Trump’s Attack on Social Security

Trump famously promised in his 2016 campaign for the presidency that he would never cut Social Security.  He just did.  How much is not yet clear.  It could be minor or it could be major, depending on how he follows up (or is allowed to follow up) on the executive order he signed on Saturday, August 8 while spending a weekend at his luxury golf course in New Jersey.  The executive order (one of four signed at that time) would defer collection of the 6.2% payroll tax paid by employees earning up to $104,000 a year for the pay periods between September 1 and December 31 (usefully straddling election day, as many immediately noted).

What would then happen on December 31?  That is not clear.  On signing the executive order, Trump said that “If I’m victorious on November 3rd, I plan to forgive these taxes and make permanent cuts to the payroll tax.  I’m going to make them all permanent.”  He later added:  “In other words, I’ll extend beyond the end of the year and terminate the tax.”

The impact on Social Security and the trust fund that supports it will depend on how far this goes.  If Trump is re-elected and he then, as promised, defers beyond December 31 collection of the payroll tax that workers pay for their Social Security, the constitutional question arises of what authority he has to do this.  While temporary deferrals of collections are allowed during a time of crisis, what happens when the president says he will bar the IRS from collecting them ever?  The president swore in his oath of office that he would uphold the law, the law clearly calls for these taxes to be collected, and a permanent deferral would clearly violate that.  But would repeated “temporary” deferrals become a violation of the statutory obligations of a president?  And he has clearly already said that he wants to make the suspension permanent and to “terminate the tax”.

There is much, therefore, which is not yet clear.  But one can examine what the impact would be under several scenarios.  They are all adverse, undermining the system of retirement benefits that has served the country well since Franklin Roosevelt signed the program into law.

Some of the implications:

a)  Deferring the collection of the Social Security payroll taxes will lead to a huge balloon payment coming due on December 31:

The executive order that Trump signed directs that firms need not (and he wants that they should not) withhold from employee paychecks the 6.2% that goes to fund the employee share of the Social Security tax.  But under current law the taxes are still due, and would need to be paid in full by December 31.

Suppose firms did decide not to withhold the 6.2% tax, and instead allow take-home pay to rise by that amount over this four-month period straddling election day.  Unless deferred further, the total of what would have been withheld will now come due on December 31, in one large balloon payment.  For those on a two-week paycheck cycle, that balloon payment would have grown to 54% of their end of the year paycheck.  It is doubtful that many employees would be very happy to see that cut in end-year pay.  Plus how would firms collect on the taxes due on workers who had been with the firm but had left for any reason before December 31?  By tax law, the firms are still obliged to pay to the IRS the payroll taxes that were due when the workers were employed with them.

Hence most expect that firms will continue to withhold for the payroll taxes due, as they always have.  The firms would likely hold off on forwarding these payments to the IRS until December 31 and instead place the funds in an escrow account to earn a bit of interest, but they would still withhold the taxes due in each paycheck just as they always have (and as their payroll systems are set up to do).  This also then defeats the whole purpose of Trump’s re-election gambit.  Workers would not see a pre-election bump up in their take-home pay.

b)  But even in this limited impact scenario, there will still be a loss to the Social Security Trust Fund:

Thus there is good reason to believe that Trump’s executive order will likely be basically just ignored.  There would, however, still be a loss to the Social Security Trust Fund, although that loss would be relatively small.

Payroll taxes paid for Social Security go directly into the Social Security Trust Fund, where they immediately begin to earn interest (at the long-term US Treasury rate).  Based on what was paid in payroll taxes in FY2019 ($1,243 billion according to the Congressional Budget Office), and adjusting for the fewer jobs now due to the sharp downturn this year, the 6.2% component of payroll taxes due would generate approximately $40 billion in revenue each month.  Assuming the $160 billion total (over four months) were then all paid in one big balloon payment on December 31 rather than monthly, the Social Security Trust Fund would lose what it would have earned in interest on the amounts deferred.  At current (low) interest rates, the total loss to Social Security would come to approximately $250 million.  Not huge, but still a loss.

c)  If collection of the 6.2% payroll tax is deferred further, beyond December 31, the losses to the Social Security Trust Fund would then grow further, and exponentially, and become disastrous if terminated:

Trump promised that “if re-elected” he would defer collection by the IRS of the taxes due further, beyond December 31.  How much further was not said, but Trump did say he would want the tax to be “terminated” altogether.  This would of course be disastrous for Social Security.  Even if the employer share of the payroll tax for Social Security (an additional 6.2%) continued to be paid in (where what would happen to it is not clear), the loss to Social Security of the employee share would lead the Trust Fund to run out in less than six years.  At that point, under current law the amounts paid to Social Security beneficiaries (retirees and dependents) would be sharply scaled back, by 50% or more (assuming the employer share of 6.2% continued to be paid).

d)  Even if the Social Security Trust Fund were kept alive by Congress acting to replenish it from other sources of tax revenues, under current law individual benefits would be reduced on those who saw their payroll tax contributions diminished:

There is also an issue at the level of individual benefits, which I have not seen mentioned but which would be significant.  The extent of this impact would depend on the particular scenario assumed, but suppose that the payroll taxes that would have come due and collected from September 1 to December 31 were permanently suspended.  For each individual, this would affect how much they had paid in to the Social Security system, where benefits are calculated by a formula based on an individual’s top 35 years of earnings (with earnings from prior years adjusted to current prices as of the year of retirement eligibility based on an average wage inflation index).

The impact on the benefits any individual will receive will then depend on the individual’s wage profile over their lifetime.  Workers may typically have 20 or 25 or maybe even 30 years of solid earnings, but then also a number of years within the 35 where they may have been not working, e.g. to raise a baby, or were unemployed, or employed only part-time, or employed in a low wage job (perhaps when a student, or when just starting out), and so on.

There would thus be a good deal of variation.  In an extreme case, the loss of four months of contributions to the Social Security Trust Fund from their employment history might have almost no impact.  This would be the case where a worker’s income in their 36th year of employment history was very similar to what it was in their 35th, and the loss in 2020 of four months of employment history would lead to 2020 dropping out of their employment top 35 altogether.  But this situation is likely to be rare.

More likely is that 2020 would remain in the top 35 years for the individual, but now with four months less of payroll contributions being recorded.  One can then calculate how much their Social Security retirement benefits would be reduced as a result.

The formulae used can be found at the Social Security website (see here, here, and here).  Using the parameters for 2020, and assuming a person had earned each year the median wages for the year (see table 4.B.3 of the 2019 Annual Statistical Supplement of Social Security), one can calculate what the benefits would be with a full year of earnings recorded for 2020 and what they would be with four months excluded, and hence the difference.

In this scenario of median earnings throughout 35 years, annual benefits to the retiree would be reduced by $105 (from $17,411 without the four months of non-payment, to $17,306 with the four months of the payroll tax not being paid).  Not huge, but not trivial either when benefits are tied to a full 35 years of earnings.  That $105 annual reduction in benefits would have been in return for the one-time reduction of $669 in payroll taxes being paid (6.2% for four months where median annual earnings of $32,378 in 2019 were assumed to apply also in 2020 despite the economic downturn).  That is, the $669 not paid in now would lead to a $105 reduction in benefits (15.8%) each and every year of retirement (assuming retirement at the Social Security normal retirement age).

The loss in retirement benefits would be greater in dollar amount if the period of non-payment of the payroll tax were extended.  Assuming, for example, a scenario where it was extended for a full year (and one then had just 34 years of contributions being paid in, with the rest at zero), with wages at the median level throughout those now 34 years, the reduction in retirement benefits would be $316 each year (three times as much as for the four-month reduction).  Payroll taxes paid would have been reduced by $2,007 in this scenario, and the $316 annual reduction is again (given how the arithmetic works) 15.8% of the $2,007 one-time reduction in payroll taxes paid.

All this assumes Social Security would continue to pay out retiree benefits in accordance with current law and assumes the Trust Fund remained adequate.  The suspension of these payroll taxes would make this difficult, as noted above, unless there was then some general bailout enacted by Congress.  But any such bailout would raise further issues.

e)  If Congress were to appropriate funds to ensure the Social Security Trust Fund remained adequately funded, the resulting gains would be far greater for those who are well off than for those who are poor:

Suppose Congress allowed these payroll taxes to be “terminated”, as Trump has called for, but then appropriated funds to ensure benefits continued to be paid as per the current formulae.  Who would gain?

For at least this part of the transaction (the origin of the funds is not clear), it would be the rich.  The savings in the payroll taxes that would be paid in order to keep one’s benefits would be five times as high for someone earning $100,000 a year as for someone earning $20,000.  The tax is a fixed 6.2% for all earnings up to the ceiling (of $137,700 in 2020, after which the tax is zero).  The difference in terms of the benefits paid would be less, since the formulae for benefits have a degree of progressivity built-in, but one can calculate with the formulae that the change in benefits from such a Congressional bailout would still be 2.3 times higher for those earning $100,000 than for those earning $20,000.

One might question whether this is the best use of such funds.  Normally one would want that the benefits accrue more to the poor than to those who are relatively well off.  The opposite would be the case here.

f)  Importantly, none of this helps those who are unemployed:

Unemployment has shot up this year due to the mismanagement of the Covid-19 crisis, with the unemployment rate rising to a level not seen in the US since the Great Depression.  Unemployment insurance, expanded in this crisis, has proven to be a critical lifeline not only to the unemployed but also to the economy as a whole, which would have collapsed by even more without the expanded programs.

Yet cutting payroll taxes for those who have a job and are on a payroll will not help with this.  If you are on a payroll you are still earning a wage, and that wage is, except in rare conditions, the same as what you had been earning before.  You have not suffered, as the newly unemployed have, due to this crisis.  Why, then, should you then be granted, in the middle of this crisis where government deficits have rocketed to unprecedented levels, a tax cut?

It makes no sense.  Some other motive must be in play.

g)  This does make sense, however, if your intention is to undermine Social Security:

Trump pushed for a cut in the payroll taxes supporting Social Security when discussions began in July in the Senate on the new Covid-19 relief bill (the House had already passed such a bill in May).  But even the Republicans in the Senate said this made no sense (as did business groups who are normally heavily in favor of tax cuts, such as the US Chamber of Commerce), and they kept it out of the bill they were drafting.

The primary advisor pushing this appears to have been Stephen Moore, an informal (unpaid) White House advisor close to Trump.  He co-authored an opinion column in The Wall Street Journal just a week before Trump’s announcement advocating the precise policy of deferring collection of the Social Security payroll tax.  Joining Moore were Arthur Laffer (author of the repeatedly disproven Laffer Curve, whom Trump had awarded the Presidential Medal of Freedom in 2019), and Larry Kudlow (Trump’s primary economic advisor and a strong advocate of tax cuts).

Moore has long been advocating for an end to Social Security, arguing that individual retirement accounts (such as 401(k)s for all) would be preferable.  As discussed above, the indefinite deferral of collection of the payroll taxes that support Social Security would, indeed, lead to a collapse of the system.  Thus this policy makes sense if you want to end Social Security.  It does not otherwise.

Yet Social Security is popular, and critically important.  Fully one-third of Americans aged 65 or older depend on Social Security for 90% or more of their income in retirement.  And 20% depend on Social Security for 100% of their income in retirement.  Cuts have serious implications, and Social Security is a highly popular program.

Thus advocates for ending Social Security cannot expect that their proposals would go far, particularly just before an election.  But suspending the payroll taxes that support the program, with a promise to terminate those taxes if re-elected, might appear to be more attractive to those who do not see the implications.

The issue then becomes whether enough see what those implications are, and vote accordingly in the election.

What a Real Tax Reform Could Look Like – II: Social Security

A.  Introduction

The previous post on this blog looked at what a true tax reform could look like, addressing issues pertaining to corporate and individual income taxes.  This post will look at what should be done for Social Security and the taxes that support it.  Our federal tax system involves more than just income taxes.  Social Security taxes are important, and indeed many individuals pay more in Social Security taxes than they do in individual income taxes.  Overall, Social Security taxes account for just over a quarter of total federal revenues collected in FY2017, and are especially important for the poor and middle classes.  With a total tax of 12.4% for Social Security (formally half paid by the employee and half by the employer, but in reality all ultimately paid by the employee), someone in the 10% income tax bracket is in fact paying tax at a 22.4% rate on their wages, someone in a 15% bracket is actually paying 27.4%, and so on up to the ceiling on wages subject to this tax of $128,400 in 2018.  They also pay a further 2.9% tax on wages for Medicare (with no ceiling), but this post will focus just on the Social Security side.

And as is well known, the Social Security Trust Fund is forecast to be depleted by around 2034 if Congress does nothing.  Social Security benefits would then be automatically scaled back by about 22%, to a level where the then current flows going into the Trust Fund would match the (cut-back) outflows.  This would be a disaster for many.  Congress needs to act.

A comprehensive tax reform thus should include measures to ensure the Social Security Trust Fund remains solvent, and is at a minimum able, for the foreseeable future, to continue to pay its obligations in full.  Also, and as will be discussed below, Social Security benefit payments are embarrassingly small.  Cutting them further is not a “solution”.  And despite their small size, many now depend on Social Security in their old age, especially as a consequence of the end of most private company defined benefit pension schemes in recent decades.  We really need to look at what can be done to strengthen and indeed expand the Social Security safety net.  The final section below will discuss a way to do that.

B.  Remove the Ceiling on Wages Subject to Social Security Tax

As was discussed in an earlier post on this blog, the Social Security Trust Fund is forecast to run out by around 2034 not because, as many presume, baby boomers will now be retiring, nor because life expectancies are turning out to be longer.  Both of these factors were taken into account in 1983, when following recommendations made by a commission chaired by Alan Greenspan, Social Security tax rates were adjusted and other measures taken to ensure the Trust Fund would remain solvent for the foreseeable future.  Those changes were made in full awareness of when the baby boomers would be retiring – they had already been born.  And while life expectancy has been lengthening, what matters is not whether life expectancy has been growing longer or not, but rather whether it has been growing to be longer than what had earlier been forecast when the changes were made in 1983.  And it hasn’t:  Life expectancy has turned out to be growing more slowly than earlier forecast, and for some groups has actually been declining.  In itself, this would have lengthened the life of the Social Security Trust Fund over what had been forecast.  But instead it was shortened.

Why is it, then, that the Trust Fund is now forecast to run out by around 2034 and not much later?  As discussed in that earlier post, the Greenspan Commission assumed that wage income inequality would not change going forward.  At the time (1983) this was a reasonable assumption to make, as income inequality had not changed much in the post World War II decades leading up to the 1980s.  But from around 1980, income distribution worsened markedly following the Reagan presidency.  This matters.  Wages above a ceiling (adjusted annually according to changes in average nominal wages) are exempted from Social Security taxes.  But with the distribution of wages becoming increasingly skewed (in favor of the rich) since 1980, adjusting the ceiling according to changes in average wages will lead to an increasing share of wages being exempted from tax.  An increasing share of wage income has been pulled into the earnings of those at the very top of the income distribution, so an increasing share of wages has become exempt from Social Security taxes.  As a direct consequence, the Social Security Trust Fund did not receive the inflows that had been forecast.  Thus it is now forecast to run out by 2034.

Unfortunately, we cannot now go back in time to fix the rates and what they covered to reflect the consequences of the increase in inequality.  Thus what needs to be done now has to be stronger than what would have been necessary then.  Given where we are now, one needs to remove the ceiling on wages subject to the Social Security tax altogether to ensure system solvency.  If that were done, the depletion of the Social Security Trust Fund (with all else unchanged, including the benefit formulae) would be postponed to about 2090.  Given the uncertainties over such a time span (more than 70 years from now), one can say this is for the foreseeable future.

The chart at the top of this post (taken from the earlier blog post on this issue) shows the paths that the Social Security Trust Fund to GDP ratio would take.  If nothing is done, the Trust Fund would be depleted by around 2034 and then turn negative (not allowed under current law) if all benefits were continued to be paid (the falling curve in black).  But if the ceiling on wages subject to tax were removed, the Trust Fund would remain positive (the upper curves in blue, where the one in light blue incorporates the impact of the resulting benefit changes under the current formulae, as benefits are tied to contributions).

As discussed in that earlier blog post, the calculations indicate the Social Security Trust Fund then would remain solvent to a forecast year of about 2090.  That is over 70 years from now, and the depletion at that time is largely driven by the assumption (by the Social Security demographers) on how fast life expectancy is forecast to rise in the future.  This could again be over-estimated.

Lifting the ceiling on wages subject to Social Security tax would also be equitable:  The poor and middle classes are subject to the 12.4% Social Security tax on all of their wages; a rich person should be similarly liable for the tax on all of his or her earnings.  And I cannot see the basis for any argument that a rich person making a million dollars a year cannot afford the tax, while a poor person can.

C.  Apply the Social Security Tax to All Forms of Income, Not Just Wages, and Then Raise Benefits

But I would go further.  In the modern era, there is no reason why the Social Security tax should be applied solely to wage earnings, while earnings from wealth are not taxed at all.  As one of the basic principles of taxation noted in the previous post on tax reform, all forms of income should be taxed similarly, and not with differing rates applied to one form (e.g. 12.4% on wages) as compared to another (e.g. 0% on income from wealth).

Broadening the base would allow, if nothing else is changed, for a reduction in the rate to produce the same in revenues.  We can calculate roughly what that lower rate would be.  Making use of IRS data for incomes reported on the Form 1040s in 2015 (the most recent year available), one can calculate that if Adjusted Gross Income (line 37 of Form 1040) was used as the base for the Social Security tax rather than just wages, the Social Security tax rate could be cut from 12.4% to 8.6% to generate the same in revenues.  That is, taxing all reported income (including income from wealth) at an 8.6% rate (instead of taxing just wages at 12.4%) would generate sufficient revenues for the Social Security Trust Fund to remain solvent for the foreseeable future.  This would be a more than 30% fall in the taxes on wages, but also, of course, a shift to those who also earn a substantial share of their income from wealth.

[Note:  There would also be second-order effects as Social Security benefits paid are tied to the taxes paid over the highest 40 years of an individual’s earnings, there is some progressivity in the formulae used, and taxes on all earnings rather than just on wages will shift the share of the taxes paid towards the rich.  But the impact of these second-order effects would be relatively small.  Also, the direction of the impact would be that the break-even tax rate could be cut a bit further to allow for the same to be paid out in benefits, or a bit more in benefits could be paid for the same tax rate.  But given that the impact would be small, we will leave them out of the calculations here.]

The 8.6% tax on all forms of income would generate the revenues needed to keep the Social Security Trust Fund solvent at the benefit levels as defined under current law.  But Social Security benefit payments are embarrassingly small.  Using figures for September 2017 from the Social Security Administration, the average benefit paid (in annualized terms) for all beneficiaries is just $15,109, for retired workers it is $16,469, and for those on disability it is $12,456.  These are not far above (and for disability indeed a bit below) the federal poverty guideline level of $13,860 in 2017 for a single individual.  And the average benefit levels, being averages, mean approximately half of the beneficiaries are receiving less.

Yet even at such low levels, Social Security benefits account for 100% of the income of 20% of beneficiaries aged 65 or higher; for 90% or more of the incomes of 33% of those aged beneficiaries, and 50% or more of the incomes of 61% of those aged beneficiaries (data for 2014; see Table 9.A1).  And for those aged 65 or older whose income is below the federal poverty line, Social Security accounts for 100% of the income of 50% of them, for 90% or more of the income of 74% of them, and for 50% or more of the income for 93% of them (see Table 9.B8).  The poor are incredibly dependent on Social Security.

Thus we really should be looking at a reform which would allow such benefit payments to rise.  The existing levels are too low to serve as an effective safety net in a country where defined benefit pension plans have largely disappeared, and the alternative approach of IRAs and 401(k)s has failed to provide adequate pensions for many if not most workers.

Higher benefits would require higher revenues.  To illustrate what might be done, suppose that instead of cutting the Social Security tax rate from the current 12.4% to a rate of 8.6% (which would just suffice to ensure the Trust Fund would remain solvent at benefit levels as defined under current law), one would instead cut the tax rate just to 10.0%.  This would allow average Social Security benefits to rise by 15.8% (= 10.0%/8.6%, but based on calculations before rounding).  One can work out that based on the distribution of Social Security benefit payments in 2015 (see table 5.B6 of the 2016 Annual Statistical Supplement), that if benefits were raised by 5% for the top third of retirees receiving Social Security and by 10% for the middle third, then the extra revenues would allow us to raise the average benefit levels by 45% for the bottom (poorest) third:

Annual Social Security Benefits

Avg in 2015

% increase

New

Difference

   Bottom Third of Retirees

$8,761

45%

$12,733

   $3,972

   Middle Third of Retirees

$16,010

15%

$18,411

   $2,401

   Top Third of Retirees

$23,591

5%

$24,771

   $1,180

Overall for Retirees

$16,044

15.8%

$18,574

   $2,531

This would make a significant difference to those most dependent in their old age on Social Security.  The poorest third of retirees receiving Social Security received (in December 2015 and then annualized) a payment of just $8,761 per year.  Increasing this by 45% would raise it to $12,733.  While still not much, it would be an increase of almost $4,000 annually.  And for a married couple where both had worked and are now receiving Social Security, the benefits would be double this.  It would make a difference.

D.  Conclusion

Conservatives have long been opposed to the Social Security system (indeed since its origin under Roosevelt), arguing that it is a Ponzi scheme, that it is unsustainable, and that the only thing we can do is to scale back benefits.  None of this is true.  Rather, Social Security has proven to be a critically important support for the incomes of the aged.  An astonishingly high share of Americans depend on it, and its importance has only increased with the end of defined benefit pension schemes for most American workers.

But there are, indeed, problems.  Due to the ceiling on wages subject to Social Security tax, and the sharp increase in inequality starting in the 1980s under Reagan and continuing since, an increasing share of wages in the nation have become exempt from this tax.  As a consequence, and if nothing is done, the Trust Fund is now forecast to run out in 2034.  This would trigger a scaling back of the already low benefits by 22%.  This would be a disaster for many.

Lifting the ceiling on wages, so that all wages are taxed equally, would resolve the Trust Fund solvency issue for the foreseeable future (to a forecast year of about 2090).  Benefits as set under the current formulae could then be maintained.  Furthermore, if the base for the tax were extended to all forms of income (including income from wealth), and not limited just to wages, benefits as set under current formulae could be sustained with the tax rate cut from the current 12.4% to a new rate of just 8.6%.

But as noted above, current benefits are low.  One should go further.  Cutting the rate to just 10%, say, would allow for a significant increase in benefits.  Focussing the increase on the poorest, who are most dependant on Social Security in their old age, a rate of 10% applied to all forms of income would allow benefits to rise by 5% for the top third of retirees, by 15% for the middle third, and by a substantial 45% for the bottom third.  This would make a real difference.

Social Security Could be Saved With the Revenues Lost Under the Trump Tax Plan

As is well known, the Social Security Trust Fund will run out in about 2034 (plus or minus a year) if nothing is done.  “Running out” means that the past accumulated stock of funds paid in through Social Security taxes on wages, plus what is paid in each year, will not suffice to cover what is due to be paid out that year to beneficiaries.  If nothing is done, Social Security payments would then be scaled back by 23% (in 2034, rising to 27% by 2091), to match the amount then being paid in each year.

This would be a disaster.  Social Security does not pay out all that much:  An average of just $15,637 annually per beneficiary for those in retirement and their survivors, and an average of just $12,452 per beneficiary for those on disability (all as of August 2017).  But despite such limited amounts, Social Security accounts for almost two-thirds (63%) of the incomes of beneficiaries age 65 or older, and 90% or more of the incomes of fully one-third of them.  Scaling back such already low payments, when so many Americans depend so much on the program, should be unthinkable.

Yet Congress has been unwilling to act, even though the upcoming crisis (if nothing is done) has been forecast for some time.  Furthermore, the longer we wait, the more severe the measures that will then be necessary to fix the problem.  It should be noted that the crisis is not on account of an aging population (one has pretty much known for 64 years how many Americans would be reaching age 65 now), nor because of a surprising jump in life expectancies (indeed, life expectancies have turned out to be lower than what had been forecast).  Rather, as discussed in an earlier post on this blog, the crisis has arisen primarily because wage income inequality has grown sharply (and unexpectedly) since around 1980, and this has pulled an increasing share of wages into the untaxed range above the ceiling for annual earnings subject to Social Security tax ($127,200 currently).

But Congress could act, and there are many different approaches that could be taken to ensure the Social Security Trust Fund remains adequately funded.  This post will discuss just one.  And that would be not to approve the Trump proposal for what he accurately calls would be a huge cut in taxes, and use the revenues that would be lost under his tax plan instead to shore up the Social Security Trust Fund.  As the chart at the top of this post shows (and as will be discussed below), this would more than suffice to ensure the Trust Fund would remain in surplus for the foreseeable future.  There would then be no need to consider slashing Social Security benefits in 2034.

The Trump tax plan was submitted to Congress on September 27.  It is actually inaccurate to call it simply the Trump tax plan as it was worked out over many months of discussions between Trump and his chief economic aides on one side, and the senior Republican leadership in both the Senate and the Congress on the other side, including the chairs of the tax-writing committees.  This was the so-called “Gang of Six”, who jointly released the plan on September 27, with the full endorsement of all.  But for simplicity, I will continue to call it the Trump tax plan.

The tax plan would sharply reduce government revenues.  The Tax Policy Center (TPC), a respected bipartisan nonprofit, has provided the most careful forecast of the revenue losses yet released.  They estimated that the plan would reduce government revenues by $2.4 trillion between 2018 and 2027, with this rising to a $3.2 trillion loss between 2028 and 2037.  The lost revenue would come to 0.9% of GDP for the 2018 to 2027 period, and 0.8% of GDP for the 2028 to 2037 period (some of the tax losses under the Trump plan are front-loaded), based on the GDP forecasts of the Social Security Trustees 2017 Annual Report (discussed below).  While less than 1% of GDP might not sound like much, such a revenue loss would be significant.  As we will see, it would suffice to ensure the Social Security Trust Fund would remain fully funded.

The chart at the top of this post shows what could be done.  The curve in green is the base case where nothing is done to shore up the Trust Fund.  It shows what the total stock of funds in the Social Security Trust Fund have been (since 1980) and would amount to, as a share of GDP, if full beneficiary payments would continue as per current law.  Note that I have included here the trust funds for both Old-Age and Survivors Insurance (OASI) and for Disability Insurance (DI).  While technically separate, they are often combined (and then referred to as OASDI).

The figures are calculated from the forecasts released in the most recent (July 2017) mandated regular annual report of the Board of Trustees of the Social Security system.  Their current forecast is that the Trust Fund would run out by around 2034, as seen in the chart.

But suppose that instead of enacting the Trump tax plan proposals, Congress decided to dedicate to the Social Security Trust Funds (OASDI) the revenues that would be lost as a consequence of those tax cuts?  The curve in the chart shown in red is a forecast of what those tax revenue losses would be each year, as a share of GDP.  These are the Tax Policy Center estimates, although extrapolated.  The TPC forecasts as published showed the estimated year-by-year losses over the first ten years (2018 to 2027), but then only for the sum of the losses over the next ten years (2028 to 2037).  I assumed a constant rate of growth from the estimate for 2027 sufficient to generate the TPC sum for 2028 to 2037, which worked out to a bit over 6.1%.  I then assumed the revenue losses would continue to grow at this rate for the remainder of the forecast period.

Note this 6.1% growth is a nominal rate of growth, reflecting both inflation and real growth.  The long-run forecasts in the Social Security Trustees report were for real GDP to grow at a rate of 2.1 or 2.2%, and inflation (in terms of the GDP price index) to grow at also 2.2%, leading to growth in nominal GDP of 4.3 or 4.4%.  Thus the forecast tax revenue losses under the Trump plan would slowly climb over time as a share of GDP, reaching 2% of GDP by about 2090.  This is as one would expect for this tax plan, as the proposals would reduce progressivity in the tax system.  As I noted before on this blog and will discuss further below, most of the benefits under the Trump tax plan would accrue to those with higher incomes.  However, one should also note that the very long-term forecasts for the outer years should not be taken too seriously.  While the trends are of interest, the specifics will almost certainly be different.

If the tax revenues that would be lost under the Trump tax plan were instead used to shore up the Social Security Trust Fund, one would get the curve shown in blue (which includes the interest earned on the balance in the Fund, at the interest rates forecast in the Trustees report).  The balance in the fund would remain positive, never dipping below 12% of GDP, and then start to rise as a share of GDP.  Even if the TPC forecasts of the revenues that would be lost under the Trump plan are somewhat off (or if Congress makes changes which will reduce somewhat the tax losses), there is some margin here.  The forecast is robust.

The alternative is to follow the Trump tax plan, and cut taxes sharply.  As I noted in my earlier post on this blog on the Trump tax plan, the proposals are heavily weighted to provisions which would especially benefit the rich.  The TPC analysis (which I did not yet have when preparing my earlier blog post) has specific estimates of this.  The chart below shows who would get the tax cuts for the forecast year of 2027:

The estimate is that 87% of the tax revenues lost under the Trump plan would go to the richest 20% of the population (those households with an income of $154,900 or more in 2027, in prices of 2017).  And indeed, almost all of this (80% of the overall total) would accrue just to the top 1%.  The top 1% are already pretty well off, and it is not clear why tax cuts focused on them would spur greater effort on their part or greater growth.  The top 1% are those households who would have an annual income of at least $912,100 in 2027, in prices of 2017.  Most of them would be making more than a million annually.

The Trump people, not surprisingly, do not accept this.  They assert that the tax cuts will spur such a rapid acceleration in growth that tax revenues will not in fact be lost.  Most economists do not agree.  As discussed in earlier posts on this blog, the historical evidence does not support the Trumpian view (the tax cuts under Reagan and Bush II did not lead to any such acceleration in growth; what they did do is reduce tax revenues); the argument that tax cuts will lead to more rapid growth is also conceptually confused and reveals a misunderstanding of basic economics; and with the economy having already reached full employment during the Obama years, there is little basis for the assertion that the economy will now be able to grow at even 3% a year on average (over a mulit-year period) much less something significantly faster.  Tax cuts have in the past led to cuts in tax revenues collected, not to increases, and there is no reason to believe this time will be different.

Thus Congress faces a choice.  It can approve the Trump tax plan (already endorsed by the Republican leadership in both chambers), with 80% of the cuts going to the richest 1%.  Or it could use those revenues to shore up the Social Security Trust Fund.  If the latter is done, the Trust Fund would not run out in 2034, and Social Security would be able to continue to pay amounts owed to retired senior citizens and their survivors, as well as to the disabled, in accordance with the commitments it has made.

I would favor the latter.  If you agree, please call or write your Senator and Member of Congress, and encourage others to do so as well.

————————————————————————

Update, October 22, 2017

The US Senate passed on October 19 a budget framework for the FY2018-27 period which would allow for $1.5 trillion in lost tax revenues over this period, and a corresponding increase in the deficit, as a consequence of new tax legislation.  It was almost fully a party line vote (all Democrats voted against it, while all Republicans other than Senator Rand Paul voted in favor).  Importantly, this vote cleared the way (under Senate rules) for it to pass a new tax law with losses of up to $1.5 trillion over the decade, and pass this with only Republican votes.  Only 50 votes in favor will be required (with Vice President Pence providing a tie-breaking vote if needed).  Democrats can be ignored.

The loss in tax revenues in this budget framework is somewhat less than the $2.4 trillion that the Tax Policy Center estimates would follow in the first decade under the Trump tax plan.  But it is still sizeable, and it is of interest to see what this lesser amount would achieve if redirected to the Social Security Trust Fund instead of being used for tax cuts.

The chart above shows what would follow.  It still turns out that the Social Security Trust Fund would be saved from insolvency, although just barely this time.

One has to make an assumption as to what would happen to tax revenues after 2027, as well as for what the time pattern would be for the $1.5 trillion in losses over the ten years from FY2018 to 27.  With nothing else available, I assumed that the losses would grow over time at the same rate as what is implied in the Tax Policy Center estimates for the losses in the second decade of the Trump tax plan as compared to the losses in the final year of the first decade.  As discussed above, these estimates implied a nominal rate of growth of 6.1% a year.  I assumed the same rate of growth here, including for the year to year growth in the first decade (summing over that decade to $1.5 trillion).

The result again is that the Social Security Trust Fund would remain solvent for the foreseeable future, although now just marginally.  The Trust Fund (as a share of GDP) would just touch zero in the years around 2080, but would then start to rise.

We therefore have a choice.  The Republican-passed budget framework has that an increase in the fiscal deficit of $1.5 trillion over the next decade is acceptable.  It could be used for tax cuts that would accrue primarily to the rich.  Or it could be used to ensure the Social Security system will be able, for the foreseeable future, to keep to its commitments to senior citizens, to their survivors, and to the disabled.

 

The Impact of Increased Inequality on the Social Security Trust Fund, and What To Do Now

Social Security Trust Fund to GDP, with benefit changes, 90% of Wages from 1984 or 2016, 1970 to 2090, revised

A.  Introduction

It is well known that with current Social Security tax and benefit rates, the Social Security Trust Fund is projected to run out by the 2030s.  The most recent projection is that this will happen in 2034.  And it is commonly believed that this is a consequence of lengthening life spans.  However, that is not really true.  Later in this century (in the period after the 2030s), life spans that are now forecast to be longer than had been anticipated before will eventually lead, if nothing is done, to depletion of the trust funds.  But the primary cause of the trust funds running out by the currently projected 2034 stems not from longer life spans, but rather from the sharp growth in US income inequality since Ronald Reagan was president.  Had inequality not grown as it has since the early 1980s, and with all else as currently projected, the Social Security Trust Fund would last to about 2056.

This particular (and important) consequence of the growing inequality in American society over the last several decades does not appear to have been recognized before.  Rather, the problems being faced by the Social Security Trust Fund are commonly said to be a consequence of lengthening life expectancies of Americans (where it is the life expectancy of those at around age 65, the traditional retirement age, that is relevant).  I have myself stated this in earlier posts on this blog.

But this assertion that longer life spans are to blame has bothered me.  Social Security tax rates and benefit formulae have been set based on what were thought at the time to be levels that would allow all scheduled benefits to be paid for the (then) foreseeable future, based on the forecasts of the time (of life expectancies and many other factors). Thus it is not correct to state that it is longer life spans per se that can be to blame for the Social Security Trust Fund running out.  Rather, it would be necessary for life spans to be lengthening by more than had been expected before for this to be the case.

This blog post will look first at these projections of life expectancy – what path was previously forecast in comparison to what in fact happened (up to now) and what is forecast (now) for the future.  We will find that the projections used to set the current Social Security tax and benefit rates (last changed in the early 1980s) had in fact forecast life spans which would be longer than what transpired in the 1980s, 1990s, and 2000s.  That is, actual life expectancies have turned out to be shorter than what had been forecast for those three decades.  However, life spans going forward are currently forecast to be longer than what had been projected earlier.  On average, it turns out that the earlier forecasts were not far off from what happened or is now expected through to 2034.  Unexpectedly longer life spans do not account for the current forecast that the Social Security Trust Fund will run out by 2034.

Rather, the problem is due to the sharp increase in wage income inequality since the early 1980s.  Only wages up to a ceiling (of $118,500 in 2016) are subject to Social Security tax.  Wages earned above that ceiling amount are exempt from the tax.  In 1982 and also in 1983, the ceiling then in effect was such that Social Security taxes were paid on 90% of all wages earned.  But as will be discussed below, increasing wage inequality since then has led to an increasing share of wages above the ceiling, and hence exempt from tax.  It is this increasing wage income inequality which is leading the Social Security Trust Fund to an expected depletion by 2034, if nothing is done.

This blog post will look at what path the Social Security Trust Fund would have taken had wage inequality not increased since 1983.  Had that been the case, 90% of wages would have been covered by Social Security tax since 1984, in the past and going forward.  But since it is now 2016 and we cannot change history, we will also look at what the path would be if the ceiling were now returned, from 2016 going forward, to a level covering 90% of wages.  The final section of the post will then look at what would happen if the wage ceiling were lifted altogether so that the rich would pay at the same rate of tax as the poor.

One final point for this introduction:  In addition to longer life spans, many commentators assert that it is the retiring baby boom generation which is depleting the Social Security Trust Fund.  But this is also not true.  The Social Security tax and benefit rates were set in full knowledge of how old the baby boomers were, and when they would be reaching retirement age.  Demographic projections are straightforward, and they had a pretty good estimate 64 years ago of how many of us would be reaching age 65 today.

B.  Projections of Increasing Life Spans for Those in Retirement

Life expectancies have been growing.  But this has been true for over two centuries, and longer expected life spans have always been built into the Social Security calculations of what the Social Security tax rates would need to be in order to provide for the covered benefits.  The issue, rather, is whether the path followed for life expectancies (actual up to now and as now expected for the future) is higher or lower than the path that had been expected earlier.

What we have seen in recent decades is that while life spans for those of higher income have continued to grow, they have increased only modestly for the bottom half of income earners.  Part of the reason for this stagnation of life expectancy for the bottom half of the income distribution is undoubtedly a consequence of stagnant real incomes for lower income earners.  As discussed in an earlier post on this blog, median real wages have hardly risen at all since 1980.  And indeed, average real household incomes of the bottom 90% of US households were lower in 2014 than they were in 1980.

Thus it is an open question whether life spans are turning out to be longer than what had been projected before, when Social Security tax and benefit rates were last adjusted.  The most recent such major adjustment was undertaken in 1983, following the report of the Greenspan Commission (formally titled the National Commission on Social Security Reform).  President Reagan appointed Alan Greenspan to be the chair (and later appointed him to be the head of the Federal Reserve Board), with the other members appointed either by Reagan or by Congress (with a mix from both parties).

The Greenspan Commission made recommendations on a set of measures (which formed the basis for legislation enacted by Congress in 1983) which together would ensure, based on the then current projections, that the Social Security Trust Fund would remain adequate through at least 2060.  They included a mix of increased tax rates (with the Social Security tax rate raised from 10.8% to 12.4%, phased in over 7 years, with this for both the old-age pensions and disability insurance funds and covering both the employer and employee contributions) and reduced benefits (with, among other changes, the “normal” retirement age increased over time).

It is now forecast, however, that the Trust Funds will run out by 2034.  What changed? The common assertion is that longer life spans account for this.  However, this is not true. The life spans used by the Greenspan Commission (see Appendix K of their report, Table 12) were in fact too high, averaging male and female together, up to about 2010, but are now forecast to be too low going forward.  More precisely, comparing those forecasts to those in the most recent 2015 Social Security Trustees Report:

Projected Life Expectancies at Age 65 - As of 1982 vs 2015, Up to 2090

 

The chart shows the forecasts (in blue) used by the Greenspan Commission (which were in turn taken from the 1982 Social Security Trustees Report) overlaid on the current (2015, in red) history and projections.  The life span forecasts used by the Greenspan Commission turned out actually to be substantially higher than what were the case or are forecast now to be the case for females to some point past 2060, higher up to the year 2000 for males, and based on the simple male/female average, higher up to about 2010 for all, than what were estimated in the 2015 report.  For the full period from 1983 to 2034 (using interpolated figures for the periods when the 1982 forecasts were only available for every 5 and then every 10 years), it turns out that the average over time of the differences in the male/female life expectancy at age 65 between the 1982 forecasts and those from 2015, balances almost exactly. The difference is only 0.01 years (one-hundreth of a year).

For the overall period up to 2034, the projections of life expectancies used by the Greenspan Commission are on average almost exactly the same as what has been seen up to now or is currently forecast going forward (cumulatively to 2034).  And it is the cumulative path which matters for the Trust Fund.  Unexpectedly longer life expectancies do not explain why the Social Security Trust Fund is now forecast to run out by 2034.  Nor, as noted above, is it due to the pending retirement of more and more of the baby boom generation.  It has long been known when they would be reaching age 65.

C.  The Ceiling on Wages Subject to Social Security Tax

Why then, is the Social Security Trust Fund now expected to run out by 2034, whereas the Greenspan Commission projected that it would be fine through 2060?  While there are many factors that go into the projections, including not just life spans but also real GDP growth rates, interest rates, real wage growth, and so on, one assumption stands out. Social Security taxes (currently at the rate of 12.4%, for employee and employer combined) only applies to wages up to a certain ceiling.  That ceiling is $118,500 in 2016. Since legislation passed in 1972, this ceiling has been indexed in most years (1979 to 1981 were exceptions) to the increase in average wages for all employees covered by Social Security.

The Greenspan Commission did not change this.  Based on the ceiling in effect in 1982 and again in 1983, wages subject to Social Security tax would have covered 90.0% of all wages in the sectors covered by Social Security.  That is, Social Security taxes would have been paid on 90% of all wages in the covered sectors in those years.  If wages for the poor, middle, and rich had then changed similarly over time (in terms of their percentage increases), with the relative distribution thus the same, an increase in the ceiling in accordance with changes in the overall average wage index would have kept 90% of wages subject to the Social Security tax.

However, wages did not change in this balanced way.  Rather, the changes were terribly skewed, with wages for the rich rising sharply since the early 1980s while wages for the middle classes and the poor stagnated.  When this happens, with wages for the rich (those earning more than the Social Security ceiling) rising by more (and indeed far more) than the wages for others, indexing the ceiling to the average wage will not suffice to keep 90% of wages subject to tax.  Rather, the share of wages paying Social Security taxes will fall.  And that is precisely what has happened:

Social Security Taxable Wages as Share of Total Wages, 1982 to 2090

Due to the increase in wage income inequality since the early 1980s, wages paying Social Security taxes fell from 90.0% of total wages in 1982 and again in 1983, to just 82.7% in 2013 (the most recent year with data, see Table 4.B1 in the 2014 Social Security Annual Statistical Supplement).  While the trend is clearly downward, note how there were upward movements in 1989/90/91, in 2001/02, and in 2008/09.  These coincided with the economic downturns at the start of the Bush I administration, the start of the Bush II administration, and the end of the Bush II administration.  During economic downturns in the US, wages of those at the very top of the income distribution (Wall Street financiers, high-end lawyers, and similar) will decline especially sharply relative to where they had been during economic booms, which will result in a higher share of all wages paid in such years falling under the ceiling.

Why did the Greenspan Commission leave the rule for the determination of the ceiling on wages subject to Social Security tax unchanged?  Based on the experience in the decades leading up to 1980, this was not unreasonable.  In the post-World War II decades up to 1980, the distribution of incomes did not change much.  As discussed in an earlier post on this blog, incomes of the rich, middle, and poor all grew at similar rates over that period, leaving the relative distribution largely unchanged.  It was not unreasonable then to assume this would continue.  And indeed, there is a footnote in a table in the annex to the Greenspan Commission report (Appendix K, Table 15, footnote c) which states:  [Referring to the column showing the historical share in total wages of wages below the ceiling, and hence subject to Social Security tax] “The percent taxable for future years [1983 and later] should remain relatively stable as the taxable earnings base rises automatically based on increases in average wage levels.”

Experience turned out to be quite different.  Income inequality has risen sharply since Reagan was president.  This reduced the share of wages subject to Social Security tax, and undermined the forecasts made by the Greenspan Commission that with the changes introduced, the Social Security Trust Fund would remain adequate until well past 2034.

Going forward, the current forecasts for the path of the share of wages falling under the ceiling and hence subject to Social Security tax are shown as the blue curve in the chart. The forecasts (starting from 2013, the year with the most recent data when the Social Security Administration prepared these projections) are that the share would continue to decline until 2016.  However, they assume the share subject to tax will then start a modest recovery, reaching a share of 82.5% 2024 at which it will then remain for the remainder of the projection period (to 2090).  (The figures are from the Social Security Technical Panel Report, September 2015, see page 64 and following.  The annual Social Security Trustees Report does not provide the figures explicitly, even though they are implicit in their projections.)

This stabilization of the share of wages subject to Social Security tax at 82.5% is critically important.  Should the wage income distribution continue to deteriorate, as it has since the early 1980s, the Social Security Trust Fund will be in even greater difficulty than is now forecast.  And it is not clear why one should assume this turnaround should now occur.

Finally, it should be noted for completeness that the share of wages subject to tax varied substantially over time in the period prior to 1982.  Typically, it was well below 90%.  When Social Security began in 1937, the ceiling then set meant that 92% of wages (in covered sectors) were subject to tax (see Table 4.B1 in the 2014 Social Security Annual Statistical Supplement).  But the ceiling was set in nominal terms (initially at $3,000), which meant that it fell in real terms over time due to steady, even if low, inflation.  Congress responded by periodically adjusting the annual ceiling upward in the 1950s, 1960s, and 1970s, but always simply setting it at a new figure in nominal terms which was then eroded once again by inflation.  Only when the new system was established in the 1970s of adjusting the ceiling annually to reflect changes in average nominal wages did the inflation issue get resolved.  But this failed to address the problem of changes in the distribution of wages, where an increasing share of wages accruing to the rich in recent decades (since Reagan was president) has led to the fall since 1983 in the share subject to tax.

Thus an increasing share of wages has been escaping Social Security taxes.  The rest of this blog post will show that this explains why the Social Security Trust Fund is now projected to run out by 2034, and what could be achieved by returning the ceiling to where it would cover 90% of wages, or by lifting it entirely.

D.  The Impact of Keeping the Ceiling at 90% of Total Wages

The chart at the top of this post shows what the consequences would be if the ceiling on wages subject to Social Security taxes had been kept at levels sufficient to cover 90% of total wages (in sectors covered by Social Security), with this either from 1984 going forward, or starting from 2016.  While the specific figures for the distant future (the numbers go out to 2090) should not be taken too seriously, the trends are of interest.

The figures are calculated from data and projections provided in the 2015 Social Security Trustees Annual Report, with most of the specific data coming from their supplemental single-year tables (and where the share of wages subject to tax used in the Social Security projections are provided in the 2015 Social Security Technical Panel Report).  Note that throughout this blog post I am combining the taxes and trust funds for Old-Age Security (OASI, for old age and survivor benefits) and for Disability Insurance (DI).  While technically separate funds, these trust funds are often combined for analysis, in part because in the past they have traditionally been able to borrow from each other (although Republicans in Congress are now trying to block this flexibility).

The Base Case line (in black) shows the path of the Social Security Trust Fund to GDP ratio based on the most recent intermediate case assumptions of Social Security, as presented in the 2015 Social Security Trustees Annual Report.  The ratio recovered from near zero in the early 1980s to reach a high of 18% of GDP in 2009, following the changes in tax and benefit rates enacted by Congress after the Greenspan Commission report.  But it then started to decline, and is expected to hit zero in 2034 based on the most recent official projections.  After that if would grow increasingly negative if benefits were to continue to be paid out according to the scheduled formulae (and taxes were to continue at the current 12.4% rate), although Social Security does not have the legal authority to continue to pay out full benefits under such circumstances.  The projections therefore show what would happen under the stated assumptions, not what would in fact take place.

But as noted above, an important assumption made by the Greenspan Commission that in fact did not hold true was that adjustments (based on changes in the average wage) of the ceiling on wages subject to Social Security tax, would leave 90% of wages in covered sectors subject to the tax.  This has not happened due to the growth in wage income inequality in the last 35 years.  With the rich (and especially the extreme rich) taking in a higher share of wages, the wages below a ceiling that was adjusted according to average wage growth has led to a lower and lower share of overall wages paying the Social Security tax.  The rich are seeing a higher share of the high wages they enjoy escaping such taxation.

The blue curves in the chart show what the path of the Social Security Trust Fund to GDP ratio would have been (and would be projected going forward, based on the same other assumptions of the base case) had the share of wages subject to Social Security taxes remained at 90% from 1984.  The dark blue curve shows what path the Trust Fund would have taken had Social Security benefits remained the same.  But since benefits are tied to Social Security taxes paid, the true path will be a bit below (shown as the light blue curve). This takes into account the resulting higher benefits (and income taxes that will be paid on these benefits) that will accrue to those paying the higher Social Security taxes.  This was fairly complicated, as one needs to work out the figures year by year for each age cohort, but can be done.  It turns out that the two curves end up being quite close to each other, but one did not know this would be the case until the calculations were done.

Had the wage income distribution not deteriorated after 1983, and with all else as in the base case path of the Social Security Trustees Report (actual for historical, or as projected going forward), the Trust Fund would have grown to a peak of 26% of GDP in 2012, before starting on a downward path.  It would eventually still have turned negative, but only in 2056.  Over the long term, the forecast increase in life expectancies (beyond what the Greenspan Commission had assumed) would have meant that further changes beyond what were enacted following the Greenspan Commission report would eventually have become necessary to keep the Trust Fund solvent.  But it would have occurred more than two decades beyond what is now forecast.

At this point in time, however, we cannot go back in time to 1984 to keep the ceiling sufficient to cover 90% of wages.  What we can do now is raise the ceiling today so that, going forward, 90% of wages would be subject to the tax.  Based on 2014 wage distribution statistics (available from Social Security), one can calculate that the ceiling in 2014 would have had to been raised from the $117,000 in effect that year, to $185,000 to once again cover 90% of wages (about $187,000 in 2016 prices). 

The red curves on the chart above show the impact of starting to do this in 2016.  The Trust Fund to GDP ratio would still fall, but now reach zero only in 2044, a decade later than currently forecast.  Although there would be an extra decade cushion as a result of the reform, there would still be a need for a longer term solution.   

E.  The Impact of Removing the Wage Ceiling Altogether

The financial impact of removing the wage ceiling altogether will be examined below.  But before doing this, it is worthwhile to consider whether, if one were designing a fair and efficient tax structure now, would a wage ceiling be included at all?  The answer is no. First, it is adds a complication, and hence it is not simple.  But more importantly, it is not fair.  A general principle for tax systems is that the rich should pay at a rate at least as high as the poor.  Indeed, if anything they should pay at a higher rate.  Yet Social Security taxes are paid at a flat rate (of 12.4% currently) for wages up to an annual ceiling, and at a zero rate for earnings above that ceiling.

While it is true that this wage ceiling has been a feature of the Social Security system since its start, this does not make this right.  I do not know the history of the debate and political compromises necessary to get the Social Security Act passed through Congress in 1935, but could well believe that such a ceiling may have been necessary to get congressional approval.  Some have argued that it helped to provide the appearance of Social Security being a self-funded (albeit mandatory) social insurance program rather than a government entitlement program.  But for whatever the original reason, there has been a ceiling.

But the Social Security tax is a tax.  It is mandatory, like any other tax.  And it should follow the basic principles of taxation.  For fairness as well as simplicity, there should be no ceiling.  The extremely rich should pay at least at the same rate as the poor.

One could go further and argue that the rates should be progressive, with marginal rates rising for those at higher incomes.  There are of course many options, and I will not go into them here, but just note that Social Security does introduce a degree of progressivity through how retirement benefits are calculated.  The poor receive back in pensions a higher amount in relation to the amounts they have paid in than the rich do.  One could play with the specific parameters to make this more or less progressive, but it is a reasonable approach.  Thus applying a flat rate of tax to all income levels is not inconsistent with progressivity for the system as a whole.

Leaving the Social Security tax rate at the current 12.4% (for employer and employee combined), but applying it to all wages from 2016 going forward and not only wages up to an annual ceiling, would lead to the following path for the Trust Fund to GDP ratio:

Social Security Trust Fund to GDP, with benefit changes, All Wages from 2016, 1970 to 2090, revised

The Trust Fund would now be projected to last until 2090.  Again, the projections for the distant future should not be taken too seriously, but they indicate that on present assumptions, eliminating the ceiling on wages subject to tax would basically resolve Trust Fund concerns for the foreseeable future.  A downward trend would eventually re-assert itself, due to the steadily growing life expectancies now forecast (see the chart in the text above for the projections from the 2015 Social Security Trustees Annual Report). Eventually there will be a need to pay in at a higher rate of tax if taxes on earnings over a given working life are to support a longer and longer expected retirement period, but this does not dominate until late in the forecast period.

As a final exercise, how high would that tax rate need to be, assuming all else (including future life expectancies) are as now forecast?  The chart below shows what the impact would be of raising the tax rate to 13.0% from 2050:

Social Security Trust Fund to GDP, with benefit changes, All Wages from 2016, 1970 to 2090, revised #2

The Social Security Trust Fund to GDP ratio would then be safely positive for at least the rest of the century, assuming the different variables are all as now forecast.  This would be a surprisingly modest increase in the tax rate from the current 12.4%.  If separated into equal employer and employee shares, as is traditionally done, the increase would be from a 6.2% tax paid by each to a 6.5% tax paid by each.  Such a separation is economically questionable, however.  Most economists would say that, under competitive conditions, the worker will pay the full tax.  Whether labor markets can be considered always to be competitive is a big question, but beyond the scope of this blog post.

F.  Summary and Conclusion

To summarize:

1)  The Social Security Trust Fund is projected to be depleted under current tax and benefit rates by the year 2034.  But this is not because retirees are living longer.  Increasing life spans have long been expected, and were factored into the estimates (the last time the rates were changed) of what the tax and benefit rates would need to be for the Trust Fund not to run out.  Nor is it because of aging baby boomers reaching retirement.  This has long been anticipated.

2)  Rather, the Social Security Trust Fund is now forecast to run out by the 2030s because of the sharp increase in wage income inequality since the early 1980s, when the Greenspan Commission did its work.  The Greenspan Commission assumed that the distribution of wage incomes would remain stable, as it had in the previous decades since World War II.  But that turned out not to be the case.

3)  If relative inequality had not grown, then raising the ceiling on wages subject to Social Security tax in line with the increase in average wages (a formula adopted in legislation of 1972, and left unchanged following the Greenspan Commission) would have kept 90% of wages subject to Social Security tax, the ratio it covered in 1982 and again in 1983.

4)  But wage income inequality has grown sharply since the early 1980s.  With the distribution increasingly skewed distribution, favoring the rich, an increasing share of wages is escaping Social Security tax.  By 2013, the tax only covered 82.7% of wages, with the rest above the ceiling and hence paying no tax.

5)  Had the ceiling remained since 1984 at levels sufficient to cover 90% of wages, and with all other variables and parameters as experienced historically or as now forecast going forward, the Social Security Trust Fund would be forecast to last until 2056.  While life expectancies (at age 65) in fact turned out on average to be lower than forecast by the Greenspan Commission until 2010 (which would have led to a higher Trust Fund balance, since less was paid out in retirement than anticipated), life expectancies going forward are now forecast to be higher than what the Greenspan Commission assumed.  This will eventually dominate.

6)  If the wage ceiling were now adjusted in 2016 to a level sufficient to cover once again 90% of wages ($187,000 in 2016), the Trust Fund would turn negative in 2044, rather than 2034 as forecast if nothing is done.

7)  As a matter of equity and following basic taxation principles, there should not be any wage ceiling at all.  The rich should pay Social Security tax at least at the same rate as the poor.  Under the current system, they pay zero on wage incomes above the ceiling.

8)  If the ceiling on wages subject to Social Security tax were eliminated altogether, with all else as in the base case Social Security projections of 2015, the Trust Fund would be expected to last until 2090.

9)  If the ceiling on wages subject to Social Security tax were eliminated altogether and the tax rate were raised from the current 12.4% to a new rate of 13.0% starting in 2050, with all else as in the base case Social Security projections of 2015, the Trust Fund would be expected to last to well beyond the current century.

The Rate of Return on Funds Paid Into Social Security Are Actually Quite Good

Social Security Real Rates of Return - Various Scenarios

 

A.  Introduction

The rate of return earned on what is paid into our Social Security accounts is actually quite good.  It is especially good when one takes into account that these are investments in safe assets, and thus that the proper comparison should be to the returns on other safe assets, not risky ones.  Yet critics of Social Security, mostly those who believe it should be shut down in its current form with some sort of savings plan invested through the financial markets (such as a 401(k) plan) substituted for it, often assert that the returns earned on the pension savings in Social Security are abysmally poor.

These critics argue that by “privatizing” Social Security, that is by shifting to individual plans invested through the financial markets, returns would be much higher and that thus our Social Security pensions would be “rescued”.  They assert that by privatizing Social Security investments, the system will be able to provide pensions that are either better than what we receive under the current system, or that similar pensions could be provided at lower contribution (Social Security tax) rates.

There are a number of problems with this.  They include that risks of poor financial returns (perhaps due, for example, to a financial collapse such as that suffered in 2008 in the last year of the Bush administration, when many Americans lost much or all of their retirement savings) would then be shifted on to individuals.  Individuals are not in a good position to take on such risks.  Individuals are also not financial professionals, nor normally in a good position to judge the competency of financial professionals who offer them services.  They also often underestimate the impact of high and compounding fees in depleting their savings over time.  For all these reasons, such an approach would serve as a bad substitute for the Social Security system such as we have now, which is designed to provide at least a minimum pension that people can rely on in their old age, with little risk.

But there is also a more fundamental problem with this approach.  It presumes that returns in the financial markets will in general be substantially higher than returns that one earns on what we pay into the Social Security system.  This blog post will show that this is simply not true.

The post looks at what the implicit rates of return are under several benchmark cases for individuals.  We pay into Social Security over our life time, and then draw down Social Security pensions in our old age.  The returns will vary for every individual, depending on their specific earnings profile (how much they earn in each year of their working career), their age, their marital situation, and other factors.  Hence there will be over 300 million different cases, one for each of the over 300 million Americans who are either paying into Social Security or are enjoying a Social Security pension now.  But by selecting a few benchmarks, and in particular extreme cases in the direction of where the returns will be relatively low, we can get a sense of the range of what the rates of return normally will be.

The chart at the top of this post shows several such cases.  The rest of this post will discuss each.

B.  Social Security Rates of Return Under Current Tax and Benefit Rates

The scenarios considered are all for an individual who is assumed to work from age 22 to age 65, who then retires at 66.  The individual is assumed to have reached age 65 in 2013 (the most recent year for which we have all the data required for the calculations), and hence reached age 62 in 2010 and was born in 1948.  The historical Social Security tax rates, the ceiling on wages subject to Social Security tax, the wage inflation factors used by Social Security to adjust for average wage growth, and the median earnings of workers by year, are all obtained from the comprehensive Annual Statistical Supplement to the Social Security Bulletin – 2014 (published April 2015).  Information on the parameters needed to calculate what the Social Security pension payments will be are also presented in detail in this Statistical Supplement, or in a more easy-to-use form for the specific case of someone reaching age 62 in 2010 in this publication of the Social Security Administration.  It is issued annually.

The Social Security pension for an individual is calculated by first taking the average annual earnings (as adjusted for average wage growth) over the 35 years of highest such earnings in a person’s working career.  For someone who always earned the median wage who reached age 62 in 2010, this would work out to $2,290 per month. The monthly pension (at full retirement age) would then be equal to 90% of the first $761, 32% of the earnings above this up to $4,586 per month, and then (if any is left, which would not be the case in this example of median earnings) 15% of the amount above $4,586.  Note the progressivity in these rates of 90% for the initial earnings, then 32%, and finally 15% for the highest earnings.  The monthly Social Security pension will then be the sum of these three components.  Since it is then adjusted for future inflation (as measured by the CPI), we do not need to make any further adjustments to determine the future pension payments in real terms.  The pensions will then be paid out from age 66 until the end of their life, which we take to be age 84, the current average life expectancy for someone who has reached the age of 65.

The historical series of payments made into the Social Security system through Social Security taxes (for Social Security Old-Age pensions only, and so excluding the taxes for Disability insurance and for Medicare) are then calculated by multiplying earnings by the tax rate (currently 10.6%, including the shares paid by both worker and employer).  The stream of payments are then put in terms of 2010 dollars using the historical CPI series from the Bureau of Labor Statistics.

We can thus calculate the real rates of return on Social Security pensions under various scenarios.  The first set of figures (lines A-1) in the chart above are for a worker whose earnings are equal to what median wages were throughout his or her working life.  (A table with the specific numbers on the rates of return is provided at the bottom of this post, for those who prefer a numerical presentation.)  The individual paid into the Social Security pension system when working, and will now draw a Social Security pension while in retirement.  One can calculate the real rate of return on this stream of payments in and then payments out, and in such a scenario for a single worker earning median wages throughout his or her career who retired at age 66 in 2014, the real rate of return works out to be 2.9%.  If the person is married, with a spouse receiving the standard spousal benefit, the real rate of return is 4.1%.

Such rates of return are pretty good, especially on what should be seen as a safe asset (provided the politicians do not kill the system).  Indeed, as discussed in an earlier post on this blog, the real rate of return (before taxes) on an investment in the S&P500 stock market index over the 50 year period 1962 to 2012, would have been just 2.9% per annum assuming fees on 401(k) type retirement accounts of 2.5% (which is typical once one aggregates the fees at all the various levels – see the discussion in section E.3 of this blog post).  But investing in the stock market, even in a broad based index such as the S&P500, is risky due to the volatility.  Retirement accounts in 401(k)’s are generally a mix of equity investments, fixed income securities (bonds of various maturities, CDs, and similar instruments), and cash.  Based on the recent average mix seen in 401(k)’s, and for the same 50 year period of 1962 to 2012, the average real rate of return achieved after the fees typically charged on such accounts would only have been 1.2%.  Social Security for a worker earning median wages is far better.

As noted above, there is a degree of progressivity in the system, as higher income earners will receive only a smaller boost in their pension (at the 15% rate) from the higher end of their earnings.  Thus the rates of return in Social Security for high income earners will be less.  The rates of return they will earn are shown on lines A-2 of the chart.  This extreme case is calculated for a worker who is assumed to have earned throughout his or her entire work life an amount equal to the maximum ceiling on wages subject to Social Security tax (which was $113,700 in 2013).  Note also that anyone earning even more than this will have the same rates of return, as they will not be paying any more into the Social Security system (it is capped at the wage ceiling subject to tax) and hence also not withdrawing any more (or less) in pension.

Such high income earners will nonetheless still see a positive real rate of return on their Social Security contributions, of 1.4% for a single earner and 2.8% if married receiving a spousal benefit.  That is, while there is some progressivity in the Social Security system, it is not such that the returns turn negative.  And the returns achieved are still better than what typical 401(k) retirement accounts earn.

One should also take into account that high income earners are living longer than low income earners.  Indeed, the increase in life expectancies have been substantial in the last 30 years for high income earners, but only modest for those in the bottom half of the earnings distribution.  While I do not have data on what the life expectancies are for a person whose earnings have been at the absolute top of the Social Security wage ceiling over the course of their careers, for the purposes here it was assumed their life expectancy (for someone who has reached age 65) would be increased to age 90 from the age of 84 for the overall population.

In such a scenario, the real rates of return for someone who paid into the Social Security system always at the wage ceiling over their entire life time and then drew a Social Security pension up to age 90 would be 2.2% if single and 3.4% if married with a standard spousal benefit.  These are far better than typical 401(k) returns, and indeed are quite good in comparison to an investment in any safe asset (once one takes into account fees).

C.  Social Security Rates of Return Assuming Higher Social Security Tax Rates

The rates of return calculated so far have been based on what the actual historical Social Security tax rates have been, and what the current benefit formula would determine for future pensions.  But as most know, at current tax and benefit rates the Social Security Trust Fund is projected to be depleted by about 2034 according to current estimates.  The reason is that life expectancies are now longer (which is a good thing), but inadequate adjustments have been made in Social Security tax rates to allow for pay-outs which will now need to cover longer lifetimes.  The problem has been gridlock in Washington, where an important faction of politicians opposed to Social Security are able to block any decision on how to pay for longer life expectancies.

There are a number of ways to ensure Social Security could be adequately funded.  One option, which I would recommend, would be simply to lift the ceiling on wages subject to Social Security tax (which was $113,700 in 2013, $118,500 in 2015, and will remain at $118,500 in 2016).  As discussed in section E.2 of this earlier blog post, it turns out that this alone should suffice to ensure the Social Security Trust Fund remains adequate for the foreseeable future.  The extra funding needed is an estimated 19.4% over what is collected now (based on calculations from an earlier post on this blog, but with data now a few years old), and it turns out that ending the wage ceiling would provide this.  At the ceiling on wages subject to Social Security tax of $113,700 in 2013, the share of workers earning at this ceiling or more was just 6.1%, but due to the skewed distribution of income in favor of the rich, untaxed wages in excess of the ceiling accounted for 17.3% of all wages paid.  That is, Social Security taxes were being paid on only 82.7% of all wages.  If the taxes were instead paid on the full 100%, Social Security would be collecting 21% more (= 100.0 / 82.7).

The extremely rich would then pay Social Security taxes at the same rate as most of the population, instead of something lower.  It should also be noted that it is the increase in life expectancy of those at the upper end of the income distribution which is driving the Social Security system into deficit at the current tax rates, as they are the ones living longer while those in the lower part of the income distribution are not.  Thus it is fair that those who will be drawing a Social Security pension for a longer period should be those who should be called on to pay more into the system.

To be highly conservative, however, for the rate of return calculations being discussed here I have assumed that the general Social Security tax rate will be increased by 19.4% on all wages below the ceiling, while the ceiling remains where it has been.  These calculations are for historical scenarios, where the purpose is to determine what the rates of return on payments into Social Security would have been had the tax rates been 19.4% higher on all, to provide for a fully funded system.  Finally, note that while these scenarios assume a higher Social Security tax rate historically, they also set the future pension benefits to be paid out to be the same as what they would be under the current benefit rates.  That is, the pay-out formulae would need to be changed to leave benefits the same despite the higher taxes being paid into the system.

The real rates of return would then be as shown in Panel B of the chart above.  While somewhat less than before, the real returns are still substantial, and still normally better than what is earned in a typical 401(k) plan.  The returns for someone earning at the median wage throughout their career will now be 2.4% if single and 3.6% if married (0.5% points less than before).  The returns for someone earning at or above the ceiling for wages subject to Social Security taxes would now be earning at the real rate of 0.8% if single and 2.2% if married for the age 84 life expectancy (0.6% points less than before), or 1.6% and 2.9% (for single and married) if the life expectancy of such high earners is in fact age 90 (also 0.6% points less, before round-off).

The real rates of return all remain positive, and generally good compared to what 401(k)’s typically earn.

D.  Conclusion

As noted above, the actual profile of Social Security taxes paid and pension received will vary by individual.  No two cases will be exactly alike.  But the calculations here indicate that for someone with median earnings, and still even in the extreme case of someone with very high earnings (where a degree of progressivity in the system will reduce the returns), the rates of return earned on what is paid into and then taken out of the Social Security system are actually quite good.  They generally are better than what is earned in a typical 401(k) account (after fees), and indeed often better than what would earn in a pure equity investment of the S&P500 index (and without the risk and volatility of such an investment).

Social Security is important and has become increasingly important.  Due to the end of many traditional defined benefit pension plans, with a forced switch to 401(k) plans or indeed often to nothing at all from the employer, Social Security now accounts (for those aged 65 or older) for a disturbingly high share on the incomes of many of the aged. Specifically, Social Security now accounts for half or more of total income for two-thirds of all those age 65 or older, and accounts for 100% of their income for one-quarter of them. And for the bottom 40% of this population, Social Security accounted for 90% or more of their total income for three-quarters of them, and 100% of their income for over half of them.

The problem is not in the Social Security system itself.  It is highly efficient, with an expense ratio in 2014 of just 0.4% of benefits paid.  Private 401(k) plans, with typical expenses of 2.5% of assets (not benefits) each year will have expenses over their life time that are 90 times as great as what Social Security costs to run.  And as seen in this post, the return on individual Social Security accounts are quite good.

The problem that Social Security faces is rather that with longer life expectancies (most importantly for those of higher income), the Social Security taxes being paid are no longer sufficient to cover the payouts to cover these longer lifetimes.  They need to be adjusted. There are several options, and my recommendation would be to start by ending the ceiling on wages subject to Social Security taxes.  This would suffice to solve the problem.  But one could go further.  As discussed in an earlier blog post (see Section E.2), not only should all wages be taxed equally, but one should extend this to taxing all forms of income equally (i.e. income from wealth as well as income from wages).  If one did this, one could then either cut the Social Security tax rate sharply, or raise the Social Security benefits that could be paid, or (and most likely) some combination of each.

But something needs to be done, or longer life spans will lead the Social Security Trust Fund to run out by around 2034.  The earlier this is resolved the better, both to ensure less of a shock when the change is finally made (as it could then be phased in over time) and for equity reasons (as it is those paying in now who are not adequately funding the system for what they will eventually drawdown).

 

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Annex:  Summary Table

Real Rates of Return from Social Security Old-Age Taxes and Benefits

A)  Social Security Scenarios – Current Rates

  1)  Earnings at Median Throughout Career

   a)  Single

2.9%

   b)  Married

4.1%

  2)  Earnings at Ceiling Throughout Career

   a)  Single

1.4%

   b)  Married

2.8%

  3)  Earnings at Ceiling, and Life Expectancy of 90

   a)  Single

2.2%

   b)  Married

3.4%

B)  Social Security with 19.4% higher tax rate

  1)  Earnings at Median Throughout Career

   a)  Single

2.4%

   b)  Married

3.6%

  2)  Earnings at Ceiling Throughout Career

   a)  Single

0.8%

   b)  Married

2.2%

  3)  Earnings at Ceiling, and Life Expectancy of 90

   a)  Single

1.6%

   b)  Married

2.9%

C)  Comparison to 401(k) Vehicles

  1)  S&P500 after typical fees

2.9%

  2)  Average 401(k) mix after typical fees

1.2%