Part XII

Welcome back! It has been a while. I added a new tax deduction to my family and I have had little free time. But I am eager to finish what I started. Today I am going to take a look at what Social Security reform would do for the budget. This topic is being widely discussed across the country, which is good, but it is also widely misunderstood, which is not so good. Before we start let me clear up some common misconceptions.

 Social Security is going bankrupt.

 This is completely false. Social Security is funded by a special payroll tax. You can look on your paystub and see it. Congress is required to spend this tax revenue on Social Security and only on Social Security. After the government pays all its Social Security obligations if there is any money left over is goes in the Social Security trust fund. In 2010 the government had a surplus in Social Security tax revenue, or in other words more was collected in Social Security payroll taxes then the government had to pay out. In fact Social Security has had a surplus every year since 1982 and the trust has grown to $2,608 billion.

Social Security won’t exist in 30 or 40 more years.

 This one is mostly false but there is a kernel of truth to it. According to the Social Security Agency projections, in the next few years the revenue from Social Security payroll taxes will not be able to cover the costs of the Social Security program. At that point we will need to start drawing on trust fund instead of putting into it, and according to the Social Security Administration current estimations the Social Security trust fund will run out in about 30 to 50 years. Now that does not mean that Social Security payments will stop, it just means that the short fall can no longer be made up by the drawing on the trust fund. So in 2061 if there is a 5% short fall that would mean that either Social Security payments would have to be cut by 5% that year or taxes would need to go up to make up the difference but it is not like the checks would just stop going out.

You might be wondering if Social Security is not going anywhere, then what it all the worrying about? The problem is Social Security will get more and more expensive over the next several decades we don’t how we are going to pay for it in the long term.

So why is Social Security getting more expensive? It is because our country’s average citizen is getting older so we have less people working (paying into Social Security) and more people are retired (drawing out of Social Security). In 1999 5.3% of the population was over 65 years old. In 2009 13.9% of the population was over 65 years old. This number is expected to rise even more over the next few decades as the baby boomers retire and people’s life expectancy increase.

So what do we do? We have to reform Social Security policy so it can function in the long term, even with an aging population.

 There are three schools of thought on how to reform Social Security

1. Privatize the trust fund

The idea behind this reform is that instead of putting the surplus from Social Security taxes into in the Social Security trust fund to buy securities, the government would use it to buy private stocks. The benefit of this is that investing in stocks generally has a much higher rate of return then securities (A decent return on a security is 5% over anywhere from 5 to 30 years, a good stock portfolio can grow about to 7% to 8% in a single good year).

What is good about it:

We could generate a lot more revenue for Social Security without raising taxes. In 2010 the Social Security trust fund produced 118 billion in interest (or about a 4.5% rate of return). The S&P 500 (an index of important American stocks) grew by 11.2%, so if Social Security trust had been moved to the private market on December 31, 2009 it would have generated by $292 billion. In other word Social Security would have generated $174 billion more without raising taxes by a single penny.

What is bad about it:

Social Security invests in securities because it is stable and extremely safe. If the government invested in the private market there would be no guarantee that the market would grow and there would be a very really possibility that the stock market could go down and the government would lose money. If the Social Security trust fund had been invested in the private market in 2008, when the market crashed, it would have shrunk by 38.5% that means that not only would have the trust fund produced no interest that year, the trust fund would have lost $1,340 billion! That is the equivalent of losing all the surplus revenue from Social Security from the year to 2000 to the date of the crash, or in other words 8 years of savings down the drain. So there is a chance that privatizing the trust fund could make things much worse.

2. Increase the retirement age

What is good about it:

Is would reduces the cost of Social Security because it would reduce the amount of time that a person would be receiving benefits and increase the amount of time that people would work (and pay taxes into Social Security). To calculate how much money would be saved you can look at Social Security's most recent demographic data. In December 2009 there were 33,514,000 people receiving Social Security retirement benefits. Out of these 12,227,000 are under the age of 70. The average monthly benefit for a retiree under 70 is $1,122.15 a month. If we had risen the retirement age to 70 in 2010 it would cut the cost of Social Security by about $13.7 billion. As for how much more would be generated in taxes. If we take the median annual salary for people over the age of 65 in 2009, which was $28,952* and use that as our yard stick for how much taxable income this group could make. That means the amount that the current retirees under 70 would be contributing in taxes to Social Security would be about $15.9 billion.

*It is worth noting that annual salary for people over the age of 65 is a little hard to figure. It is true that the median annual salary was $28,952, but that includes people on Social Security. So it is hard to say whether that number would be higher or lower if people would have to wait to 70 to get benefits. On the one hand the age group of 55-64 make considerably more ($41,269 annually) so it is debatable how much of that drop is due to people who choose to quite working because the can receive Social Security and how much is due to a people physical needed to retire.

What is bad about it:

For most people there is a noticeable difference in physical ability from 65 years old and 70 years old. Odds are many of the people who would be no longer be on Social Security and those who would have to wait longer to get on Social Security would become physical unable to work before turning 70. Especially people whose education or work experience would limit them to physically demanding jobs. So inevitably there would be an upswing in people who would file for disability insurance (so not solving the problem). Additionally, it is hard to know how much more money would be generated in taxes because if we raised the retirement age. Because people could just stop working at an earlier age and live off of savings or a pension until Social Security to kicks in when they turn 70. So the savings of $13.7 billion and extra revenue of $15.9 billion might be overly optimistic.

3. Lift the cap on taxes for Social Security

Social Security is funded by a payroll tax. You pay 6.2% of your income to Social Security and your employer pays the equivalent of 6.2% or your salary (if your are self employed you pay the whole 12.4% yourself). But there is a catch; you only pay Social Security taxes on the first $106,800 you make annually. So you can never pay more than $6621.60 in Social Security taxes a year ($13,243.20 if you are self-employed). So whether you make $106,801 or $10 billion a year you will never pay more than $13,243.20 a year (though they do adjust the cap for inflation from time to time). So if you lifted the payroll tax cap you would have to pay your 6.2% on your whole income and not just the first $106,800.

What is good about it:

It would raise a lot more money. As you may recall from Part VII the vast majority of money made in the country is made by people who make more than $200,000 a year. So most of the money being made in the county is not taxed for Social Security. So how much more revenue would be raised if they lifted the cap? Considering that in 2010 there was $7,991 billion paid to employees in the US and self employed individuals made another $1,055 billion. If we taxed the total amount at the current rate without an income cap it would gross about $1,121 billion, or about $256 billion more than was actually raised in 2010.

What is bad about it about it:

 Given the current way the Social Security calculates how much a person gets in retirement benefits, the tax cap is taken into account. To actually raise revenue we would need to eliminate the cap on the tax and keep the cap on benefits. This would mean that the Social Security benefits would be capped at about $2,366 per month (how much you would receive if you made more than $106,800 every year for 35 years. That means that a small group of Americans who make more than the cap (about 12% to 13%) would have a lower benefit to tax ratio than the rest of the country, which essentially means that they are paying more for the same level of benefits.

So which one should we do to help balance the budget?

Well, since Social Security was solvent in 2010 (it collected more in revenue that it paid in benefits) none of these plans would have much of an immediate effect (though they would help save us from a long term budget crisis 30 or 40 years from now. With that said let’s revisit each plan and see what these plans would do.

Plan number one, the plan to privatize the Social Security trust fund would be the cheapest as it would not require any tax increases and would no doubt help the economy because of the increased investment. But, there are a couple of hiccups. First we cannot just transfer the whole trust fund to the private market at once. It would have to be done gradually as the existing securities mature, so there would not be much of an immediate effect. Secondly there is no guarantee that the markets will perform well enough to cover the rising expenses of Social Security as the baby boomers retire. So it is a more risky choice.

Plan two is probably the least effective as it would push many people from receiving on form of Social Security to another and even if that was not the case would not save enough money to make much of a difference.

Plan three, eliminating the tax cap, would raise the most money, about $256 billion more a year. This would not do anything in the short-term because all the extra money would go into the Social Security trust fund. But in the long term, the Social Security trust fund would larger, so it would produce more interest and last longer. Maybe even long enough to ride out the Baby Boomers retiring, and that way Social Security may never add to the debt.

The Verdict:

None of these plans would reduce the deficit in the short term. But in the long term lifting the cap of taxable income for Social Security would be the most likely plan to raise enough money for Social Security to make a significant difference.