Social Security is one of America’s most successful government programs. It has helped millions of Americans avoid poverty in old age, upon becoming disabled, or after the death of a family wage earner. Although the program faces a long-term deficit, lawmakers do not have to destroy the program in order to save it.
In his State of the Union address this week, President Bush called for creating voluntary individual accounts within Social Security. That approach, however, is fundamentally flawed. Tax-favored individual accounts such as 401(k)s and IRAs already provide an extremely useful supplement to Social Security. But they are simply inappropriate for the basic tier of income during retirement, disability, and other times of need; those nearing retirement need a reliable source of income that is protected against inflation and lasts as long as they live.
Furthermore, the President’s approach would substantially expand the budget deficit for an extended period, adding $1 trillion to the deficit over the next decade alone. Remarkably, despite growing concerns about the magnitude of the deficit, other recent individual account proposals involve even more substantial increases in the budget deficit. To avoid this expansion in the deficit and to increase national saving, individual accounts would have to be financed by additional taxes – a step that Mr. Bush has ruled out.
So if the President’s approach is the wrong way to go, what should be done? In a recent book, we propose a plan that restores balance to Social Security without drawing on general revenues, protects benefits for workers who are 55 or older in 2004, preserves the program’s basic structure, and strengthens the security offered to the most vulnerable beneficiaries. Our plan for restoring long-term balance has three components, each of which addresses a factor that contributes to the long-term deficit and each of which combines adjustments to benefits and revenue.
Life Expectancy. Increasing life expectancy raises the value of Social Security benefits to workers, because benefits last as long as the recipient is alive. By the same token, however, it raises Social Security’s cost, because beneficiaries collect benefits over a longer period. To offset these costs, we would index Social Security to life expectancy – with about half the adjustment through monthly benefits and the other half through payroll taxes.
Earnings Inequality. Earnings have been rising most rapidly among workers with the highest earnings, which affects Social Security’s financing because the Social Security payroll tax is imposed only up to a maximum taxable level ($87,900 in 2004). In addition, higher earners have experienced more rapid gains in life expectancy than those with lower earnings, which adds to Social Security’s financing gap and makes the system less progressive on a lifetime basis (since higher earners collect benefits for an increasingly larger number of years relative to lower earners). To address these concerns, our plan would gradually increase the maximum taxable earnings base until the share of total earnings that is above the base—and hence escapes the payroll tax—has declined to 13 percent, roughly its average level over the past twenty years. We would also reduce benefits for the highest earners (about 15 percent of workers) to offset the effects of their disproportionately rapid gains in life expectancy.
Legacy Debt. Early generations of Social Security beneficiaries, including most of those receiving benefits today, received larger benefits than could have been financed from their contributions plus the returns on those contributions at a market rate of interest. As we explain in our book, this history imposes a “legacy debt” on future beneficiaries of the program. Financing that debt requires lower benefits than can be earned by contributions accumulated at a market rate of interest. Whatever the misleading claims of proponents to the contrary, by the way, creating individual accounts does not change this basic fact. With or without individual accounts, the legacy debt must be financed by lower benefits and/or higher taxes in the future.
To finance Social Security’s legacy debt more fairly, our plan would cover all newly hired state and local government workers, to ensure that eventually all workers bear a portion of the cost of the benefits paid out to earlier generations. Second, we impose a modest “legacy tax” on earnings above the maximum taxable earnings base, thereby ensuring that very high earners contribute to financing the legacy debt in proportion to their full earnings. Finally, starting in 2023, we impose a universal legacy charge on future workers and beneficiaries, roughly half in the form of benefit reductions for all beneficiaries, and the rest in the form of very modest increases in the payroll tax.
As an alternative to some of these benefit reductions or revenue increases, policymakers could dedicate revenue from another specific source to Social Security. For example, the estate tax could be reformed rather than eliminated entirely, as President Bush has proposed, and some or all of that revenue could be dedicated to Social Security.
Our three-part proposal would restore long-term balance to Social Security and finance protections for some particularly vulnerable beneficiaries — workers with low lifetime earnings, widows and widowers, disabled workers, and young survivors of deceased workers. Revenues would be projected to be sufficient for expenditures over the next seventy-five years, and the system would be expected to remain in balance thereafter.
What would all of this mean for individual workers’ taxes and benefits? Workers who are 55 or older in 2004 would experience no change in their benefits. For younger workers, our proposal does modestly and gradually reduce benefits relative to those scheduled under current law. For example, a 45-year-old average earner (in 2004) would experience less than a 1 percent reduction in benefits. And a 35-year-old with average earnings would experience less than a 5 percent reduction.
To increase revenue under our plan, the combined payroll tax is projected to gradually increase, for example from 12.4 percent in 2005 to 13.7 percent in 2045. For an average earner, even if the rate scheduled for 2045 were implemented this year, the increase would amount only to an extra $37 per month in combined employer-employee taxes. This gradual increase helps ensure that Social Security continues to provide an adequate level of benefits.
In evaluating these modest benefit reductions and revenue increases, remember that our plan does not involve any of the accounting gimmicks common to other recent Social Security proposals. For example, many recent plans have assumed trillions of dollars in transfers from the rest of the budget to Social Security – despite large projected deficits outside Social Security. As the Center on Budget and Policy Priorities recently argued, “Given the sorry state of the federal budget, a truly notable accomplishment would be to develop a plan that restores long-term Social Security solvency without any general revenue transfers.” Our plan does that.
Peter A. Diamond is an Institute Professor at the Massachusetts Institute of Technology. He has been president and chair of the board of the National Academy of Social Insurance. His recent books include Social Security Reform, The 1999 Lindahl Lectures (Oxford University Press, 2002) and Taxation, Incomplete Markets, and Social Security: The 2000 Munich Lectures (MIT Press, 2002).
Peter R. Orszag is the Joseph A. Pechman Senior Fellow in Economic Studies at the Brookings Institution and a codirector of the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution. He previously served as special assistant to the president for economic policy during the Clinton administration.
Peter Diamond and Peter Orszag are the authors of a recent Brookings Institution book, Saving Social Security: A Balanced Approach