher poverty for others. The system’s financing via a flat tax on wages, for example, cuts most deeply into the disposable incomes of millions of lower-income workers, and destroys potential jobs at the bottom of the wage scale. And as real public spending on the elderly has risen for years while it has fallen for virtually everyone else, can’t we conclude that Social Security is crowding out support for other legitimate purposes, especially support for young children, who now suffer poverty rates twice those of the elderly?

Despite this success, Social Security shares all the serious defects of the modern welfare state. As an unfunded system of windfall cash transfers from current workers to retirees, often amounting to hundreds of thousands of dollars per retiree, it is fiscally unsustainable over time. 

National Ponzi Scheme

Social Security’s basic fiscal problem is widely recognized: In about 15 years, annual payroll tax revenues will be insufficient to maintain the annual cash benefits promised to the baby boomers as they begin to retire. It was this prospect that persuaded Congress in 1983 to raise payroll tax rates (and cut benefits modestly). In theory, the tax would then generate tens of billions of dollars a year in excess revenues, which were supposed to be saved to produce the additional monies needed when baby boomers retired. In practice, every dollar of the surplus is being spent on other government programs.  Thus, working people are paying higher taxes today that are not generating the additional savings required to help finance their own retirement benefits.

The revenue shortfall actually did not begin with the baby boom; it was built into the system, in what the Nobel economist Paul Samuelson once called a national Ponzi scheme. 

Social Security has always been an unfunded pay-as-you-go program, starting with a small group of people receiving small cash benefits financed by a low tax rate. Inevitably, both the number of beneficiaries and the size of their benefits have increased as the program has matured. This is sustainable only if the number of workers and the economy’s payroll tax base increase even faster—that is, so long as you have a baby boom and strong economic growth. 

Social Security has always been an unfunded pay-as-you-go program, starting with a small group of people receiving small cash benefits financed by a low tax rate...and..The numbers do not look good. 

A system which in 1950 required every 100 workers to help support six retirees today requires each 100 workers to help support almost 27 retirees. The baby boom will worsen this problem:  When the last of the post-World War II babies retires in 2030, every 100 workers will have to help support nearly 43 retirees. This growing burden is based not only on the number of retirees, but also on longer life spans. Those who retired in 1935, for example, represented less than 60 percent of all those born 65 years earlier, and on average each lived 13 more years. Those retiring today represent more that 77 percent of those born 65 years earlier, and they can expect to live another 17 years. And by 2030, those retiring should represent 85 percent of those born 65 years earlier, and they should expect to live another 20 years.

Most important of all, Social Security cash payments have been rising even faster than the number of people receiving them or their life spans. 

In 1940, the average Social Security benefit was equal to about 20 percent of the average wage. By 1970, the average payment had reached 36 percent of the average wage. The basic benefit continues to rise, but relative to working people’s incomes it has stabilized at about 41 percent of the average wage—not counting the addition of other retirement benefits, most notably Medicare.

As these numbers suggest, Social Security payments do not simply increase with inflation. Rather, every year each new cohort of retirees receives larger real cash benefits than those preceding them with the same real lifetime earnings. When a person retires, his original monthly cash benefit is figured, first, by taking the history of his monthly earnings on which he paid payroll taxes, and then adjusting them not just for inflation but also for the real wage growth throughout the economy over the course of his working life. Next, a progressive factor is introduced: Each person’s initial monthly benefit is then determined by replacing 90 percent of roughly the first $400 of earned income, 32 percent of roughly the next $2,000 or so, and 15 percent of roughly the next $3,000. It is on top of this that a retiree’s future cash payments are adjusted upward every year to offset inflation.

Social Security is fiscally unsustainable because these arrangements produce truly enormous payments for tens of millions of people that grow greater with every new crop of retirees. 

Economists C. Eugene Steuerle and Jon M. Bakija analyzed the lifetime cash retirement benefits going to an average two-earner working couple—a husband who earned average wages and a wife who earned half the average. (All figures are given in 1993 dollars.) If the couple retired in 1960, they would have collected $102,000 in Social Security cash payments over the course of their retirements. But if the same couple had retired in 1980, they would have received more than $208,000. And if they had retired this year, they would collect more than $226,000. By 2030, when the last baby boomer retires, our couple will receive cash payments totalling over $316,000.

For such a system to maintain itself, its revenues somehow have to increase faster than either the wages or the numbers of workers paying for it. That’s why the payroll tax rate has also been going up for the last 40 years, by 2 to 3 percentage points every decade, not even counting Medicare—from 3 percent in 1950, to 6 percent in 1960, to 8.2 percent in 1970, to 10.2 percent in 1980, and to 12.4 percent today. We would have required even higher tax rates if it had not been for the baby boom entering the workforce, along with millions of new immigrants and female workers.

In spite of all this, people’s tax payments will not catch up with the cash benefits they will receive for many years to come. If our two-earner couple had retired in 1960, the value of all of their previous payroll taxes—adjusted for both inflation and a 2 percent average rate of return on the payments—would have totaled $13,300 (once again, in 1993 dollars). In exchange, they would have received $102,000 from Social Security, a net real windfall of $88,700. 

If they had retired in 1980, they would have paid in $75,200 and received $208,400, a gain of $133,300.  After 1980, years of rising payroll taxes begin to eat away at the net benefits; still, they remain substantial. Our couple retiring today will have paid in $148,000, and they can expect to collect $226,600, a gain of $78,600. But when the last hypothetical baby boomer couple retires in 2030, the adjusted value of the taxes they will have paid to support previous retirees will reach $287,100, for which they can expect $316,500 from the Social Security Administration, a net real gain of $29,400.

These examples reveal a secret about Social Security’s true economic character: 

It doesn’t even remotely resemble a genuine insurance system. Insurance systems sustain themselves by providing cash benefits roughly equal to previous cash payments, adjusted for inflation and a market rate of return. Social Security, in contrast, promises that everyone will receive far more than he or she ever paid in. It is the epitome of the modern welfare state proposition that everyone should be able to consume more than he or she produces.

Social Security and Economic Growth

A welfare state can get away with this for a while, but only so long as it can deliver rising rates of economic growth or a labor force that grows at a faster rate than those depending on it for their transfers. Our own welfare state expanded on just this basis: The labor force grew faster than those depending on it for benefits, initially when the World War II veterans reentered the labor force, and next when the baby boom reached working age.

Unfortunately for us, this stratagem has two debilitating flaws:

First, the rate of new workers began slowing down when the last baby boomer entered the workforce.  

Second, if labor-force growth slows, the economic growth required to pay for rising benefits has to depend on increased economic investment. But that investment depends on strong savings, which the Social Security program itself tends to discourage.

"Social Security is crowding out support for other legitimate social purposes, especially support for young children, who now suffer poverty 
rates twice those of the elderly."

What about savings? Economists generally agree that the two facts of economic life that drive people to save are opportunity and need. Opportunity comes first:  People save more and save at higher rates when their incomes rise rapidly. Why have our private savings rates fallen? Mainly because the opportunity isn’t there: Most people’s incomes have stopped rising appreciably. Americans who were age 20 or 30 in 1950 saw their inflation-adjusted incomes more than double by the time they reached age 40 or 50 in 1970—and they saved at 7 percent to 8 percent annual rates. But those who were age 20 or 30 in 1970 saw their real incomes grow by less than 25 percent over the next 20 years—and the U.S. private savings rate fell by more than half.

But there’s more to the low-savings story. As slow income gains have reduced opportunities to save, expectations of huge net cash transfers from Social Security reduce the need to save. Economists may disagree about the power of this effect, but few doubt its existence. By one estimate (not the largest, by far), each dollar of expected Social Security wealth reduces private savings by 2 to 3 cents. If that’s anywhere near accurate, the current Social Security program has cut our potential private savings rate by one-half to two-thirds. If that’s true, the vast increase in Social Security lifetime cash benefits has played a substantial role in our slow economic growth over the last generation.

Government could have squared this circle if it had offset the lower individual savings rate by saving and investing itself for their retirements—the justification for the 1983 payroll tax increases. It hasn’t worked out that way. Government uses Social Security’s current excess revenues not to run a budget surplus that would provide the capital for higher long-term growth, but to underwrite budget deficits.

And because this system allows retirees to depend primarily on annuity payments, rather than assets, their resources are likely to be entirely consumed. These are the chief reasons why an average 70-year-old today consumes about 25 percent more than the average 30-yearold, as compared to 1960, when 70-year-olds consumed 35 percent less than those age 30.

Social Security increases consumption, and so reduces national savings, in other ways as well. By design, it transfers cash from young working people (who are more likely to save) to old retired people (who are more likely to consume)—and it has been doing so at rising rates.

Who Gains, Who Loses?

Perhaps the cruelest irony of Social Security today is that, often, it transfers cash from those with less to those with more. 

When Social Security was established in the 1930s, the country intended to shift income to elderly people, whose savings had been decimated by the Depression, and to continue doing so on the expectation that each subsequent generation would be better off.  But in many respects this is no longer the case, especially when we compare younger workers hit hard by stagnant wages against many recent retirees collecting rising cash benefits.

Americans age 65 to 69, for example, reported median incomes of $20,500 in 1993—incomes supported in part by the payroll taxes of less affluent 20- to 24-year-olds (with average incomes of $12,500), and 25- to 29-year-olds (average income, $19,500).  Moreover, retired Americans are generally even better off than the income data would suggest. 
Social Security promises that everyone will receive far more than he or she ever paid in. It is the epitome of the modern welfare state proposition that everyone should be able to consume more than he or she produces.

To begin, older people pay much lower taxes than other people with the same incomes, in part, of course, because they generally don’t pay Social Security taxes. For example, people over age 65 in the bottom fifth of all incomes pay roughly 3 percent of their incomes in federal taxes, while everyone else in the bottom fifth bears, on average, a 10 percent effective tax rate. And this persists in all five income quintiles. In the middle of the income distribution, retirees bear an average federal tax burden of less than 8 percent, while everyone else pays an average of more than 22 percent. These data probably understate the full tax advantages of older Americans: By one survey, elderly people also under-report their taxable incomes at 10 times the rate of working people—most of whose taxes are withheld automatically. In addition, retirees’ income usually goes further because they support smaller-than-average households and receive larger-than-average in-kind benefits.

By one estimate, if we take all of these factors into account—relative money income, taxes, household size and living expenses, and in-kind benefits—the current per capita disposable income of retired Americans is 40 percent higher than that of everyone else. 

Moreover, older Americans today are also far wealthier than younger ones: The median net worth of Americans age 65 and over is double that of all other Americans. Despite all this, those with lower incomes are taxed to help support those with more.

Not all elderly people are affluent.  In fact, both income and wealth fall sharply at very high ages—in part because the oldest retirees receive much smaller Social Security checks than more recent retirees. People age 75 to 79, for example, report average incomes below $15,000, less than any younger group except those age 20 to 24. Those 80 and over have average incomes of less than $13,000. Social Security may be deeply flawed, but its defects do not include overly generous payments to very old low-income people, most of them widows.

The economic straits of the low-income elderly, moreover, point to another troubling feature of Social Security:  It provides regressive transfers within generations, as well as among them.

Among those who must pay for the current benefits, the payroll tax hits hardest those least able to pay it.  Not only is the wage and salary income subject to the Social Security tax capped at $65,000, but all income from interest, dividends, and capital gains is totally exempt. As a result, the bottom three-fourths of working Americans have to pay a 12.4 percent Social Security tax on virtually all of their earnings, while the top one-fourth pay no Social Security tax on that portion of their salaries that exceeds the cap, nor on their capital incomes. Only at the very bottom do these taxes turn progressive, when the Earned Income Tax Credit offsets payroll taxes paid by the working poor.

The regular hikes in payroll tax rates have only worsened the regressivity of this financing system. Now, it largely offsets the progressivity of income taxes. In 1955,the combined income tax and payroll tax burden was clearly progressive. Working people earning half the median income bore an effective total tax burden of 4 percent;average-income people, a 9 percent burden; and those with twice the median income, a 12.5 percent burden.  By 1991, everyone was paying much higher taxes.  But with regressive payroll taxes now playing such a large role, the total tax burden had become much flatter:  20.1 percent for lower-income people; 24.5 percent for middle-income people; and 25.6 percent for those with high incomes. A tax system that in 1955 required the affluent to bear three times the tax burden of the poor now asks the most well-to-do to pay taxes at an effective rate that’s only one-fourth greater than that imposed on the least well-off—and Social Security financing is the chief reason.

Finally, these taxes finance a system that transfers the largest cash benefits to the richest people. This result follows directly from Social Security’s basic formulas.  Despite higher replacement rates for roughly the first $2,400 in monthly wages, the cash benefit still rises not on the basis of how much support people need or even on how much taxes they paid, but on how much they earned in wages. And the same process that increases the base benefit for each new cohort of retirees also widens the gap every year between the cash payments received by those who were highly paid and those who were low paid.

This gap now often amounts to hundreds of thousands of dollars over the course of people’s retirements. For example, a low-income, one-earner couple who retired in 1980 could expect to receive Social Security checks totalling about $129,000 (measured in 1993 dollars); while a high-earning, one-earner couple will receive more than $264,000, or more than twice as much. If the same two couples retired this year, the low earners could expect to collect almost $135,000 and the high earners more than $305,000. And when the last baby boomer retires in 2030, the low earners will get a little more than $187,000, while their high-earning counterparts will collect $493,000.  The total effect is even greater, because the well-to-do people receiving the largest Social Security checks also have the greatest wealth.

What’s To Be Done?

Social Security answers genuine social needs—but not very well. The challenge is to preserve its purpose and achievements, on a new basis that is fiscally and economically sustainable and socially supportable.

The first task is to address Social Security’s basic fiscal problem. And this cannot be done without somehow containing the claims not only of baby boomers in decades to come, but also of those nearing retirement today and even some who already are retired. We can take reasonable account of our own growing productive lifespans by gradually raising the retirement age to 70, in increments of a few months every year. In addition, although the interest groups that claim to speak for the elderly will probably howl in protest, the huge lifetime cash transfers promised to current high-income retirees can be reduced.

The guiding principle of Social Security reform, however, should be to end the perpetual welfare-state mindset that everyone, regardless of their resources, can claim public monies in order to consume more than they produce over their lifetimes. The fundamental step is to reestablish Social Security as a true insurance system, under which most people are guaranteed not windfall cash benefits, but payments corresponding to the economic value of their contributions.

We can do this with a new public-private, two-tier system, which could also address the current program’s drain on private savings. Under the first tier, the major share of payroll tax payments would be shifted gradually to mandatory private savings accounts, perhaps over two decades. And the second tier would restore a measure of genuine progressivity to the system by using the remainder of the payroll tax to supplement the resources of retired people with low lifetime incomes.

Much as today’s unfunded pay-as-you-go program is breeding its own demise, a system of mandatory private saving would contain the seeds of its own success. By increasing private savings, higher capital formation can drive economic growth, which in turn can provide the economic basis for benefits as well as greater public investments.  But none of this is possible unless and until we agree to end our long collective silence about the character and problems of Social Security.

Robert J. Shapiro is vice president of the Progressive Policy Institute.

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