The Challenges Facing Social Security and the Options for Reform [Part 3/3]

IV. Options for Social Security Reform: Diamond-Orszag vs. Feldstein-Samwick

Diamond and Orszag argue that Social Security should be reformed through a “balanced approach,” that is, conventional methods that would increase revenue—via increases in marginal payroll taxes—and decrease benefits via lowering lifetime benefits to wealthier Americans.  Their opponents, Feldstein and Samwick, argue that Social Security should be reformed through mixed system that includes both payroll tax funding and investment based initiatives.

Diamond-Orszag

·      The Plan — Only 13% of income for the highest lifetime earners should escape the    payroll tax cap. Their benefits should also be reduced. The legacy debt accrued by earlier generations must be paid off by,   (1) mandating that newly higher government workers pay into Social Security (approximately 4 million) (2) imposing a legacy tax on earnings above the maximum taxable earnings base for high lifetime earners (3) imposing a universal legacy charge via increases in payroll taxes beginning in 2023.

·      Advantages — (1) Progressive: This is a progressive plan that adversely affects top income earners and benefits lower income earners. As a result, in a static model, it may help reduce income inequality. (2) Tax Base Widens — The newly hired workers who would have to pay into Social Security (approximately 4 million) will increase OASDI revenues via the payroll tax.

·      Disadvantages — (1) Deadweight Loss (DWL): Higher marginal tax rates will generate a deadweight loss (loss of economic efficiency). More analysis needs to be done to determine the magnitude of the DWL. (2) Politics —  It may be politically unpopular in the U.S. High income earners already pay 39.6% of their income in taxes. Therefore, such a policy may not fare well with Republicans (and some Democrats) and may be stopped dead in its tracks. (3) Tax Incidence — If employers are hit with a tax increase, they may shift the tax burden to their employees via reduced wages.  If the pool is expanded to government workers, then state and local governments must also finance part of Social Security.

Feldstein- Samwick

·    The Plan — If they also make an out-of-pocket equal contribution, employees allocate 1.5% of their 12.4% payroll tax to Personal Retirement Accounts (PRAs). By their analysis, Feldstein and Samwick determine that the funds in the PRAs and variable-rate annuities will earn a 5.5% real rate of return.[1] [2] Pay-as-you-go benefits from the payroll tax would gradually fall over time, but would not be eliminated. The PRAs can be bequeathed to anyone one chooses if one dies before retirement age.

·      Advantages — (1) Increased National Savings — Because S = I + NX, the accounting identity tells us that national savings would increase. (2) Increase in future business activity— business activity would rise from the increased national savings. (3) Government cannot access funds — The PRAs would not allow Congress access to the funds for additional projects. (4) Labor Supply: More people would be incentivized to join the labor force because PRA funds depend on the payroll tax; the payroll tax would presumable not increase and may gradually decrease over time.

·      Disadvantages — (1) Transitional burden: Today’s workers bear the burden of financing current retiree benefits. They also have to save for their own benefits. The transitional costs are high to today’s workers. (2) Risk— The market (variable rate annuities) may expose individuals to unnecessary risk compared to fixed rate annuities.

Policy Recommendation:

After completing the cost-benefit analysis in this memo, it would be prudent for the U.S. Senate Committee on Finance to support the Feldstein-Samwick mixed system reform proposal as outlined in section “The Plan,” under  “Feldstein-Samwick. In order to offset the transitional costs of the reform policies, the U.S. Senate Committee on Finance is advised to provide appropriate tax deductibles to current workers and to consider reducing marginal tax rates on current workers so that their burden of financing the inception of the reform policies is alleviated. Lastly,  in order to tackle the problem of risk, the U.S. Senate Committee on Finance is strongly advised to implement essential provisions in the reform policies as advocated by Jeffrey Liebman: protecting investors from high costs and poor investment decisions during accumulation, maintaining redistribution, and protecting retirees from decumulation.[3]

Word Count: 689

---

[1] Feldstein-Samwick, 2001.

[2] Feldstein, Harvard, 2013.

[3] Liebman, 2005.

The Challenges Facing Social Security and the Options for Reform [Part 2/3]

            

III.  The Gap in OASDI Spending and Payroll Tax Revenue: Future Actuarial Balance

An Increase in the Number of Beneficiaries

During the next few decades, the number of beneficiaries will increase as the baby-boom generation ages and begins to leave the labor force.[1] Additionally, an increase in the life expectancy rate due to better health and medical technology, coupled with a constant birth rate will cause an increase in the number of beneficiaries and a shortfall in revenues for Social Security.[2]

·      A shrinking workforce coupled with increased enrollment — In June 2010, there were 2.8 workers per Social Security beneficiary; by 2035, the CBO projects that this will decrease to 1.9 workers per Social Security beneficiary (a decrease of 32%). Though incomes will rise as the economy expands, a rise in incomes due to technological innovation and increases in production over time will not be enough to sustain current outlays because other entitlement spending is expected to rise more than incomes do (e.g. Medicaid, Medicare).[3] Assuming no tax increases, the decrease in the ratio of worker to beneficiary will result in a decrease in future OASDI revenues.

Broken tax laws and an expected decrease in the share of earnings subject to the payroll tax

Under current law, the 6.2% payroll tax only applies to the first $113,700 of income. Additionally, in the last few decades the U.S. has experienced an increase in income inequality. By CBO and OASDI Trustees Reports estimates, the top 1% of households saw a 275% increase in income from 1979-2007, while households near the middle income levels saw only a 42$ increase in income during the same time period.[4]

·      Income inequality, the payroll tax, and the share of earnings subject to the payroll tax — Under current law, the top income earners will pay a smaller percentage of their earnings in payroll taxes over time.  If the rest of the workforce does not experience a greater increase in income levels, contributions from middle-class Americans will not rise. CBO projects that earnings inequality will increase somewhat during the next few decades and that the share of earnings subject to the payroll tax, which has averaged around 85 percent in recent years, will decline to around 83 percent in 2036.[5] Moreover, demographers and medical specialists have presented substantial evidence that wealthier Americans have higher life expectancy rate than those in the lower income levels, thus they are collecting more in lifetime Social Security benefits.

Expanding DI Rolls

The Social Security Disability Reform Act (1984) had the effect of making the disability application process much more subjective and stipulated that an individual has to have a “fatal health condition,” or must be unable to engage in “substantial gainful activity” in order to obtain DI.[6] These ultimately had the effect of expanding rolls for individuals with conditions such as depression, other mental health concerns, and even back pain. Additionally, the expansion of DI can also be attributed to an increase in the number of aging workers, and a sluggish economy in which more individuals are filing for DI. The main problem with current DI Rolls, besides the payout structure addressed below, is that there is no foolproof system for individuals to prove that they are in need of DI benefits.[7]

·      Payouts – The CBO estimates that the DI program has expanded by a factor of 6 from 1970-2007. In 2011, benefits were paid to $8.3 million individuals and expenditures increase by a factor of 9 to $128 billion.

Word Count: 665

---

[1] op.cit., “October 2012, page 9.

[2] Demographers generally predict that life expectancy will continue to rise and that birth rates will remain as they are now, so scheduled outlays are projected to resume their upward trajectory around 2050, reaching

6.6 percent of GDP in 2086. CBO, October 2012, page 9.

[3] Feldstein, Harvard 2013, op.cit., CBO, June 2012, p. 12-26.

[4] Congressional Budget Office, “Trends in Distribution of Household Income Between 1979 and 2009,” October 2011. OASDI “Trustees Report: Summary 2009,” 2009.

[5] op.cit., CBO, October 2012, page 10.

[6] op.cit., Feldstein, Harvard, 2001, 2013.

The Challenges Facing Social Security and the Options for Reform [Part 1/3]

 M  E  M  O  R  A  N  D  U  M

Date: April 29, 2013

To:  The Honorable Max Baucus

        Chairman, U.S Senate Committee on Finance

From: Bledar Blake Zenuni, Econ 1420 Student

Re: The Challenges Facing Social Security and the Options for Reform

         Under current law, the CBO projects that the combined trust funds that make up Social Security—the Old-Age, Survivors, and Disability Insurance (OASDI) trust fund—would be exhausted in 2034. The OASDI is currently facing an increase in the actuarial deficit, with spending expected to reach 6.1% of GDP over the next 75 years while payroll tax revenues level off at 5.2% of GDP. The gap between OASDI spending and payroll tax revenues are mainly driven by (1) an increase in the number of beneficiaries, (2) broken tax laws coupled with an expected decrease in the share of earnings subject to the payroll tax and (3) expanding DI rolls.

The two most cited sets of proposals to reform social security are Diamond-Orszag and Feldstein-Samwick:

           

A.   Diamond-Orszag — A balanced approach: combining increased taxes with benefit reductions.

B.    Feldstein-Samwick: A mixed system: save more now and invest those savings in a productive way (includes privatization).

The U.S. Senate Committee on Finance is advised to support the reform policies of option B because they increase national savings, lower the present value of the cost of providing any level of benefits, and avoid future tax increases. Option A would generate a deadweight loss (loss of economic efficiency) associated with higher marginal taxes, whereas Option B would avoid it.

I.    Social Security Outlays

    

         2010 marked the first year since 1983 that outlays were greater than total revenues for Social Security.[1] In FY 2012, the U.S. spent 22% of its budget on Social Security. Under current law, Social Security outlays will exceed 20% of its revenues by 2030.

II. Projections for OASDI’s Exhaustion Date(s) and OASDI’s Actuarial Balance

OASDI’s Exhaustion Date(s)

         The CBO predicts that under current law the DI trust fund will be exhausted in fiscal year 2016 and the Old-Age and Survivors Insurance (OASI) trust fund will be exhausted in 2038.[2] The common analytic convention is to consider the OASI and DI trust funds as the combined OASDI trust fund. The CBO projects that if some future legislation were to shift resources from the OASI trust fund to the DI trust fund, the OASDI trust fund would be exhausted in 2034.[3]

           

OASDI’s Actuarial Balance

In 2011, OASDI spending and total revenue equaled 4.87% of GDP and 4.69% of GDP, respectively.[4] In this memo, “spending” denotes total outlays (benefits plus administrative costs), and “payroll tax revenue” includes revenue generate from both payroll taxes and income taxes on benefits that are credited to the Social Security trust funds. Table 1 shows the CBO’s projected actuarial balances for Social Security.

Table 1: Financial Measures for Social Security Under CBO’s Long-Term Budget Scenarios

Source: Congressional Budget Office[5]

The actuarial balances for table 1 can be summarized by the following:

·      Under the extended baseline scenario, from 2012-2086 the annual cost rate is projected to be of 6.1% of GDP whereas the annual payroll tax revenues level off at 5.2% of GDP; the actuarial balance (difference) is -0.7% of GDP.[6]

·       Under the extended alternative fiscal scenario, from 2012-2086 the annual cost rate is projected to be 6.1 % of GDP whereas the annual payroll tax revenue is projected to be 5.2% of GDP; the actuarial balance (difference) is -0.9% of GDP.[7]

Moreover, in FY 2012, revenues were $726 billion, or 4.69% of GDP, whereas Social Security outlays were $777 billion (OASI: 82%; DI: 18%), or 4.87% of GDP. In the year of exhaustion, revenues will be 5.06% of GDP, whereas outlays will be 6.19% of GDP.[8]

Word Count: 745

---

[1] Congressional Budget Office, “The 2012 Long-Term Projections for Social Security: Additional Information,” October 2012, Page 3.

[2] Ibid., page 4.

[3] Ibid., page 5.

[4] Ibid., page 9-10.

[5] Congressional Budget Office, “The 2012 Long Term  Budget Outlook,” June 2012, Page 72.

[6] Note: The extended baseline scenario generally adheres closely to current law, following CBO’s 10-year baseline budget projections through 2022 and then extending the baseline concept for the rest of the long-term projection period. CBO, Page 72.

[7] Note: The extended alternative fiscal scenario incorporates the assumptions that certain policies that have been in place for a number of years will be continued and that some provisions of law that might be difficult to sustain for a long period will be modified. CBO, page 72-73.

[8] op.cit., “October 2012, page 6-8.