Category Archives: Fiscal Issues

Mitt Romney’s Economic Policy Address: Full of Factual Errors

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On March 19, Mitt Romney presented at the University of Chicago a (mercifully short) policy address that laid out his criticisms of Obama’s economic policies (see here for a transcript).  The primary theme was that under Obama, high taxes and an overbearing regulatory burden have stifled “economic freedom” and that “The Obama administration’s assault on our economic freedom is the principal reason why the recovery has been so tepid”.

Romney’s address is interesting as it illustrates well how even such carefully prepared addresses in the current Republican campaign have been replete with factual errors.  A listener to such presentations will normally presume that the speaker will have gotten their facts right, and they will distinguish factual statements with statements of opinion.  The listners may or may not agree with the opinions, but they will normally give the speaker the benefit of the doubt on factual statements.  Unfortunately, political discourse in this Republican campaign has degenerated to the point where numerous statements, carefully prepared and presented as fact, are simply not true.  But by repetition, it is not surprising that many in the American public have become confused into thinking such statements are true when they are factually wrong.

Perhaps the most basic and glaring of the factual inaccuracies in Romney’s speech (and a cornerstone of his argument in the speech) is his statements that taxes (and tax rates) have risen under Obama.  But federal taxes have been repeatedly cut under Obama, at a total cost to the budget of close to $1.5 trillion (as estimated by the bipartisan Committee for a Responsible Federal Budget):

Tax Cuts Signed Into Law by Obama
Date Signed Amount ($b)
A.  Tax Provisions in 2009 Stimulus Package 2/17/09 $420.0
B.  2010 Tax Cut Package 12/17/10 $880.9
C.  2012 Payroll Tax Cut Extension 12/23/11 and 2/22/12 $115.5
D.  Other – Various Dates in 2009 and 2010 various $64.2
TOTAL $1,480.6

$1.5 trillion in tax cuts is not small, and one would think hard to ignore, yet Romney asserts that big tax increases under Obama have stifled the recovery.  And in addition to the $1.5 trillion in tax cuts, there has not been a single tax increase under Obama.

In large part because of these policy actions cutting taxes, federal government revenue during the Obama presidency has been the lowest of any presidency since 1950.  Between 1951 and 2008, government revenues varied between a low of 16.1% of GDP and a high of 20.6%, and averaged 18.0%.  Revenues were 17.6% of GDP in 2008, the last year of Bush.  During Obama’s term, the share was 15.1%, 15.1%, 15.4% and a projected 15.8% for 2009 to 2012, respectively.  Yet Romney condemns increases in taxes as stifling the recovery.  It would be more accurate to say that major cuts in taxes have not led to a strong recovery.

It may well be the case that Obama would have preferred a better balance in the extensive tax cuts, and it is true that Obama has proposed selected tax increases (e.g. on those making more than $250,000, and a minimum tax rate on those making more than $1 million a year).  But these have not been enacted.  Yet Romney asserts that as a result of Obama, businessmen are facing a higher tax (as well as regulatory) burden, and that “those taxes and costs add up.  Businesses shut down.  Jobs disappear.  Entrepreneurs decide it’s too risky and too costly to invest and to hire.”

The other half of the Romney assertion (in addition to big tax increases), is that Obama has burdened businesses with stifling regulations.  Yet as has been noted before in this blog, productivity growth has in fact been quite strong during the Obama term.  Stifling regulations would have hurt productivity, yet multifactor productivity rose in 2010 by more than it had in any other single year since the data series began in 1987 (see here); labor productivity has increased in the current recovery at a pace similar to the highest it has in any recovery in the past four decades in the US (see here); and the increase in labor productivity under Obama while wages have been flat have in fact led to a sharp rise in profits of American businesses (see here).  None of this is consistent with Romney’s assertion that burdensome regulations under Obama have held back businesses.  Rather, businesses are not producing and employing more because there is not a demand for what they can produce (and profitably produce; see here).  And demand has been deficient in large part due to the reduction (not increase, as Romney asserts) in government demand (see here).

Romney supports his assertion that overbearing regulations under Obama have led to the slow recovery simply through several anecdotes.  But his choices of anecdotes are interesting, as the specific ones cited stem from cases that arose during the Bush administration.  Specifically, he asserts that over-reaching regulators “would have banned Thomas Edison’s light bulb”.  And then immediately says “Oh yeah, Obama’s regulators actually did just that.”  But actually, Obama’s regulators are enforcing a law passed and signed by Bush in 2007.  I assume that Romney would have complained even more loudly if Obama had chosen to ignore a law that is on the books, despite his constitutional requirement to enforce the laws.

Another example is of a case where the EPA was enforcing a law against development of land in a wetlands area, with Romney saying the regulators would not even allow the individuals to pursue a case in court against it.  But the Supreme Court in fact issued a decision on the case the same week as Romney’s speech in Chicago.  And most relevant is that the EPA originally moved to protect this wetland in 2005, in the first year of Bush’s second term.  This was not a case brought under Obama.  But Romney did not blame over-zealous regulators under a Republican administration.

Romney also makes the claim that the federal government has exploded under Obama, with 140,000 new federal employees hired.  But the figures on federal government employment issued by the Bureau of Labor Statistics (as part of their statistics on employment in all of the main sectors) shows that federal government employment only rose by about 30,000 between January 2009 and February 2012 (a total increase of 0.9% over a period of more than three years, or 0.3% per year).  Furthermore, if one excludes an increase of 60,000 in civilian Defense Department workers, federal government employment in fact fell by 30,000 over this period.  It appears that Romney is quoting a figure on federal employment that excludes US Postal workers, even though the official statistics of the BLS includes them.  Even if one makes this selective choice of what statistics to cite, an increase of 140,000 federal workers (excluding postal workers), is an increase at a rate of only 2.2% per year.  This is not an explosion.  And Romney ignores the sharp reductions of state and local government workers in recent years.  Total government workers (state and local, as well as federal) have fallen by 580,000 over this period, contributing directly to a substantial share of the unemployed.

Romney also criticizes Obama on some more substantive points, on which differences of opinion are fair.  Specifically, he criticizes the Dodd-Frank bill that changes regulation of the financial sector, which Obama signed into law, and he criticizes changes in regulation of oil and gas drilling in the Gulf of Mexico.  On matters such as these, there can be substantive differences, and political campaigns should center on such issues.  However, I would have thought it would be clear that after the biggest financial meltdown in US history, caused by absence of regulation to control the risks that built up in the financial system in the housing bubble, that better and smarter financial regulation was needed.  And after the Deepwater Horizon off-shore oil platform blew up in 2010, with loss of life and almost 5 million barrels of oil released to the sea, that better regulation of such drilling activities was needed.  Romney and other political figures may disagree, but that is what elections are for.

Recovering from the Recession: Fiscal Drag Can Explain the Slow Recovery

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I.  Introduction

Economic recovery from the 2008 financial collapse and economic downturn has been slow, with unemployment still high in 2012.  Republican political officials, whether the presidential candidates or the Republican leaders in Congress, have charged that this has been due to an unprecedented explosion in government spending during the Obama administration, and that the way to a fast recovery would be to slash drastically that government spending.  Senator Mitch McConnell, the Republican Leader in the Senate, for example, has repeatedly harped on what he has called the “failed stimulus package” of Obama, and has successfully blocked any effort to extend any fiscal stimulus to address the continued weak state of the recovery.

They point to the recovery during the Reagan years from the downturn that began in July 1981.  This was the sharpest downturn the US had suffered until then since the Great Depression, and the Republicans point to the subsequent recovery as an example of how (they assert) cutting back on government spending will lead to a strong recovery.  Unemployment reached a peak of 10.8% in the Reagan downturn in late 1982, surpassing even the peak of 10.0% reached in the current downturn.  But the unemployment rate then fell to 7.2% by election day in November 1984, and Reagan was re-elected in a landslide.

Recovery from the 2008 downturn has indeed been slow.  But it is simply false to say that fiscal spending has exploded during the Obama years, while it was contained during the Reagan years.  In fact, it was the exact opposite.  Understanding begins with getting the facts right.  And once one does, one sees that fiscal drag can fully explain the slow recovery from the 2008 downturn, while the recovery during the Reagan years was helped by the largest expansion of fiscal spending in any downturn of at least the last four decades.

II.  The Path of Real GDP

Start with the path of real GDP at each of the downturns since the 1970s (with the data here and below from the Bureau of Economic Analysis of the US Department of Commerce):

The graph shows the path of real GDP in the three years (12 quarters) before each business cycle peak since the 1970s (as dated by the NBER, the recognized entity that does this for the US), to four years (16 quarters) after the peak.  Recessions start from the business cycle peaks, with negative growth then for varying periods (of between 6 months and 18 months in the recessions tracked here) before the economy starts to grow again.  Six recessions have been called by the NBER in the US over the last four decades.  The NBER stresses that it concludes whether or not the economy went into recession based on a wide range of indicators, and not simply real GDP decline, but generally, negative GDP growth of two quarters or more is commonly associated with a recession.

As the graph shows, the downturn that followed the business cycle peak of December 2007 was the largest of any of those tracked here, with most of the decline occurring in 2008, before Obama took office, and in the first quarter of 2009, when Obama was inaugurated.  The economy stabilized quickly under Obama, and then recovered but only slowly.  By 16 quarters after the quarter of the business cycle peak (i.e. by the fourth quarter of 2011, the most recent period for which we have data), real GDP was barely above where it had been at the peak.  This was the worst performance for GDP of any downturn of those tracked here, and indeed the worst since the Great Depression (other than the fall in output after 1945, which is a special case).

The recession that began in July 1981 (shown in green in the figure) at first followed a strongly negative path, but after five quarters began to recover.  The economy then recovered faster than in any other US downturn of the last four decades, and by 16 quarters out, real GDP was over 14% above where it had been at the pre-recession peak. Republican officials argue that government cut-backs under Reagan account for this strong recovery.

III.  The Path of Government Spending

But what was in fact the path of government spending?  There are a couple of different measures of government expenditures one can use, but they tell similar stories.  First, one can look at direct government expenditures, for either consumption or investment.  This is the concept of government spending which enters directly as one component of demand in the GDP accounts:

In the downturn following the December 2007 peak, government expenditures rose in the first six quarters following the business cycle peak in the middle of the range seen in the other downturns.  But then it flattened out, and then it fell.  By the 16th quarter following the peak, real government spending was barely (less than 1%) above where it had been at the business cycle peak, four years before, and was the lowest for any of the six downturns of the last four decades (although close to that following the 1990 downturn, which was then into the Clinton years).  In contrast, government spending in the 1980s, during the Reagan years, continued to grow rapidly, so that by 16 quarters out it was almost 19% above where it had been four years earlier.  This growth in government spending during the Reagan period was by far the most rapid growth in such spending seen in any of the downturns.  Government spending growth following the March 2001 business cycle peak (i.e. during the Bush II years) was second highest after Reagan, but only a bit over 10% higher rather than 19% higher.

If one believes in the Republican assertions that fiscal spending will restrain growth and that fiscal cuts in periods of high unemployment will spur growth, then one would have seen slow growth during the Reagan period and rapid growth during the Obama period.  In fact, one saw the opposite.  Fiscal austerity is bad for growth, while fiscal expansion when the economy is in recession will spur growth.

It should be noted that government spending considered here is total government spending, at the state and local level as well as federal.  State and local spending is on the order of 60% of the total in recent years.  The cut-backs in recent years in total government spending has been driven by cut-backs in spending at the state and local levels, many of whom have followed conservative fiscal policy either by statute (balanced budget requirements when revenues are falling) or by choice.  In the four years following the December 2007 cyclical peak, state and local spending indeed fell by 6%.  This was offset to a degree by growth of 13% in spending at the federal level (of which 8.8% occurred in the last year of the Bush administration, while 4.1% total occurred over the three years of the Obama administration).  A similar breakdown during the Reagan years following the July 1981 downturn shows that state and local government spending rose by a total of 13.6% in the four years, while federal spending under Reagan rose by a total of 25.4% in those four years, for overall growth in government spending of 19%.  This large increase in federal spending does not support the common assertion that Reagan followed a policy of small government.  Federal spending grew almost twice as fast under Reagan as it did in the Bush II / Obama period following the 2008 downturn.

We therefore find that government spending on consumption and investment grew sharply during the Reagan years following the July 1981 downturn, more than in any other downturn in the US over the last four decades, and that the economy then recovered well.  In contrast, overall government spending (including state and local) was flat in the most recent downturn (rising at first in the last year of the Bush administration, but then flattening out and then falling), and the recovery has been weak.

It could be argued, however, that the government accounts that appear as a component of GDP (as direct consumption or investment of goods or services) do not capture the full influence of government spending on the economy, as it leaves out transfers.  Transfers include amounts distributed under Social Security, Medicare, unemployment insurance, and similar programs, which are indeed a significant component of government expenditures.  The purchases of good or services (or the amounts saved) are then undertaken by households, where it will appear in the GDP accounts.  But including transfers in the total for government spending will not change the story:

One again sees government spending increasing over the initial periods in each of the six downturns tracked, including that following the December 2007 peak.  This continues into the first complete quarter during the Obama administration, after which it flattens out and then falls.  By quarter 16, government spending including transfers in the Obama period is tied for the smallest growth seen in any of the six downturns (all at about 9% higher), along with that following the 1990 and 2001 downturns.  Once again, sharply higher growth is seen following the 1981 downturn, with total government spending including transfers was 21% higher after four years in this Reagan period.

By either measure of government spending, therefore, with or without transfers, government spending rose rapidly during the Reagan period while it flattened out and then fell during the Obama term.  This has produced a strong fiscal drag which has harmed the recovery.  In contrast, strong growth in government spending during the Reagan period was associated with strong GDP growth.

IV.  The Path of Residential Investment

There will, of course, be many other things operating on the economy at any given time, so it would be too simplistic to assign all blame or credit for GDP recovery on government spending alone.  Government spending is powerful, and does have a major impact on growth, but there are other things going on at the same time.  In the most recent downturn, the most significant other factor affecting aggregate demand for output has been residential investment.

Residential investment had risen sharply during the Bush II presidency, as has been discussed previously in this blog (see here).  The housing bubble then burst after reaching a peak in prices in early 2006 (see here), housing construction fell to levels not seen in decades, and such construction remains stagnant.

The collapse in residential investment seen in the most recent downturn in unprecedented.  While residential investment has typically fallen at the start of the downturn (and indeed was often already falling before the start of the overall economic downturn), the falls had never been so sharp and extended as now.  Four years since the business cycle peak in December 2007 (and six years since the peak in residential investment), residential investment remains weak, with no sign yet of recovery.  There are two reasons:  1)  The housing bubble reaching a peak in 2005/06 was unprecedented in size in the past half century, with residential investment reaching 6.3% of GDP in the fourth quarter of 2005, and then collapsing to just 2.2% of GDP in 2010/11; and 2) The downturn that started after the overall GDP peak in December 2007 was fundamentally caused by this bursting of the housing bubble, which led to mortgage delinquencies, financial stress in the financial institutions who held such mortgages, and then to collapse of the financial system.

V.  The Impact on GDP Recovery of the Fiscal Drag and of Housing

Finally, it is of interest to see what the impacts on GDP recovery might have been, had there not been the fiscal drag seen in recent years, or if residential investment had followed a different path.  There are many counterfactuals one could envision, but of particular interest would be the path of government spending seen during the Reagan years, as this is often held up by Republicans as the example to follow.  The following table shows what the impact would have been, along with a counterfactual scenario which keeps residential investment flat at the level it had been in 2007Q4.

Counterfactual Scenarios    All figures as a share of GDP.  Note that the shortfall from Full Employment GDP was 5.8% of 2011Q4 GDP (CBO estimate) Direct Impact Multiplier of 1.5
Government Consumption & Investment increases                                   as in 1981Q3-1985Q3 3.4% 5.1%
Total Government Spending (incl. Transfers) increases                             as in 1981Q3-1985Q3 4.0% 6.0%
Residential Investment flat at 2007Q4 level 1.4% 2.1%

The results indicate that the fiscal drag in recent years can by itself account for the shortfall of current GDP from its full employment level.  The estimate of full employment GDP comes from the January 31, 2012, economic baseline forecast of the Congressional Budget Office (see here), and is 5.8% above where current GDP was as of the end of 2011.  That is, if GDP were 5.8% higher, we would be at full employment (or “potential”) GDP, as estimated by the CBO.

In the first line of the table, government consumption and investment expenditure is increased by how much it was in 1981Q3 to 1985Q3 during the Reagan years, rather than the much slower growth (indeed essentially no growth) of 2007Q4 to 2011Q4.  The direct impact would have been to increase GDP by 3.4%.  Assuming a very modest multiplier of 1.5 (many would argue that the multiplier when the economy is in recession as now, with Federal Reserve Board interest rates close to zero, would be 2 or more), the impact would be 5.1% of GDP.  This is close to what would be needed to make up for the 5.8% gap.

In the scenario where total government spending (including transfers) is increased as it was during the Reagan years rather than the slow growth that has been chosen in recent years, GDP would have been 4.0% higher by the direct impact alone, and by 6.0% with a multiplier of 1.5.  This would have fully closed the gap.

One can also look at scenarios for residential investment.  Given how high the housing bubble had gone in 2005/6, it would be unrealistic to believe that housing would bounce back up quickly, and certainly not to the bubble levels.  But in a scenario where housing had simply recovered in real terms to the level seen in the fourth quarter of 2007 (when it was 4.0% of GDP), the direct impact on GDP would have 1.4%, or 2.1% assuming a multiplier of 1.5.  While still quite significant, these impacts are less than that resulting from the slow growth of government spending in recent years.

VI.  Conclusion

In summary:

1)  The recovery of GDP in the recent economic downturn has been slow, with unemployment still high.  Not only is a vast amount of potential output being lost, but long periods of unemployment is particularly cruel to the lives of those who must suffer this.

2)  Prominent Republican leaders have repeatedly asserted that the slow recovery has been due to an explosion of government spending under Obama.  This is simply not true.  Growth in government spending since the onset of the recession in December 2007 has been slower than in any other downturn of the last four decades in the US, and has been far less than the growth seen following the 1981 downturn during the Reagan years.

3)  Growth in government spending following the 1981 downturn during the Reagan period was in fact the highest by a substantial margin of any of the six downturns.

4)  If government spending had been allowed to grow in the recent downturn as it had during these Reagan years, the economy by the end of 2011 would likely have been at or close to full employment.

5)  Residential investment has also collapsed following the housing bubble that reached its peak in 2005/6, and has contributed substantially to the current downturn.  Its impact, while significant, is however quantitatively less than the impact of slow government spending, since residential investment is normally (and even at its peak) well less than government spending as a share of GDP.

Social Security: The Issues Can Be Solved

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I.  Introduction

The Social Security system has been the most successful social program of the US of the past century.  Poverty among the elderly was common before Social Security.  Such poverty is now rare.  Enacted in 1935, the Social Security system has provided retirement and retiree survivor benefits to all, and has provided disability benefits to those who became disabled.  While not generous in its benefits, Social Security acts as a minimum safety net for all, and as guaranteed pension income that supplements other sources of retirement savings.  The system has been fully paid for through a dedicated payroll tax, at a rate currently of 12.4% on wage earnings of up to $106,800 per year (as of 2011; it is adjusted annually to reflect average wage growth in the economy).  While the tax is formally paid half by the worker and half by the employer, in reality all comes from worker wages.

But this popular, successful, and self-standing program will be under stress in the years ahead.  While this has commonly been attributed to the stress caused by the upcoming retirement of the baby boomers, we will see below that the fundamental issue is rather longer life expectancies.  Longer life expectancy a good thing, but it needs to be paid for.  There will indeed be difficulties if nothing is done, and this has led, not surprisingly, to apocalyptic warnings by the Republican presidential candidates.  Advocating for an end to Social Security as a government-run minimum safety net retirement program, the Republican candidates have forecast disaster.

The most clear was Texas Governor Rick Perry, who in the September 7, 2011, GOP debate stated that “it [Social Security] is a monstrous lie.  It is a Ponzi scheme to tell our kids that are 25 or 30 years old today, you’re paying into a program that’s going to be there.”  Congressman Ron Paul had earlier, in the 2008 campaign, said (referring to the younger generation): “… there’s no money there, and they’re going to have to pay 50 years and they’re not going to get anything.”  While the other Republican candidates did not go so far as to call it a Ponzi scheme, the impression conveyed remained that if nothing is done, Social Security payments to retirees would collapse to nothing once the Social Security Trust Fund ran out.  If nothing is done, on current projections this would happen in  2038.

All this reflects a fundamental misunderstanding of what the Social Security system is, how it operates, and what can be done to ensure its continued viability.  Actually, there are a number of options on what can be done to ensure continued viability.  This note will review a few.  They are not that extreme, as the problem is not really that great.

It is also true that while the problem of Social Security finances can be fairly easily resolved, major issues do exist with the other major entitlement program, Medicare and other health care costs borne through the government budget.  These will require more fundamental reforms of the health care financing system in the US.  The Obama reforms make a start on this, and are a step in the right direction, but do not go far enough.  But health system financing is not the issue being addressed in this note here.

II.  The Deficit if Nothing is Done

To start, one needs too look at what Social Security revenues and benefits (as currently set) have been and are expected to be:

The historical data and the projections come from the Congressional Budget Office, in an August 2011 report.  Long term projections are necessary, but are of course subject to a good deal of uncertainty.  Up until 2009, more was paid each year in payroll taxes for Social Security (for both retirement and disability) than was paid out in benefits.  The Social Security Trust Fund (an account at the US Treasury) grew each year.  But starting in 2010, with an expansion in the number of citizens enrolling in Social Security benefits (with many taking early retirement in the 2008 downturn and then slow recovery, with unemployment high), outlays bumped up while revenues bumped down, and the expected cross-over between outlays and revenues was brought a few years earlier than had been expected before.  The bumps around the trends are clear in the diagram.

Going forward, outlays are expected to rise to about 6.1% of GDP by about 2035, with revenues then of about 4.9% of GDP, leading to deficits of about 1.2% of GDP.  But it is interesting and important to note that outlays are then expected to be largely steady as a share of GDP for at least the next 50 years, and maybe longer, falling a bit at first and then rising a bit.  Revenues are expected to rise by a small amount over time, to about 5.1% of GDP by 2052, and then be flat.  Deficits will fluctuate within a relatively narrow band of about 1% of GDP after 2035.  This is important.  Politicians opposed to Social Security have conveyed the impression that Social Security deficits will rise steadily over time forever, and thus that the problem is not solvable in the current system.  That is not the case.  The deficits will grow to about 1% of GDP, which is of course significant, but then they are expected to stay at roughly that level for the foreseeable future after that.

III.  Dealing with a Deficit of 1% of GDP

The deficit of 1% of GDP each year does need to be addressed.  But to put the 1% in perspective, note that the cost of the Bush tax cuts (as estimated by the Congressional Budget Office) is currently about 2.5% of GDP, and is expected to rise to 2.7% of GDP by 2021.  By simple extrapolation, the losses from the Bush tax cuts would be around 3% of GDP by 2030.  Hence one could cover the entire deficit in the Social Security accounts by foregoing only one-third of the Bush tax cuts.  [Two points:  1)  Note that it is not necessary that Social Security outlays have to be covered 100% by the Social Security payroll tax, even though that has been the case until now.  One could cover it also by general tax revenues.  Indeed, the special 2% point cut in Social Security payroll tax rates enacted for 2011 and 2012 with the objective of spurring employment is being covered by transfers from general tax revenues to the Social Security Trust Funds.  And 2) While in a previous blog posting, I had noted that ending the Bush tax cuts would by itself resolve the US fiscal deficit issue (over at least the next decade), it is not double-counting to also note this would resolve the deficits in the Social Security system.  The Social Security accounts are consolidated with the general US government accounts, and thus the 1% of GDP deficit in the Social Security system is part of the overall fiscal deficit that is at issue.]

Note also that if nothing is done, benefits paid out under Social Security to retirees and the disabled would not immediately drop to zero should the Social Security Trust Fund be depleted.  On current projections, the balance in the Trust Fund would, if nothing is done, drop to zero in about 2038.  But in those years, Social Security revenues would still come to 5.0% of GDP each year.  Hence benefits equal to 5.0% of GDP would still be paid.  This would require a scaling back of benefits of about 18 to 19% in those years relative to what would be due.  While it would be irresponsible and inexcusable for the politicians to have allowed it to get to that point, scaling back of benefits by 18 to 19% is quite different than saying they would then drop to nothing, as Governor Perry and Congressman Paul asserted.

What could be done to cover the 1% of GDP deficit?  As noted above, such a deficit could be covered by general tax revenues.  It would not be that much, and indeed equal only to one-third of the revenues that would be lost in those years should the Bush tax cuts be extended, as all the Republican presidential candidates have vociferously argued for.  Indeed, the Republican candidates have all set forth proposals for even far larger tax cuts than these, as was discussed in a past post.  If the country can afford such tax cuts, any one of which would be a large multiple of the revenues required to cover Social Security obligations, then it can afford what is needed to cover Social Security.

But setting aside for now the option of covering the Social Security deficit from other revenue sources, what would be the options should they be constrained purely to the current Social Security system itself?  By definition, they could then come only from three possible sources:  lower administrative costs, higher payroll tax rates, or lower benefits.  We will take up each in turn.

a)  Lower Administrative Expenses?

Social Security administrative costs in 2010 were only 0.9% of what was paid out in benefits in that year.  And they have been at about this level, of below 1% of outlays, each year since 1990.  They are even lower for the retirement component, at only 0.6% of benefits paid in the year, while somewhat more (at 2.3%) for the disability component, as disability requires closer monitoring and more complicated assessment of cases.

These administrative costs are incredibly low.  It is important to keep in mind that these are costs compared to annual outlays.  Private retirement programs, as annuities or managed through 401k’s or similar programs, will typically have annual expenses of 1 to 2% of assets.  Assuming even a highly generous rate of return on assets of 10% a year, admin expenses of 1 to 2% of assets will eat up 10 to 20% of returns and hence benefits.  Social Security admin expenses of just 0.9% (and 0.6% on the retirement component) is far superior to the 10 to 20% cost that private plans charge.  The Government run Social Security system is incredibly efficient, and one should not expect to be able to reduce the admin expenses significantly further.

b)  Increase Revenues?

The second option is to increase the payroll tax rate.  There is no reason why this cannot be done, and indeed the payroll tax rate was increased 21 times in the 40 years between 1950 and 1990.  But since 1990, i.e. for over 20 years now, the payroll tax rate has never been changed, but rather held constant at 12.4%.  The Social Security deficit problem that has now appeared is largely due to this.

Base case projections plus three scenarios were examined:

The diagram shows the ratio of the size of the Social Security Trust Fund to the benefits paid out each year, all as a share of GDP.  The calculations were done based on the data accompanying the August 2011 CBO report cited above.  Interest earned in the Trust Fund (at the rate for US Treasuries) was accounted for.  In all scenarios, benefits were left as projected by the CBO, even though under the current benefit formulas, benefits would adjust if payroll tax collections are.  That is, I am assuming that the benefit formulas would be adjusted so that benefits would remain neutral, at the levels projected in the base case despite higher payroll tax collections in the scenarios.

In the base case (shown in green with the square symbols), the Trust Fund ratio will reach a peak of 17.5% of GDP in 2012, but will then fall if nothing is done until reaching zero in about 2038.  At that point it will be falling by about 1% of GDP each year (equal to the annual deficit, as discussed above).  Unless supplemented by general tax revenues (which could be done, as noted above), or by a payroll tax rise, benefits would need to be scaled back by about 18 or 19% to reflect the 5.0% of GDP payroll tax collections expected for those years with the current tax rates.  The question is what rate of payroll tax would be necessary so that benefits would not need to be crudely scaled back by such an amount.

To help understand what is going on, in the first scenario we look at a case that helps explain why Social Security finances have deteriorated.  As has been noted in previous posts, wage compensation has lagged profits in recent years, and in particular over the last decade.  As a consequence, the wage share of GDP has fallen.  Since the Social Security payroll tax is on wages up to some limit (with that limit adjusted annually based on average wage rates), the smaller share of wages in GDP has translated into a smaller share in GDP of payroll subject to the Social Security tax.  Prior to 2000 (back to at least 1985, when the CBO data starts), this ratio had always been close to 40% of GDP, and in 2000 it was equal to exactly 40.0%.  It was still at 40.2% of GDP in 2001, but then it fell significantly, to 37% of GDP by 2010, where the CBO expects it to remain (+/- about a half percent) to at least 2085.

Scenario 1 looks at the case where we assume the taxable wage share had remained at 40% of GDP from 2001 onwards.  With benefits unchanged, this alone would extend the date the Trust Fund ratio would fall to zero, from the year 2038 in the base to 2063, or 25 years later.  That is, part of the reason the Social Security Trust Fund is in difficulty is the compression in wages subject to the payroll tax (to the benefit of profits and high income workers) over the last decade.  Without this compression (and leaving benefits unchanged), the Trust Fund would be sustained even at the current payroll tax rate for a further 25 years.

But countering this wage compression cannot be accomplished by some administrative rule.  It is what it is, for complex reasons.  Scenario 2 then examines what increase in the payroll tax would lead to a similar 25 year extension of the life of the Trust Fund before it would be depleted.  Scenario 2 shows that an increase in the payroll tax rate from the current 12.4% to just 13.5%, starting in 2012, would suffice to do this.  Such an increase in the payroll tax rate is not so large.

A payroll tax increase to a 13.5% rate in Scenario 2 would still not be a permanent solution, however. The Trust Fund ratio would be falling in 2065, and would continue to fall if nothing further is done.  Scenario 3 then looks at what the payroll tax rate would need to be to put the system in balance, with the change only made in 2038.  Until 2038, the Trust Fund would be allowed to be brought down from its current high balance.   Scenario 3 shows that a payroll tax rate of 14.8% (from 12.4% until 2038) would do this.  The system would then be roughly in balance, until at least 2065 (on current CBO projections).

An increase in the payroll tax rate from 12.4% to 14.8% is a bit less than a 20% increase in the rate.  It is no coincidence that raising revenues from 5% of GDP projected in the base case to the 6% of GDP required to cover scheduled benefits is also 20%.  They are basically the same thing.  But an interesting question is why did such a 20% gap open up.  The special Social Security Commission chaired by Alan Greenspan, established by President Reagan in December 1981 and reporting back in January 1983, proposed changes in the payroll tax rate and other measures to allow the Social Security Trust Fund to suffice to cover expected benefits for a 75 year period, i.e. to 2058.  On current projections, it is now expected to suffice for only 55 years (from 1983 to 2038).  One cause of this, as considered above as Scenario 1, is the compression of wages as a share of GDP that Americans have experienced since 2000.  Without this (although leaving benefits unchanged), the Trust Fund would be projected to last until 2065.

The unexpected compression in wages may therefore explain why changes are now required to cover a projected Social Security deficit.  But an additional, and more fundamental cause, is lengthening life expectancies.  This will be addressed next below.

c)  Reduce Benefits?

Social Security pays retirement benefits from retirement age (originally age 65, but currently 67 for those born in 1960 and later, and where reduced benefits can be obtained as early as age 62) until death.  But expected lifetimes have grown.  Some observers have noted that life expectancy was just 62 in 1935, when Social Security was passed (with a retirement age of 65), and is now 75.  While true, these are not really the numbers needed.  The increase in life expectancy has been largely driven by reductions in infant mortality, and those who die in infancy never enter the work force.

Rather, one needs to look at the likelihood that those entering the work force will live to retirement age, plus the remaining life expectancy for someone who has reached retirement age.  While technically one needs to look at the full distribution of probabilities, two figures will suffice for the purposes here:  the percentage of the population at age 21 who will survive to age 65, and the average remaining life expectancy for someone who has reached age 65.   In 1940, 57% of those aged 21 were expected to survive to age 65, and for those reaching 65 the average remaining life expectancy was 14 years.  Thus, Social Security retirement benefits were on average expected to cover 8 years of benefits (= 57% of 14 years).  But by 2010, this had more than doubled to 17 years.  That is, even with constant retirement benefits paid each year, the total expected to be paid out will have more than doubled.

Longer life expectancy is of course a good thing.  But the extra costs need to be covered.  But if one rules out use of general tax revenues, and rules out also any changes in the payroll tax rate, and with admin costs that are already minimal, all that is left is to cut benefits.

But benefits are already low, as Social Security simply provides a low floor level of income sufficient to keep most out of poverty, and not much more.  The average Social Security retirement benefit paid in 2011 was only $14,124, and was less for lower income workers.  These cannot go lower without putting the elderly who depend on Social Security into poverty.

One might also consider raising the normal retirement age, thus reducing the number of years expected to be covered by Social Security.  But while average expected lifetimes (and hence the expected number of years under Social Security) have risen, most of this increase in recent decades has been among higher income workers.  Lower income workers, who depend most on Social Security, have not seen such an increase in life expectancy.  A study by Hilary Waldron of the Social Security Administration, published in the Social Security Bulletin, vol. 67, no. 3, 2007, found that the average expected remaining lifetime of a male aged 65 rose from 15.5 years to 21.5 years (an increase of 6.0 years) between 1977 and 2006 for someone in the top half of the wage distribution, but only from 14.8 years to 16.1 years (an increase of 1.3 years) for someone in the bottom half of the wage distribution.

Thus while remaining life expectancies at age 65 have risen, this has mostly been due to the increases by those enjoying relatively high incomes.  It would be perverse then to penalize lower income workers by reducing their already low benefits, to cover the costs associated with more years of payments to those enjoying increased years of life expectancy at the upper end of the income distribution.

Should one therefore choose to cut benefits to cover the Social Security deficit, the cuts should be focused on those at the higher income levels.  The distribution formula for retirement benefits under Social Security is already modestly progressive, and it could be made more progressive.  One could also do this by coupling an increase in the normal retirement age with a more progressive distribution of benefits, with the extent of this increased progressivity sufficient to ensure lower income workers are not penalized by the improvement in living standards that those with higher income have mostly enjoyed.

d)  The Republican Proposals to Privatize Social Security

Before closing, a few words should be said on the Republican proposals to privatize Social Security.  Social Security as a pay-as-you-go public minimum pension scheme would be ended, and instead the funds would be directed to individually managed private retirement accounts, similar to IRA’s or 401k’s.  But this would mean:

1)  There would no longer be a minimum floor income that all Americans would be able to count on in their old age.  Social Security provides this minimum floor.  And for almost all Americans, Social Security is only one of several sources of income they receive in their retirement:  It is a supplement to income received through company pension plans, tax-advantaged savings through IRA’s and 401k’s and similar programs, and other savings they have built. There is nothing that blocks those enrolled in Social Security also to save via these other forms for their retirement, and indeed such savings is strongly encouraged.  But under the Republican proposals, the Social Security pillar in the set of alternative savings schemes would be eliminated, and would no longer exist as a safety net for all.

2)  By moving the revenues now going to Social Security to self-managed investments such as 401k’s, one will be forcing people to take on the risks of 401k’s.  Those whose 401k’s were invested in the equity markets know how risky this can be, following the crash of 2008.

3)  Savings invested through the equivalent of 401k’s will have to pay the administrative costs of such investments, which are an order of magnitude higher than they are for Social Security, as was discussed above.  Admin expenses for Social Security retirement programs are only 0.6% of benefits paid.  For private investments, the share will depend on the returns, but could easily be 10 to 20% of benefits.  The only beneficiaries of these Republican proposals would be the private investment management companies, who would enjoy fees an order of magnitude greater than the costs Social Security incurs.

4)  Finally, redirecting payroll taxes from Social Security to new privately-directed accounts would lead to a fiscal crisis, as the Government would lose revenues equal to about 5% of GDP, while benefits to existing retirees (and those soon to retire) would need to continue.  None of the Republicans have said how this increase in the deficit of 5% of GDP would be covered.

The different Republican plans differ in detail, but are largely similar in their outline.  The most absurd is the one proposed by Newt Gingrich, where he would provide a guaranteed floor income to all, equal to what Social Security now pays.  While this would seemingly address the first point noted above (of no more a minimum floor income in retirement), Gingrich says nothing on how the cost of this would be covered.  Not only would he redirect the 5% of GDP in payroll taxes away from the Social Security system, but he would also take on a commitment to provide up to 6% of GDP for the benefits that would be due under Social Security, should the private investments fail.  The potential gap would be 11% of GDP.  It would be a fiscal disaster to ignore this.

IV.  Conclusion

In summary:

1)  If nothing is done, the Social Security system will be running a deficit that will rise to about 1% of GDP by 2030.  But while significant, this deficit is then forecast to remain at roughly this level until at least 2085 on current projections.  Such a deficit is manageable.

2)  The deficit has increased due to lengthening life expectancies (in particular by upper income people) and due to the compression in wages seen since 2000.

3)  If nothing is done, then on current projections, the Social Security Trust Fund will be drawn down to zero by 2038.  But that does not mean Social Security payments to retirees and the disabled would then have to drop to zero, as Republican presidential candidates have stated.  There would still be on-going payroll tax revenues of about 5.0% of GDP, which would cover benefits reduced by 18 to 19% from their scheduled levels.

4)  A deficit of 1% of GDP could be resolved by:

a)  Use of general tax revenues.  The 1% of GDP would be covered simply by scaling back the Bush tax cuts by one-third.

b)  An increase of the payroll tax rate.  An increase in the rate from the current 12.4% to  a rate of 14.8% from 2038 onwards would suffice.

c)  One could also in principle cut benefits, but this is not recommended.  The benefits are already low, and provide a minimum floor income for the elderly as a safety net.  If benefits were to be cut, they should be cut for the higher income recipients (who have mostly enjoyed the increase in life expectancy that is stressing the system) rather than the lower income recipients.

5)  The Republican proposals to privatize the system would end Social Security as a minimum safety net for all Americans, would expose everyone to market risks, and would be fiscally irresponsible as revenues equal to 5% of GDP would be lost.  The only beneficiaries would be the private investment management companies who would supervise the new accounts, and who charge fees an order of magnitude higher than the administrative costs of the Social Security Administration.