PPA 419 – Aging Service Administration Lecture 4b – Social Security Reform

Commission to Strengthen Social Security Reform Plans  Reform Model 1 establishes a voluntary personal account option but does not specify other changes in Social Security’s benefit and revenue structure to achieve full long-term sustainability.  Workers can voluntarily invest 2 percent of their taxable wages in a personal account.  In exchange, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 3.5 percent above inflation.  No other changes are made to traditional Social Security.  Expected benefits to retirees rise while the annual cash deficit of Social Security falls by the end of the valuation period.  Workers, retirees, and taxpayers continue to face uncertainty because a large financing gap remains requiring future benefit changes or substantial new revenues.  Additional revenues are needed to keep the trust fund solvent starting in the 2030s.

Commission to Strengthen Social Security Reform Plans  Reform Model 2 enables future retirees to receive Social Security benefits that are at least as great as today’s retirees, even after adjusting for inflation, and increases Social Security benefits paid to low-income workers. Model 2 establishes a voluntary personal account without raising taxes or requiring additional worker contributions. It achieves solvency and balances Social Security revenues and costs.  Workers can voluntarily redirect 4 percent of their payroll taxes up to $1000 annually to a personal account (the maximum contribution is indexed annually to wage growth). No additional contribution from the worker would be required.  In exchange for the account, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 2 percent above inflation.  Workers opting for personal accounts can reasonably expect combined benefits greater than those paid to current retirees; greater than those paid to workers without accounts; and greater than the future benefits payable under the current system should it not be reformed.  The plan makes Social Security more progressive by establishing a minimum benefit payable to 30-year minimum wage workers of 120 percent of the poverty line. Additional protections against poverty are provided for survivors as well.

Commission to Strengthen Social Security Reform Plans  Reform Model 2 enables future retirees to receive Social Security benefits that are at least as great as today’s retirees, even after adjusting for inflation, and increases Social Security benefits paid to low-income workers. Model 2 establishes a voluntary personal account without raising taxes or requiring additional worker contributions. It achieves solvency and balances Social Security revenues and costs.  Workers can voluntarily redirect 4 percent of their payroll taxes up to $1000 annually to a personal account (the Benefits under the traditional component of Social Security would be price indexed, beginning in  Expected benefits payable to a medium earner choosing a personal account and retiring in 2052 would be 59 percent above benefits currently paid to today’s retirees. At the end of the75-year valuation period, the personal account system would hold $12.3 trillion (in today’s dollars; $1.3 trillion in present value), much of which would be new saving. This accomplishment would need neither increased taxes nor increased worker contributions over the long term.  Temporary transfers from general revenue would be needed to keep the Trust Fund solvent between 2025 and  This model achieves a positive system cash flow at the end of the 75-year valuation period under all participation rates.

Commission to Strengthen Social Security Reform Plans  Reform Model 3 establishes a voluntary personal account option that generally enables workers to reach or exceed current-law scheduled benefits and wage replacement ratios. It achieves solvency by adding revenues and by slowing benefit growth less than price indexing.  Personal accounts are created by a match of part of the payroll tax – 2.5 percent up to $1000 annually (indexed annually for wage growth) – for any worker who contributes an additional 1 percent of wages subject to Social Security payroll taxes.  The add-on contribution is partially subsidized for workers in a progressive manner by a refundable tax credit.  In exchange, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 2.5 percent above inflation.  The plan makes the traditional Social Security system more progressive by establishing a minimum benefit payable to 30-year minimum wage workers of 100 percent of the poverty line (111 percent for a 40-year worker). This minimum benefit would be indexed to wage growth. Additional protections against poverty are provided for survivors as well.

Commission to Strengthen Social Security Reform Plans  Reform Model 3 establishes a voluntary personal account option that generally enables workers to reach or exceed current-law scheduled benefits and wage replacement ratios. It achieves solvency by adding revenues and by slowing benefit growth less than price indexing.  Benefits under the traditional component of Social Security would be modified by:  adjusting the growth rate in benefits for actual future changes in life expectancy,  increasing work incentives by decreasing the benefits for early retirement and increasing the benefits for late retirement, and  flattening out the benefit formula (reducing the third bend point factor from 15 to 10 percent).  Benefits payable to workers who opt for personal accounts would be expected to exceed scheduled benefit levels and current replacement rates.  Benefits payable to workers who do not opt for personal accounts would be over 50 percent higher than those currently paid to today’s retirees.  New sources of dedicated revenue are added in the equivalent amount of 0.6 percent of payroll over the 75-year period, and continuing thereafter.  Additional temporary transfers from general revenues would be needed to keep the Trust Fund solvent between 2034 and 2063.

Source  Christopher J. Niggle, “The Political Economy of Social Security Reform Proposals.” Journal of Economic Issues 34:

Introduction  Various interest groups and the executive branch of the U.S. government have proposed fundamental changes in the structure of the U.S. Social Security System.  Most changes have involved privatization  Justified by projected deficits in SS budget and low projected rates of return for current and future recipients.

Introduction  Niggle makes several arguments.  The probability of an important SS budget is very low.  It is very possible that the system as currently configures will run surpluses rather than deficits in the future.  The privatization schemes will not likely raise the rate of return.

Introduction  Niggle (contd.)  The privatization schemes would probably increase inequality, aged poverty, financial insecurity, and macroeconomic financial instability.  The privatization schemes will not raise the aggregate rates of saving or investment and may reduce them.

Social Security Finance and Budget Projections  Benefits are financed by taxes.  6.2% of both employer and employee income up to $87,900 in  As a result, tax system is regressive.  Benefits are progressive.  Benefits decline as a proportion of income.  Benefits go to disabled, spouses, dependents.  Overall effect to reduce income inequality.

Social Security Finance and Budget Projections  Original funding system “pay as you go.” Benefits matched outlays.  Since 1983, prefunding  Source of surpluses.  Surpluses in asset portfolio consisting of nonmarketable U.S. Treasury securities.  Government borrows surplus and pays interest in the form of bonds (at 5.9%).  In the future, the interest will allow the system to finance future deficits.

Social Security Finance and Budget Projections  Projected deficits results of assumptions  Demographic projections, labor force participation, unemployment, labor productivity, real wage growth, price inflation, growth in national income.  Council’s assumptions may be overly pessimistic.  Low cost scenario produces surpluses for near future. Intermediate and high project deficits starting in  Assume more labor force growth, but not as much as 20 th century. Assume 4.5 unemployment rate (lower than council’s). Assume growth in GDP and productivity at their historic rates (not low like council). Result: Surplus of $9B in 2030.

Financial versus Real Burdens in Pension Systems and Prefunding  Real burden of supporting pension recipients is goods and services they receive currently.  Financial burden transfers money payments from taxpayers to recipients.

Financial versus Real Burdens in Pension Systems and Prefunding  If pension system prefunded, some taxes may be exchanged for other financial instruments and future income streams used to finance future benefits.  Current surpluses burden only future consumption by workers. Neither current system nor proposed privatization will increase capital formation.  Total dependency ratio likely to fall or stay the same.

Privatization Proposals  Reasons  Funding crisis (false)  Low rate of return (false)  Pure privatization cannot guarantee past returns in stock market  Management fees and privatization costs make system expensive (Chile).

Privatization, Saving, Investment, Economic Growth  Argument: Privatization will lead to higher rates of saving, investment, productivity, and GDP growth.  Not likely.

Alternatives to Privatization  Slight Change  Raise taxes, eliminate cap on income.  Major Change  Return Social Security to PAYGO system with slight reserves.  Finance out of general revenue.  Index benefits to growth in real wages.

Political Economy of Reform Proposals  No funding crisis. Minor adjustments would fix problem.  Privatization would not improve collective living standards.  Reform would benefit:  Firms in financial system that manage portfolios.  High income earners  Current shareholders.