The Everlasting Problems with Social Security

David Barker, Ph.D

During the 1936 presidential election campaign, one year after the Social Security Act was enacted, Alf Landon, the Republican nominee, predicted the eventual failure of the program. He drew an analogy between Social Security and a father mismanaging the family finances:

“The father of the family is a kindly man, so kindly that he borrows all he can to add to the family’s pleasure. At the same time he impresses upon his sons and daughters the necessity of saving for their old age. Every month they bring 6 percent of their wages to him so that he may act as trustee and invest their savings for their old age. The father decides that the best investment is his own IOU. So every month he puts aside in a box his IOU carefully executed, and, moreover, bearing interest at 3 per cent. And every month he spends the money that his children bring him, partly in meeting his regular expenses, and the rest in various experiments that fascinate him. Years pass, the children grow old, the day comes when they have to open their father’s box. What do they find? Roll after roll of neatly executed IOU’s.”

Landon added that “there is every probability that the cash they pay in will be used for current deficits and new extravagances.” Landon was correct that Social Security surpluses would be used as general government revenue, and that the system would depend on treasury bonds to stay afloat when there were deficits.

During the next presidential election campaign, the first held after Social Security had been implemented, Wendell Willkie, the Republican nominee in 1940, declared that if policy was not changed, “no social security will ever be paid, because this nation will go bankrupt.” The first annual report of the Social Security trust fund, published in 1941, predicted eventual insolvency because the fraction of the population over age 65, then 7%, “may eventually rise to perhaps 14 to 16 percent.” Current Census projections show this ratio reaching 14% in 2012.

In 2010, Social Security expenditures exceeded payroll tax revenue, and at current tax and benefit levels, surpluses are not expected again. Ever. In twenty four years the trust fund – money the federal government owes the Social Security system - is expected to be exhausted. In other words, the disaster foreseen 70 years ago when the program was first implemented is happening right on schedule.

Social Security has run deficits before. Lowering the retirement age for women and extending benefits to new groups during the 1950s led to a shortfall in 1957, which was closed by gradually raising the payroll tax rate from 4% (the total paid by employees and employers) in 1956 to 6% in 1960. Generous indexation of benefits to inflation contributed to another deficit in 1975 which lasted until 1983, when the recommendations of a bipartisan commission were adopted. The retirement age was increased and payroll taxes were gradually raised to 12.4%.

In addition to benefit increases, demographics have contributed to Social Security’s problems. The baby boom of the 1950s quickly turned into the baby bust of the late 1960s and early 1970s. Census Bureau demographers in 1973 expected the birth rate to rebound to the level of the 1950s, but by the late 1970s it was becoming clear that when baby boomers retire, there might not be enough workers to support them. Increases in life expectancy were less of a surprise. Life expectancy after age 65 had already risen by a year from the turn of the 20th century to the time Social Security was enacted. Life expectancy after age 65 for women then increased from 13 years to over 17 years by 1970 and to 19 years by 1990. Gains for women have slowed since then, but the same measure for men, after staying fairly stable from 1950 to 1970, increased from 13 to 16 years between 1970 and 2000. Both men’s and women’s life expectancies after age 65 are expected to continue to increase.

Long term difficulties for Social Security were apparent in 1940, but by the late 1970s the combined effects of generous benefits and unfavorable demographics were becoming difficult to ignore. A book published in 1977 titled “The Crisis in Social Security,” with contributions from many prominent economists, predicted serious problems beginning around the year 2010.

In the past, when long term insolvency of Social Security was predicted, payroll taxes were raised. Since the reforms of the early 1980s, however, even though the demographic time bomb of baby boomer retirement was in plain sight, the payroll tax rate was not raised, and was actually lowered to 10.4% in 2011. Increased political polarization appears to have made it impossible for the parties to agree on significant tax increases or benefit reductions. The only things they can agree on are policies that weaken the program’s finances, such as the payroll tax cut of 2011 and increases to cost of living adjustments enacted in 1986.

From an economist’s point of view, solutions are simple; raise payroll taxes or reduce future benefits below what has been promised. Social Security payroll taxes are now only imposed on the first $110,100 of wages and salaries, while Medicare taxes have no limit. Eliminating the cap would essentially solve Social Security’s short and medium term problems – projections indicate that with this change, the trust fund would last until 2083. Changing the formula for computing initial benefits in a way that would cut benefits to high income beneficiaries by around 24% and low income beneficiaries by 3% would also solve the system’s problems. Some combination of the two might be less harsh than either by itself and could conceivably result in permanent fiscal balance.

If the current political deadlock continues, however, Social Security will eventually be unable to fund promised benefit levels. What might happen? As expenditures exceed revenue, the shortfall would have to be covered by the federal government just like any other program. Congress could refuse to pay, but the concept of the “trust fund” might make such a refusal politically difficult. Social Security has supported the federal government for decades by lending its surpluses, so voters might force the federal government to return the favor. Once the theoretical trust fund is exhausted, however, the argument for subsidy might weaken considerably.

If Social Security is on its own after the trust fund is exhausted, benefits might fluctuate with payroll tax revenue. Congressional Budget Office Projections indicate that by 2035, when workers now in their forties expect to retire, Social Security expenditures will exceed revenues by approximately 20%. Uncertainties in these projections suggest that the shortfall could be as large as 29%, or as small as 10%. Reductions of this magnitude would not cause the elderly to starve, but they would result in a significant reduction in the standard of living of many seniors.

A larger question than fiscal sustainability that is seldom considered is whether Social Security in its current form should be saved at all. The benefit of Social Security is that the elderly and disabled are cushioned from the hardships of poverty. Without Social Security, most of these people would probably find support from relatives, charities, and savings, but some portion of them would likely fall through the cracks. The cost of Social Security is a lower rate of economic growth. If workers know that they must save or starve in retirement, they will save more than they do now. Savings fund investments, and investments in general produce new technologies, buildings and capital equipment that make workers more productive. Over time these improvements result in a higher standard of living for everyone. In addition, higher taxes on every extra dollar earned for workers below the payroll tax cap nudge workers into working less. For some of those who are on the fence about working or not, higher taxes will be the deciding factor. When added to federal and state tax rates, which could total as much as 43% for workers earning amounts under the payroll tax cap if the Bush tax cuts expire, the additional 12.4% in payroll taxes could convince many workers to stay home or cut back on working hours.

Looking far into the future, the drag that Social Security puts on economic growth is substantial. 

Harvard professor Martin Feldstein, former Chairman of the Council of Economic Advisors estimates that doing away with Social Security taxes would raise private savings by 60%. If reduced saving cuts the rate of economic growth even by a fraction of one percent, the wealth effects over decades can be large.

In order to simultaneously provide for the elderly and disabled while promoting saving, the current pay-as-you-go system could be replaced with a fully funded system. In other words, instead of taxing workers to pay retired people, everyone could save and contribute to a fund and interest and dividends from the fund would pay retirees. The problem is how to start such a system. In 1940 there was no giant pool of savings from which to draw interest, so the only way to begin the program with payments to the elderly and those near retirement was to tax workers. No matter when it is done, switching to a fully funded system will require substantial funds.

Not surprisingly, overhauling Social Security has proven to be a very difficult task. Two presidents, Ronald Reagan and George W. Bush, were ideologically committed to major changes in Social Security, but their plans died in Congress. During Barry Goldwater’s 1964 presidential campaign, Reagan, criticizing “the schemes of the do-gooders,” suggested that the left had used Social Security as part of a bait-and-switch tactic to socialize America. The program, he said, had been sold as a modest insurance plan to protect widows, the disabled, and the elderly from destitution, but had expanded into a gigantic welfare program. The program’s revenues, sold as insurance premiums, were simply another “tax for the general use of the government.” Reagan suggested at that time that those in Social Security should have greater control over their individual accounts, and that others should be allowed to opt out of the program, saying “can't we introduce voluntary features that would permit a citizen who can do better on his own to be excused upon presentation of evidence that he had made provision for the non-earning years?” In his 1976 run for the presidency, Reagan made similar proposals, but in 1980 he denied having supported making Social Security voluntary: “I suggested that if this is an insurance program, certainly the person who's paying in should be able to name his own beneficiaries. And that's the closest I've ever come to anything voluntary with social security.”

Early in Reagan’s presidency, he proposed significant cuts in Social Security benefits. People retiring at 62 would receive only 55% of full benefits, instead of the 80% early retirees received at the time (today, those retiring at age 62 receive 70% of full benefits). Eligibility for disability payments was to be tightened, and aid to students with retired parents was to be reduced. Tip O’Neill said of the proposal, “I’m not talking about politics. I’m talking about decency. It is a rotten thing to do. It is a despicable thing.” The Senate voted 96-0 against the proposal. Reagan ended up supporting much smaller cuts combined with a tax increase that mostly preserved Social Security in its current state. A later proposal to freeze cost of living adjustments barely passed in the Senate, failed in the House, and is believed to have been a major reason why Republicans lost control of the Senate in 1986.

The strength and bipartisan nature of support for partial privatization of Social Security during the Clinton administration is now hard to believe. The stock market boom of the 1990s convinced many that the program’s biggest problem was that it was failing to capitalize on rising stock prices. The budget surplus of the federal government was available to fund the conversion of Social Security from a pay-as-you-go to a fully funded system. In 1997 President Clinton and House Speaker Newt Gingrich negotiated a secret deal, detailed in the book “The Pact” by Steven Gillon, which would have simultaneously funded benefits for retirees and diverted federal money into private accounts for younger workers, eventually resulting in a regulated, but privatized retirement system. The agreement fell apart because of the Monica Lewinsky scandal. Clinton could no longer ignore the left wing of his party since he needed them to avoid impeachment. The prospects for a deal supported by a bipartisan coalition of centrists faded.

George W. Bush voiced support for partial privatization during his first term, and immediately after being reelected, he made Social Security reform his top priority. With budget surpluses a thing of the past, however, and with Congress far more polarized than it had been less than a decade earlier because of war, recession, and a disputed election, the effort failed. The episode contributed to the Republican loss of control of Congress in 2006. Bush’s main contribution to entitlement policy ended up being a major expansion of Medicare. Bush’s program, Medicare Part D, is now estimated to be over $7 trillion in the red.

The efforts of presidents Reagan, Clinton, and Bush demonstrate that Social Security reform is probably best attempted during a second presidential term. Reagan quickly gave up on reform during his first term when it proved unpopular, but managed to enact more modest reforms during his second term. Clinton would not have taken the risk of allying with Gingrich on such a major issue during his first term. Bush’s failure, if it had occurred during his first term, probably would have cost him reelection. These examples suggest that a Romney victory in 2012 would mean postponing reform for at least four years.

Romney has been quite clear in the 2012 campaign that he would not raise payroll taxes, although he would reverse the temporary cut enacted in 2011 and extended into 2012. In responding to Rick Perry’s attacks on Social Security, Romney also made clear his support for maintaining Social Security as a federal program without any cuts in benefits for those who are 55 years of age or older. In his book, “No Apology: The Case for American Greatness,” Romney echoes many of the points made by Ronald Reagan during the 1960s; that Social Security has grown far beyond the original intent of the program, and that past surpluses have been spent on other government programs instead of being saved and invested to pay future benefits. He does not, however, advocate significant cuts in benefits or a major overhaul of the system. The 2008 stock market crash, he says, suggests that individual accounts should be added to the Social Security program, not substituted for it, and that they should be voluntary.

Romney supports smaller changes that would save money, such as gradually raising the retirement age, and changing the index used to compute initial benefits. Such changes, however, are certain to be strenuously opposed by liberal groups. Given the past history of presidential failure on the issue, Romney’s strong support for maintaining Social Security on the campaign trail, and the fact that there will be more difficult problems, such as Medicare, for him to deal with, a solution to Social Security’s problems seems unlikely in the next four years if Romney is elected. A reelected Romney in 2016 would probably not want to repeat George W. Bush’s mistake of spending much of his accumulated political capital on a major reform of Social Security, but he might be willing to go along with the recommendations of a bipartisan commission that recommended smaller changes.

Oddly enough, the future seems more difficult to predict if Obama is reelected. Obama ran on a platform of finding bipartisan solutions to long term problems, but instead polarization has increased, and his signature legislative accomplishments were passed by party-line votes. Judging by his campaign rhetoric so far in 2012, the election may further polarize the country. The question is whether Obama initially believed in bipartisanship but was forced by political reality into governing from a narrow base, or whether he was always strictly partisan, and only promised compromise to get elected. We have no way of knowing the answer to that question. If Obama is faced with a Republican Congress, he might try to do what Clinton planned to do before scandal upset his plans and completely overhaul the entitlement programs with bipartisan majorities. On the other hand, he and congressional Republicans might continue the fight and accomplish nothing. Obama and a Democratic Congress would likely not have a filibuster-proof majority in the Senate, and would probably face a Republican minority unwilling to compromise on anything.

The problems of Social Security are trivial compared to those of Medicare and the rest of the federal government. Eliminating the cap on payroll taxes, raising the retirement age, making cost of living adjustments less generous, indexing initial benefits to prices instead of wages, and cutting benefits for wealthier recipients could easily put the program on a firm financial foundation. Political realities, however, make even these changes unlikely. The system’s problems have been known for decades, yet little has been done. If anything, the political situation is worse than it was during past attempts at reform. It is sobering to consider that if the odds of solving such an easy problem are so low, the odds of solving the hard problems are probably even lower.

Social Security is not in danger of collapsing, but if changes are not made, significant benefit reductions will occur within the lifetimes of people who are currently middle-aged. If changes are made, they will either involve benefit reductions or adding to the already heavy burden of taxation. Social Security is not the biggest problem faced by the federal government, but it illustrates the overarching problem of our time: we overestimated our wealth and overpromised benefits, sooner or later some groups will pay for this mistake with a lower standard of living than they expected.