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.

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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).

 

============================================================

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%

Concrete Measures to Address Real Income Stagnation of the Poor and Middle Classes

Piketty - Saez 1945 to 2013, June 2015, log scale

I.  Introduction

The distribution of the gains from economic growth has gotten horribly skewed since around 1980, as the graph above shows (using a log scale so that distances on the vertical scale are equal relative changes).  Average real incomes of the bottom 90% of households have fallen by 5% in real terms since 1980, while the real incomes of the top 0.01% have grown by 325%.  This is astounding.  Something has changed for the far worse in recent decades.  The real incomes of these groups grew at roughly similar rates in the post-World War II decades leading up to 1980, but then diverged sharply.

An earlier post on this blog looked at the proximate factors which took substantial growth in GDP per capita (which grew at about the same pace after 1980 as it had before) down to median wages that simply stagnated.  As discussed in that post, this was principally due to a shift in distribution from labor to capital, and a shift within labor from the lower paid to the higher paid.  (Demographic effects, principally the increased participation of women in the labor force, as well as increases in the prices of items such as medical care relative to the prices of other goods, were also both important during this period. However, both have now become neutral, and are not factors leading to the continuing stagnation in recent years of median wages.)

The purpose of this blog post is to look at concrete policy measures that can be taken to address the problem.  The issue is not slow growth:  As noted above, per capita growth in GDP since 1980 has been similar to what it was before.  The problem, rather, is the distribution of the gains from that growth, which has become terribly skewed.

Discussion of this is also timely, as a consensus appears to be forming among political leaders in both major parties that something needs to be done about the stagnant incomes of the poor and middle classes.  Several of the candidates seeking the Republican presidential nomination have said they wish to make this a primary issue of the 2016 campaign.  This is good.  If they are serious, then they would support measures such as those laid out below.  I doubt they will, as they were strenuously opposed in the past to many of them, and indeed championed the changes in policy from the Reagan period onwards which are, at a minimum, associated in time with the deterioration in distribution seen in the chart above.  But one can hope.

This is a long blog post, as it discusses a long list of measures that could be taken to address the predicament of the poor and middle classes.  Many (although not all) of these policies have been reviewed in previous posts on this blog.  Thus the discussion here will in such cases be kept individually brief, with the reader encouraged to follow the links to the earlier blog posts for more substantive discussion of the points being made.  And the reader with limited time may wish to scan through the section headings, and focus on those topics of most interest.

II.  A Policy Program

A.  Labor Market

We start with the labor market, as it is fundamental.

1)  Raise the minimum wage:  The minimum wage is now less in real terms than what it was in 1950, during the presidency of Harry Truman.  This is amazing.  Or perhaps what is amazing is the argument made by some that raising it would price workers out of their jobs.  Real GDP per capita is now 3.75 times what it was then, and labor productivity has grown to 3.5 times what it was then.  But the minimum wage is now less in real terms than what it was then.  The minimum wage in 1950 was not too high to price low paid workers out of the market, and labor productivity is three and a half times higher now.

Obama has called for the minimum wage to rise to $10.10 per hour from its current $7.25 per hour (with this then indexed to the rate of inflation).  This would bring the minimum wage back only to where it was in the 1960s, a half century ago.  There is no evidence that such a rise will hurt low wage workers, and it would still leave a full time worker (at 40 hours a week, and with no vacation time, so 52 weeks per year times 40 hours per week = 2,080 hours per year) at such a minimum wage (2,080 x $10.10 = $21,008 per year) earning well less than what is needed to bring a family of four up to the poverty line ($24,250 per year for a family of four in 2015).  This is the minimum that should be done. Indeed, it should be more.

2)  Ensure predictable work hours:  Many workers, particularly in sectors such as retail and food service (whether fast food or traditional restaurants), are increasingly being required to accept “flexible” work hours, where their employer tells them only a short time ahead what days to come in, at what time to report, and for how many hours.  They might be told a few days before, or only the day before, or sometimes only on the day of possible work, whether they will be needed and should report to work.  This is sometimes called “just-in-time” scheduling (a term taken from just-in-time inventory management) or “on-call” scheduling, and managers are rewarded for what is seen as “optimizing” their use of labor.

But it plays havoc with the life of many workers.  They cannot take a second job in the evening to help make ends meet, if they do not know whether their primary job may sometimes require that they come in on short notice to work an evening shift.  Students cannot enroll in college classes in order to finish a degree if they do not know whether they might be called in during class time.  Parents and especially single mothers can have great difficulty in arranging for child care when their work schedules are unpredictable.  And an unpredictable number of weekly work hours, of perhaps 30 hours one week and 20 hours the next, makes budgeting impossible.

Recent developments in computer and communications technology have made on-call scheduling possible and increasingly common.  Establishments such as Starbucks can receive at some central office real-time information on coffee sales (from the cash registers, via an Internet connection), and together with other factors (weather forecasts; whether a convention is in town) can run sophisticated software algorithms predicting how many workers will be needed, exactly when, and which ones should be called in.

The problems this creates for low income workers has only recently come to be recognized.  An important spark was a story in the New York Times on August 13, 2014, on the impact on a worker at Starbucks.  This led Starbucks the very next day to announce it would change its practices, but a review a month later by another news organization raised questions as to whether anything of significance had really changed.

Starbucks can possibly be shamed into improving it working conditions, as it sells high-end coffee to those with significant disposable income.  And if the problem were solely with Starbucks and a few similar firms, a shaming approach might possibly be effective. However, while Starbucks may have become the symbol, the practice has unfortunately become increasingly widespread.  Furthermore, there is competitive pressure across firms to adopt such practices.  If Starbucks stops the practice, it may face coffee retailers who continue to “optimize” their use of labor through such practices, who can then take away business by charging less.  There is thus pressure on firms to impose the lowest standards they can get away with.

There is no federal law against such labor practices.  There may be state laws which might constrain the practices in some way in certain jurisdictions, but they are not widespread. What is needed is a legislated solution which will apply generally, and should be undertaken at the federal level.  This has been done before.

Abuses of labor had become common during the “gilded age” of the late 1800s / early 1900s (when income distribution was, not coincidentally, as bad as it is now).  Progressive Era and later New Deal reforms addressed some of the more egregious issues.  Work place safety and child labor laws were enacted, a minimum wage was established, and a 40 hour work week was set as the standard, where a worker is required to be paid overtime at the rate of “time and a half” (150% of their regular wage) for any hours worked beyond 40 in a week.

The issue of unpredictable work hours could be addressed similarly.  All workers would have a normal set of hours, defined individually and a function of their particular job.  They would always be paid for this set of normal hours.  But it is recognized that firms may have an unexpected need for additional workers at certain times (for example to substitute for a worker who is sick).  Workers could take on such additional shifts beyond their regular hours if they so chose, but as a financial inducement for the firm not to rely on such job calls, the firm would be required to pay 150% of normal wages for such time (as for overtime work).

This would lead firms to assess better when they need workers and when not, and build this into the standard work schedules.  Firms have little incentive to do this now, since the cost of unpredictable schedules is shifted onto the workers.  Note also that with this system there will not be an incentive to further split up jobs, as all workers will be assigned an individualized normal schedule.  The firms will gain no flexibility by splitting a 30 hour a week job into one of 20 hours and one of 10 hours.  They will still need to determine when workers are expected to be needed, in order to assign hours accordingly.  And to the extent they do not do this carefully, they will be penalized as they will then need to pay 150% of the wage when a worker needs to be brought in to cover those extra hours.

Predictability in hours is extremely important to low wage workers.  Indeed, it is quite possibly more important than raising the minimum wage.  It will shift some of the costs of unpredictability back onto the firm, where it had been until modern computer and communications technology (and lax labor laws that did not foresee this) allowed the firms to shift onto workers the cost of unpredictability.  Firms did this to raise profits, and business profits did indeed then rise while wage earnings stagnated.  This is precisely the issue that needs to be corrected.

3)  Manage policies to return the economy rapidly back to full employment when there are economic downturns:  While it would be ideal always to keep the economy at or close to full employment, economic downturns happen, most recently in 2008 in the last year of the Bush administration.  But when they do, the priority should be to return the economy to full employment as rapidly as possible.  Everyone can of course agree on this. Differences arise, however, on how to do it.

Monetary policy should be used to the extent possible, but there is a limit to how much it can do since interest rates cannot go below zero.  And they have been at essentially zero since late 2008, following the Lehman Brothers collapse.  The Fed can also try to reduce long term rates (such as through quantitative easing), and while its policy here has had some beneficial effect, it is also limited.

Monetary policy in a downturn such as that just experienced must therefore be supported also by expansionary fiscal policy.  Additional government spending is the most effective way to expand demand, as it does this directly.  Tax cuts can also help, but are less effective since a significant share of the reduction in taxes may be partly saved by households (and likely will be largely saved by higher income households).  There will thus be less stimulative effect per dollar from tax cuts than from direct spending.

Unfortunately, government spending was cut each year from 2010 up to 2014. This was the first time in at least 40 years that government has cut spending in a downturn.  Hence the economic recovery has been the slowest of any over that period, and only picked up in 2014, when government spending was finally allowed to increase.

Republicans have argued that to return the economy to full employment, one should instead reduce regulations.  But this makes no sense.  Regulations in the middle of a downturn are not far different from what they were before the downturn began, so how can they be blamed for the unemployment, and how would reducing them lead to less unemployment?  And if some regulations are wrong, one should change them, whether the economy has high unemployment or low unemployment.  Regulations do not serve as a macro policy to reduce unemployment, but rather serve a micro purpose to ensure the economy functions efficiently.

A slack labor market will have a direct effect on income inequality.  When there is available labor that is unemployed, a laborer will have little leverage to negotiate for higher wages. And unemployment has been higher, on average, in the three decades following 1980 than in the three decades before 1980.  A simple regression analysis suggests that if the average rate of unemployment after 1980 had simply matched what it had been before 1980, then the real incomes of the bottom 20% of households would not only have grown at a rate similar to how fast they had grown before, but also at a rate similar to that of the top 20% in the period after 1980.  That is, there would have been continued growth in the real incomes of the bottom 20% after 1980, instead of stagnation, and no increase in inequality relative to the top 20%.  Keeping the economy at close to full employment is critical to the poor and middle classes.

B.  Fiscal Policy

Fiscal policy is therefore an important instrument to keep the economy at full employment, or to return it to full employment from a downturn.  What specifically should be done?

1)  End the Congressional budgetary “pay-as-you-go” rules when in or recovering from a recession:  The Budget Enforcement Act of 1990 required that, as a budgetary rule, any increase in mandatory government spending or reductions in taxes must be “paid for” over the next five years as well as the next ten years by offsetting spending cuts or tax increases, so as to be budget neutral over these periods.  While the rules have been modified over the years, were not in place for a period during the Bush II administration, and were not always abided by (such as for the large tax cuts at the start of the Bush administration), they have acted in recent years to limit the government spending that was needed to recover from the downturn.

Over the course of a full business cycle, covering the full period over when the economy is at or close to full employment and when it is not, a limit on the size of the government deficit is warranted.  But by setting such a limit to apply identically and continuously both in a downturn and when the economy is booming, one limits the government expenditures that may be needed for a rapid recovery.  The rule should be suspended during any period when the economy is in a recession or recovering from one, to be replaced by a rule that applies over the course of the business cycle as a whole and which focusses on the government debt to GDP ratio rather than simply the government deficit.

2)  Stop cuts to important safety net programs such as food stamps and unemployment insurance, especially in a downturn:   Safety net programs such as food stamps (now called SNAP) and unemployment insurance are critically important to the poor and middle classes, and especially so in a downturn. They provide limited support to households who lost their jobs or other sources of income in the recession, due to no fault of their own.  (The 2008 downturn was a consequence of the reckless management of banks and other financial institutions in the US, and the policy decision of the Bush administration officials not to make use of their regulatory powers to limit it.  This led to very high bank leverage, a build-up of the housing bubble, and then collapse when the housing bubble burst.)

As unemployment rose and incomes fell, especially of the poor and near poor, many more households became eligible for food stamps and, having lost jobs, for unemployment insurance.  Expenditures on these and other safety net programs expanded, as they are designed to do in a downturn.  But Congressional Republicans then forced through cuts in the key safety net programs (e.g. unemployment insurance, and food stamps) by limiting eligibility, and have sought much more extensive cuts.

If one wishes to help the poor and near poor, one does not cut programs which help them directly, and especially not when they most need them.  These programs are also extremely efficient.  The food stamp program (SNAP) spends only 5% of its budget on administrative costs.  Few charities are anywhere close to as efficient, but at least some prominent Republicans think otherwise.  Former Congresswoman Michele Bachmann, at one point the leading contender for the Republican presidential nomination in 2012, asserted that 70% of food stamp funding went to “bureaucrats”.  This was absurdly wrong.

Safety net programs in the US, while efficient for the money spent, are however highly limited in how much they do spend.  US income inequality or poverty rates are actually not worse than those seen in other high income OECD economies in terms of wages and other income paid to workers. That is, the US capitalist market economy does not itself produce more unequal outcomes than those of other high income OECD economies.  The US is near the average in this across all the OECD countries.  But once one takes into account government taxes and transfers, the US turns out to be the very worst, both in terms of inequality (as measured by the Gini coefficient) and in terms of poverty (by the share of the population considered poor).  The problem is not that the US tax and transfer programs are not especially progressive:  They are in fact more progressive than in most countries.  The problem is that they are simply too small to matter.

3)  Implement a public infrastructure investment program:  American public infrastructure is an embarrassment.  Compared to other high income countries, US roads, bridges, mass transit, and other public structures, are clearly inadequate in scale, are in terrible condition due to inadequate maintenance, and constitute what is in effect a growing debt that will need to be repaid in the future when they finally have to be rebuilt (normally at much greater cost than if they had been maintained properly).

Public investment has been cut back especially sharply in recent years, whether measured as a share of GDP or simply in real per capita terms, as a consequence of Congressional cuts in the budget.  But while the cuts have been especially sharp since 2010, the problem is long-standing.  Amazingly, US non-defense public investment in structures in 2013 was less, in real per capita terms, than what it was in 1960, even though real per capita GDP almost tripled over this period.

It should therefore be no surprise that roads and bridges are in poor condition (with some bridges that have even collapsed), mass transit systems are in poor repair, and all are grossly inadequate to what we need.  This impacts especially the middle classes, who have to sit in traffic jams daily just to get to work.  Toll roads or tolled lanes built by private concessionaires have become fashionable in recent years to build roads that government is no longer willing to pay for, but they can be expensive.  The tolled lanes opened recently in Northern Virginia in the I95/I495 corridor have tolls that, for the entire length, could conceivably reach $40 or more per trip (and double that per day).  Rich people can afford this, but most of those with middle class incomes cannot.

Adequate public infrastructure is needed to raise productivity and for the economy to grow.  And the recent severe downturn should have been a time for a special effort to expand such investment, putting to work unemployed construction and other workers, in firms that had capacity to produce more than they could sell due to low demand in the downturn.  Furthermore, the government could have borrowed long term funds during this period at historically low rates, and even at times at negative real rates.  It was insanity not to utilize the unemployed labor and underutilized firms, financed by funds at low or even negative real cost, to build and repair infrastructure that the economy and especially the poor and middle classes desperately need.

But this was not done.  It instead will need to be done over the coming years (and at much higher cost, due to the lack of maintenance), when the economy is hopefully at full employment, interest rates have returned to normal levels, and anything extra spent on public infrastructure will need to come out of less being available for other goods and services, including for private investment.

4)  Increase public support to higher education:  At one time, students could pay for the total costs of attending a state university, including room and board, through work at just the minimum wage during summers and part time during the academic terms.  This is no longer the case.  In part this is due to the fall in the minimum wage in real terms from where it had been in the 1960s.  But it was also a consequence of the rising cost of university education (a result of Baumol’s cost disease) coupled with sharp cutbacks in the share of these costs covered by state support to their colleges and universities, shifting more of the cost onto students and their families.

This reduction in state support to their colleges and universities needs to be reversed, or soon state schools will in effect no longer exist.  They will have become essentially private schools catering to those who can afford them.  And while federal programs exist to help students (most importantly the Pell Grant program, which provides grants of up to $5,775 per year, in academic year 2015/16), they are limited and family income based.  The maximum Pell Grant goes only to the poorest households.

There are different ways to assist students from poor and middle class households to continue their schooling beyond high school.  President Obama, in this year’s State of the Union address, proposed for example that federal support be provided so that community colleges would stop charging tuition for students in good standing.  One would in essence be extending the availability of public schooling from 12 years now to 14 years.  The budget cost would be relatively modest at just $6 billion per year.  Others have suggested, constructively, that using such funds to expand the Pell Grant program would achieve the same aim, while assisting also those low income and middle class students who would do better by enrolling in a four-year college.

The response of the Republicans in Congress has, however, been in the opposite direction.  While rejecting Obama’s proposal for community colleges, the recent proposal from the House Budget Committee would instead freeze the maximum Pell Grant at $5,775 for at least the next ten years, thus leading to its erosion in real terms as prices rise (much as the minimum wage has eroded over time due to inflation).

C.  Tax Policy

Tax policy has a direct impact on income distribution.  But while most still accept the principle that taxes should be progressive (the principle that the rich should pay taxes at a higher rate than the poor), the tax system the US in fact has is regressive in many of its aspects.

1)  Stop the preferential tax treatment of income from wealth:  The wealthy pay a lower rate of taxes on their income from wealth than most of the population pays on their income from labor.  In terms of policy options to address inequality, little would be more straightforward than to end the practice of taxing income from wealth at lower rates than income from work.  Tax rates on all income groups could then be reduced, with the same total tax revenues collected.

The long-term capital gains tax rate on most assets is only 15% for most earners (there is an additional 3.8% for those households earning more than $250,000 bringing the rate to 18.8%, with this rising by a further 5% points to 23.8% for those earning $464,850 or more in 2015).  These rates on income from wealth are well below what is paid by most on income from labor (wages).  While the regular income tax rates (on wages) vary formally from 10% in the lowest bracket to 39.6% in the highest, one should add to these the social insurance taxes due.  These are often referred to loosely as Social Security taxes, but they include both Social Security at a 12.4% rate (up to a ceiling in 2015 of $118,500), and Medicare taxes at a 2.9% rate (with no ceiling).  Note also that while formally the employee pays half of this and the employer pays half, analysts agree that all of the tax really comes out of wages.

Once one includes social insurance taxes on wages, the effective tax rates on income from labor goes from 25.3% for the lowest bracket to 40.3% on those earning between $74,900 and $118,500, after which it drops down to 27.9% as the Social Security ceiling has been hit, and then starts to rise again.  The long-term capital gains rate is always below this even for the very richest, and normally far below.

To add further complication, preferential rates of 25% apply to long-term capital gains on certain commercial building assets (“Unrecaptured Section 1250” gains), and 28% apply to collectibles (such as fine art or gold coins) and certain small business stock. These are still well below what most pay in taxes on income from work.

This system not only worsens income inequality, but also creates complications and introduces distortions.  Many of those with high income are able to shift the categorization of their incomes from what for others would be wage income, to income which is treated as long-term capital gains.  Properly structured stock options, for example, allow CEOs and other senior managers to shift income from what would otherwise be taxed at ordinary income tax rates to the low rates for capital gains.  “Carried interest” does the same for fund managers.  With many fund managers earning over $100 million in a year, and indeed some earning over $1 billion, this preferential tax treatment of such extremely high earnings is perverse.

The reform would be simple.  All forms of income, whether from labor or from wealth, would be taxed at the same progressive rates that rise with total household income.  The one issue, which can be easily addressed, is that income from long-term capital gains should be adjusted for inflation, to put the gains all in terms of current year prices.  But this can easily be done by scaling up the cost basis based on the change in the general price level between when the asset was bought and when it was sold.  The IRS could supply a simple table for this.

2)  Reduce marginal effective tax rates on the poor:  Conservatives have long argued for cuts in marginal tax rates for the rich, arguing this would lead to faster growth (“supply-side economics”).  While there is no evidence that lower tax rates in recent decades have in fact led to faster growth, this was the stated rationale for the big tax cuts under Reagan and then Bush II.

Liberals have noted that if one were really concerned about high marginal tax rates, you would look at the high marginal effective tax rates being paid at the other end of the income scale – by the poor and those of moderate income.  Studies have found that these can range as high as 80 or even 100%.  The marginal effective tax rates take into account the impact of means-tested programs being phased out as one’s income rises.  When extra income is earned, you will pay not only a portion of this in taxes, but you will also lose a portion of benefits that are being provided (such as food stamps) in programs that phase out as income grows.  If the extra paid in taxes plus the amount lost in benefits matches additional earnings, the marginal effective tax rate will be 100%.

Conservatives have started to pay attention to this.  An opinion column in the Wall Street Journal last September by Senators Marco Rubio and Mike Lee (both Tea Party favorites) decried the 80 to 100% marginal effective tax rates that low income workers might face, arguing this can act as a strong disincentive to work.

In reality, the rates being faced by the poor are normally less, although still substantial. The issue is complex since the effective tax paid will depend not only on income, but on such factors as:  1)  Family composition (whether married and number and age of children); 2) Where one lives (what state and often what city or county); 3)  Particular benefit program qualification criteria (which will vary by program, and will often depend on many factors other than income); and 4) Whether the individual always enrolls in programs they are qualified for, as one may not be aware of certain benefit programs, or find the benefits to be too small to be worthwhile (because of difficulties and complications in enrolling, with these quite possibly deliberate difficulties in some jurisdictions).

The Congressional Budget Office, in a careful study issued in November 2012, concluded that the marginal effective tax rate for citizens with incomes of up to 450% of the federal poverty line averaged about 30% in 2012.  And under law as then in effect, this would rise to 32% in 2013 and 35% in 2014.  There was a good deal of variation within the average, with a marginal effective tax rate of as much as 95% (for example, for single mothers with one child with an income in the range of about $18,000 to $20,000, which was just above the poverty line for such a household).  But rates of 40% or more were not uncommon.

Such rates, even when not at the 80 to 100% extremes cited by Senators Rubio and Lee, are high.  Even at just 30% (the average) they are double what those who are far better off pay in long-term capital taxes.  While the conservative senators argue that such high marginal rates discourage work effort (there is in fact little evidence that this is the case – when you are poor, you are desperate for whatever you can get), such high marginal rates are in any case unfair.  If one wants to help those of low and moderate income, these effective tax rates should be reduced.

There are three ways, and only three ways, to reduce the marginal effective tax rates on the poor.  One is to get rid of the benefit programs for the poor altogether.  If they receive no food stamps to begin with, one has nothing to lose when incomes rise.  But this then penalizes the poor directly.

One could also phase out the programs more slowly, and pay for this by reducing the benefits to the poorest.  This is then a transfer from the poorest to the somewhat better off than the poorest.  Senators Rubio and Lee proposed this route (without explicitly calling it that) by reducing benefits such as food stamps and providing instead larger child tax credits for all households (including the rich).  This would be a transfer from the poorest to those of higher income (including the rich), and especially to those with large families.  The poorest would be penalized.

Finally, the third and only remaining option is to phase out the benefit programs more slowly.  This reduces the marginal effective tax rate that poor households will face if they are able to obtain jobs paying more than what they earned before.  It will not penalize the poorest, but it does of course require that budgets for the programs then rise.  But this will be support made available directly to the poor, and in particular to the working poor (as they are the ones facing the high marginal effective tax rates from additional earnings). If one is concerned about poverty and inequality, this is precisely the support that should be provided.

3)  Tax inherited wealth the same as any other wealth:  Wealth that is inherited enjoys significant tax benefits.  The only exception is wealth that is so large that it becomes subject to the estate tax (greater than $10.86 million for a married couple in 2015).  But few pay this due to that high ceiling, as well as since one can establish trusts and use other legal mechanisms to avoid the tax.  Indeed, in 2013 (the most recent year with available data), estate taxes were due on less than 0.2% of estates; the other 99.8% had no such taxes due.  This is down from over 6% of estates in the mid-1970s, due to repeated changes in tax law which narrowed and reduced further and further what would be due.

Any wealth that is passed along within the effective $10.86 million ceiling will never be subject to tax on capital gains made up to the point it was passed along.  That is, the cost basis is “stepped-up” to the value upon the date of death.  If one had purchased $100,000 of General Electric stock 40 years ago, the stepped-up value now would be roughly $3 million, and no taxes would ever be due on that $2.9 million of gain.

This is not fair.  Taxes on such wealth should be treated like taxes on any other wealth, and as argued in item #1 of this section above, all sources of income should be taxed the same (recognizing, importantly, that capital gains should be adjusted for inflation).

Some have argued that this cannot be done for inherited wealth since those inheriting the wealth may not know what the original cost basis was.  But this is not a valid excuse.  First of all, the two most important categories of wealth that are passed along through estates are homes and other real estate, and stocks and bonds and other such traded financial assets.  There are government land records on all real estate transactions, so it is easy (and indeed a matter of public record that anyone can look up) to find the purchase price of a home or other real estate.  And purchases of stocks, bonds, and other trade financial assets are done via a brokerage, which will have such records.

Second, if there are any other assets with special value (such as valuable coins or works of art) that will be passed along through an estate, the owner of those assets can include a record of their cost basis as part of the will or trust document that grants the asset to those inheriting the estate.

4)  Equal tax benefits for deductions should be provided for all income levels:  Under the current tax system, if a rich person in a 40% marginal income tax bracket makes a $100 contribution to some charity, then the government provides a gift to that rich person of $40 through the tax system, so that the net cost will only be $60.  If a middle class person in a 20% marginal tax bracket makes a $100 gift to the exact same charity, then the government will pay them back $20, for a net cost of $80.  And if a poor person in the 10% bracket makes a $100 gift to that same charity, the net cost to him will be $90.

This is enormously unfair.  There is no reason why deductions should be made more valuable to a rich person than to a poor person.  And there is an easy way to remedy it. Instead to treating deductions as subtractions from taxable income, one could take some percentage of deductions (say 20%) as a subtraction from taxes that would otherwise be due.  The $100 gift to the charity would then cost the rich person, the middle class person, and the poor person, the same $80 for each.

5)  Set tax rates progressively, and at the rates needed to ensure a prudent fiscal balance over the course of the business cycle:  I have argued above that all forms of income should be taxed similarly.  Whether you earn income from working or from wealth, two households with the same total income should pay taxes at the same rates.  This is not only for fairness.  It would also simplify the system dramatically.  And this is not only for the obvious reason that calculations are easier with one set of rates, but also because the current diverse rates interact between themselves in complex ways, which make computing taxes due a headache when there are different rates for different types of income.  Perhaps most importantly, it would eliminate the incentive to shift income from one category to another (e.g. from wage income to stock options) where lower taxes are due.  That creates distortions and wastes resources that should be used for productive activities.

There remains the question of what the new rates should be.  I do not have the data or the detailed tax models which would allow one to work that out, but a few points can be made.  One is that the new tax rates would be lower (at any given level of income) than what regular income tax rates (on wage income) are now.  This is because the tax rates on income from wealth (such as for capital gains, or inherited wealth) would be unified with the now higher tax rates on income from labor, so the new overall tax rates on regular income can be lower than before to yield the same level of tax revenues.  General income tax rates would come down.

Second, one should of course preserve the principle of progressivity in the tax code.  Rich people should pay taxes at a higher rate than poor people.  As Warren Buffitt argued eloquently in a New York Times column in 2011 (“Stop Coddling the Super-Rich”), there is no economic justification for the rich to pay taxes at lower rates than those with less income.  And it is grossly unfair as well.  Their secretaries should not pay at higher rates than the rich (fully legally) pay.

Third, one needs to recognize that the purpose of taxes is to raise revenues, and rates should thus be set at the levels required to cover government expenditures over time.  As argued above, the budgetary accounts should not be forced to balance each and every year, since fiscal policy is extremely important to move the economy back to full employment in an economic downturn (and fiscal policy is basically all that is available when interest rates are at the zero lower bound, as they have been since late 2008 in the US).

But over the full course of the business cycle, tax rates should be set so that the tax revenues collected suffice to keep the government debt to GDP ratio at a stable and reasonable level. This implies deficits when unemployment is high, and surpluses when the economy is close to full employment.  The economy was at full employment in 2006-07 (unsustainably so due to the housing bubble building up in those years) with the unemployment rate below 5% and as low as 4.4%.  Unfortunately, due to the Bush II tax cuts, the government’s fiscal deficit in those years was still significant.

Applying these principles, the tax rates needed for this would need to be worked out.  This can be done, but I do not myself have access to the data that would be required.  In the end, I suspect that regular income tax rates could be reduced substantially from what they are now, with this still sufficient to provide for adequate government expenditures over the course of the business cycle.  But the rich would pay more while those of low to moderate income would pay less, and whether this would then be possible politically is of course a different issue.

D.  Health Insurance

Access to health insurance is important.  A careful statistical analysis published in 2009 found that the likelihood of dying is higher for the uninsured than for the insured, and the lack of universal health insurance (as was then the case in the US) was leading to an estimated 45,000 more Americans dying each year than would be the case if they had health insurance.  This is greater than the number of Americans killed in action over the entire period of the Vietnam War.

The ObamaCare reforms have been a big step forward to making it possible for all Americans to obtain access to health care, but it remains under threat.  If Republicans are serious about helping the poor and middle classes, they should support the following.

1)  First, stop trying to block health care access for all:  ObamaCare, while not perfect (it reflects political compromises, and is based on the system of individual mandates first proposed by the conservative Heritage Foundation in 1989), is nonetheless working.  An estimated 16.4 million Americans now have health insurance coverage, which they did not have before ObamaCare became available.  And a Gallup poll found that there was a higher satisfaction rate among those obtaining health insurance policies through the ObamaCare exchanges, than among those with traditional health insurance policies (mostly via employers).

Despite this, Republicans continue to campaign aggressively to terminate ObamaCare, and have supported lawsuits in the courts to try to end this health care access.  A case now before the Supreme Court, with findings to be announced this month (June 2015), may declare that the federal government payments made through certain of the ObamaCare exchanges (those not run by the states) to those of low to moderate income, cannot be continued.  If the Supreme Court finds in favor of those opposed to such payments, these low and moderate income households will no longer be able to obtain affordable health insurance.

If the Republican presidential candidates are in fact in favor of helping the poor and middle classes, they should call for an end to the continued efforts by their Republican colleagues to terminate ObamaCare.  There are ways it could be improved (e.g. by taking more aggressive actions to bring down the cost of medical care to all in the US), but it is working as intended, and indeed better than even its advocates expected.

2)  Extend Medicaid in all states in the US:  The ObamaCare reforms built on the system of existing health insurance coverage.  Medicare would remain the same for those over age 65; employees in firms would normally pay for health insurance coverage through employer based plans; Medicaid would expand from covering (generally) those up to the poverty line to include also those with income up to 133% of the poverty line; and all those remaining without health insurance would be allowed to purchase coverage from private health insurers competing on internet-based health insurance exchanges, where those with incomes of up to 400% of the poverty line would receive federal subsidies to make such health insurance affordable.

The Medicaid expansion to cover all those with incomes of up to 133% of the poverty line was thus one of the building blocks in the ObamaCare reforms to enable all Americans to obtain access to affordable health care.  Because of its historical origins in health care programs for the poor that had traditionally been implemented in the states, Medicaid is implemented at the state level even though it is funded jointly with the federal government. For the Medicaid expansion to 133% of the poverty line, the federal government through the legislation setting up ObamaCare committed to funding 100% of the incremental costs in the first three years (2014 to 2016) with this then phased down to 90% in 2020 and thereafter.

Despite this generous federal funding, the Supreme Court decided in 2012, in its decision that also found ObamaCare in general to be constitutional, that Congress could not force the states to expand Medicaid to the higher income limits.  Thus the expansion became optional for the states, and as of April 2015, 21 states have decided not to.  The 21 states are mostly in the south or the mountain west, with Republican legislatures and/or Republican governors or mostly both.

Blocking this Medicaid expansion in these states is being done even though an expansion would cost little or nothing.  There is literally no state cost in the first three years as the federal government would cover 100% of the extra costs.  And while the federal share would fall then to a still high 90% for 2020 and thereafter, allowing more of the poor to be covered by Medicaid will reduce state costs.  The poor in this gap in coverage are forced to resort to expensive emergency room care, for which they cannot pay, when their health gets so bad that it cannot be ignored.  These costs are then partially compensated by the state.

A careful analysis for Virginia, undertaken for the state by Price Waterhouse Coopers, concluded that if Virginia opted in to the Medicaid expansion, the state would save $601 million in state budget costs over the period 2014 to 2022.  And this did not even include the indirect benefits to the budget from higher tax revenues, as a consequence of the additional jobs that would be created (nurses and other care providers, etc.) and the higher incomes of hospitals from less uncompensated care.

Denying affordable health care to the poor with incomes of between 100% and 133% of the poverty line is callous.  These are the working poor, and there really is no excuse.

3)  Ensure employers pay a proportionate share for health insurance for their part-time workers:  Employers have traditionally not allowed part time employees to obtain (through their wage compensation package) health insurance cover in employer-based plans.  There was a practical reason for this, as health insurance plans only provided cover in full.  It has been difficult to provide partial plans, so part time workers have traditionally gotten nothing.

This has now changed with the introduction of the ObamaCare health insurance market exchanges.  Those without health insurance coverage through their employers can now purchase a health insurance plan directly.  One could therefore now require that all employers make a proportionate contribution to the cost of the health insurance plans for their part time workers.  That is, for someone working half time (20 hours a week normally) the employer would contribute half of what that employer pays for the health insurance plans for their full time workers.

There would then be no incentive (and competitive advantage) for an employer to split a full time job with health insurance benefits into two half time jobs with no health insurance benefits for either worker.  Under the current system of normally no health insurance benefits for part time workers, employer are in essence shifting the cost of health insurance fully onto the worker and onto the federal government (and hence general taxpayer) if the worker earns so little that they are eligible for federal government subsidies to purchase health insurance on the exchanges.

The proportional employer contribution would be paid to the “account” of the worker in the same way (and at the same time) as Social Security and Medicare taxes are paid for the worker.  The funds from this account would then be used to cover part of the costs of the worker purchasing health insurance on the ObamaCare exchanges.  And if the worker was working in two (and sometimes three or more) part time jobs in order to make ends meet, the total paid in from all of the worker’s employers might well suffice to cover the cost of the health insurance plan in full.

4)  Allow competition from low cost public health insurance:  As part of the political compromises necessary to get ObamaCare passed in the face of steadfast Republican opposition, only private health insurers are allowed to participate in the ObamaCare health insurance exchanges.  Yet Medicare, which provides health insurance to all Americans age 65 and older, is far more efficient than private health insurance providers.  Giving Americans the option (not a requirement) to purchase Medicare administered health insurance on the ObamaCare exchanges would introduce much needed competition. There are often only a few insurers competing in the exchanges, which are all state-based (3 or fewer insurers in 15 of the 51 states plus Washington, DC, with only one insurer offering policies in West Virginia).

But even with multiple insurers competing on the state exchanges, the private insurers in general have high costs.  Private health insurers nationwide (and for all the policies they offer) have administrative costs plus profits equal to 14.0% of the health insurance benefits they pay out.  This is huge.  The same figure for Medicare is only 2.1%.  Medicare costs only one-seventh as much to administer as private health insurance.  And note these lower costs are not coming out of low payments to doctors and hospitals since the 14.0% and 2.1% are being measured relative to claims paid.

It would be straightforward to allow Medicare to compete on the health insurance exchanges.  One would require that Medicare charge rates sufficient (for the resulting client base, which will of course be younger than and generally healthier than Medicare’s senior citizens) to recover its full costs for such coverage.  But Medicare could use its existing administrative structure, including computer systems and contracts with doctors, hospitals, and other medical care providers at the rates that have already been negotiated.

Purchasing a Medicare administered health insurance policy on the exchanges would be fully optional.  No one participating in the exchanges would be required to buy it.  But with its lower costs, the competition Medicare would introduce into the exchanges could be highly effective in bringing down costs.

E.  Pensions

Probably the greatest failure of any social experiment of recent decades has been the switch of employer pension plans from the traditional defined benefit plans that were common up to the early 1980s, to defined contribution schemes (such as 401(k) plans) that have grown to dominance since the 1980s.  In doing this, employers not only shifted the investment, actuarial, and other risks on to the individual workers, but also typically reduced their matching funding shares significantly.

The end result is that workers are now typically woefully unprepared for retirement.  The funds accumulated in their 401(k) and IRA accounts for households (with head of household aged 55 to 64) with a 401(k) account, only amounted to $111,000 in 2013 (for the median household).  Such an accumulation, for households who will soon be in retirement, would suffice to provide only less than $400 a month by the traditional formulas, or $4,800 per year.

This is woefully inadequate, and these households will need to rely on what they can get from Social Security.  But Social Security payments are also not much.  For 2012 (the most recent year with such data), the median Social Security pension payment per beneficiary (age 65 or more) was just $16,799 per year, or per family unit (with head aged 65 or more) just $19,222 per year.  Furthermore, if nothing is done, the Social Security Trust Fund will run down to a zero balance in 2033 based on the most recent projections.

Fully funding Social Security is eminently solvable, as will be discussed below.  The annual cost (including for disability insurance) will rise from roughly 5% of GDP currently to 6% of GDP in 2030, as the baby boomers retire, or an increase of just 1% of GDP.  But what many do not realize is that on current projections, Social Security expenditures are then expected to remain stable (under current benefit rules) at that 6% of GDP for the foreseeable future, in projections that go out 75 years.  One can find 1% of GDP to save Social Security.  But the politicians in Washington will need to agree to do so.

There are several measures that need to be taken to ensure income security for the poor and middle classes in their old age:

1)  Raise, and certainly do not reduce, Social Security payments to those of low and modest income:  Social Security payments, while a crucial safety net, are low.  As noted above, the median payments in 2012 for those aged 65 and older were just $16,799 per beneficiary and $19,222 per recipient family (for the old age component). Such payments are minimal.  Yet these are just medians, meaning half of all recipients received less than even those figures.

Despite being so low, these Social Security payments are critical to many Americans. For the entire population of those aged 65 and older, Social Security accounted for half or more of their total regular income for two-thirds of the population (65% to be precise); Social Security accounted for 90% or more of their income for over a third of the population (36%); and Social Security accounted for 100% of their income for a quarter of the population (24%).  This is incredible, and shows the failure of the current pension systems in the US to provide a reasonable income in retirement for American workers.

The situation is, not surprisingly, worse for those of low to moderate income.  For the bottom 40% of the population by income, where 40% is by far not a small or insignificant share, Social Security accounted for half or more of their regular total income for 95% of them.  Social Security accounted for 90% or more of their income for three-quarters (74%) of them, and for 100% of their income for over half of them (53%).

Social Security benefits are by no means large.  Yet a large share of Americans depend on them.  They should not be cut, but rather should be raised, at least for those of low to moderate income who are critically dependent on them in their old age.

2)  Broaden the base for Social Security taxes to ensure the system remains fully funded:  As noted above, the Social Security Trust Fund will be depleted in 2033 (based on current projections, and including the disability component – while technically separate, the trust funds for old age and for disability insurance are normally treated together).  While some argue, with some justification, that the Trust Fund is fundamentally just an accounting tool, which can be “topped-up” with regular federal government transfers if necessary, there are also good reasons to stay with the Trust Fund rules.  They help keep the Social Security system out of routine Washington politics, and the temptation by conservatives to cut Social Security benefits in order to reduce the size of government.

Under the current Trust Fund rules, participation in the Social Security system is mandatory; taxes are paid on wage earnings (up to a ceiling of $118,500 in 2015); at a rate of 12.4% for Social Security pension and disability coverage for the employer and employee combined (excluding the 2.9% with no wage ceiling for Medicare); and upon retirement, these contributors will receive regular monthly payments from Social Security until they die, based on a formula which is linked to how much was paid into the Social Security Trust Fund during their working career (for the 35 years of highest inflation adjusted earnings).  The formula is complex, and “tilted” in the sense that those earning less will receive back somewhat more than they paid in, while those earning in the upper end of the taxable range will receive back somewhat less.  There is therefore some progressivity, but the degree of progressivity is limited.  Finally, the taxes paid into the fund will earn interest at the rate of the long-term Treasury bond yield of the time, so the taxes paid in to the fund grow over time with interest.

Based on these Trust Fund rules and on current projections of growth in worker earnings (and its distribution) and of what pay-outs will be as workers retire, the Trust Fund is expected to be depleted in 2033.  The basic cause is not that Social Security administration is inefficient and wasting funds.  It is, in fact, incredibly efficient, with a cost of administration of just 0.5% of benefits paid out (on the old age component).  Note this is not on assets, but on benefits paid.  As will be discussed further below, the typical expenses on savings in 401(k) and similar accounts will be 2 to 3% of assets each and every year.

The principal cause of the Trust Fund being depleted, rather, is that life expectancies have lengthened, and hence the period over which Social Security old-age payments are made have grown.  Crudely (and ignoring interest for this simple example), if life expectancy at age of retirement has grown by 50%, so that the number of years during which one will draw Social Security payments has grown by 50%, then the amount needed to be paid in to the Trust Fund to cover this lengthened life will need to grow by 50%.

Longer life expectancies are good.  The Social Security Trust Fund will run out of assets in 2033 not because the funds are being wasted (as noted above, administrative costs are incredibly low), but because people are living longer.  But this will need to be paid for.

But it is also critically important to recognize who is living longer.  As incomes have stagnated for those other than the rich since Reagan took office (see the chart at the top of this post), life expectancies for the poor and middle classes have in fact not increased substantially.  Rather, the overall life expectancy is rising principally because those at higher income levels are enjoying much longer life expectancies (in part precisely because their incomes have been growing so fast).

Specifically, life expectancy for a man at age 65 in the bottom half of earnings rose from 79.8 years in 1977 to 81.1 years in 2006, an increase of just 1.3 years.  But life expectancy at age 65 for a man in the top half of earnings rose from 80.5 years in 1977 (only 0.7 years longer than men in the lower half of the earnings distribution in that year) to 86.5 years in 2006, an increase of 6.0 years.  People are living longer, but it is mostly only those of higher income who are enjoying this.  Life expectancies have not changed much for those of low to moderate income.

It would therefore be perverse to penalize those of lower income to make up for the Trust Fund shortfall, when it is the lengthening of the life spans of those of higher income which is leading to the depletion of the Trust Fund.  Yet proposals to raise the retirement age, or to increase Social Security taxes on all, would charge the poor as much as the rich to make up for the Trust Fund deficit.

Rather than penalize the poor, Social Security taxes should be raised on those who are better off to pay for their increasing lifetime benefits.  And this is of course also precisely what one should want to do if one is concerned about inequality.

The obvious solution is to broaden the tax base for the Social Security tax to include incomes now excluded – which are also incomes that accrue to the rich.  First, note that the shortfall to be made up when the Social Security Trust Fund is expected to be depleted (if nothing is done) in the 2030s would require a 20% increase in revenues.  That is, following a transition between now and about 2030 as the baby boomer generation retires, the long term projection is that Social Security tax and other revenues will level off at about 5% of GDP, while Social Security obligations will level off at about 6% of GDP. That is, we will need revenues to increase by about 20% to make up the shortfall, to get to 6% of GDP from 5%.  (A more precise estimate, but from my blog post of a few years ago, is an increase of 19.4%).

Broadening the Social Security tax base would easily provide such an amount of funding. For wages alone, there is the current ceiling of $118,500 (in 2015) on wages subject to Social Security tax.  At this ceiling, only 83% of all wages paid are subject to this tax.  This is down from 89% in 1980 as an increasing share of wages are being paid to the very well off (those with wages above the ceiling).  If one were to tax 100% of wages rather than only the current 83%, one would in fact obtain the funds needed, as that alone would provide an increase of over 20% (100/83 = 1.205).

But broadening the base should not stop at simply ensuring the taxes paying for Social Security are paid by all wage earners equally, rich and poor.  There is no economic rationale why only wage income should be taxed for this purpose, and not also income from wealth.  And income from wealth is primarily earned by the wealthy.

Using figures from the National Income and Product (GDP) accounts, total private income (including not just wages, but also income from interest, dividends, rents, and so on, but excluding government transfers) in 2014 was 65% more than just wages alone.  (Note that while these income concepts from the GDP accounts are not the same as the income concepts defined in the income tax code, they suffice for the illustrative purposes here.)  A uniform tax rate of 7.5% rather than 12.4% (12.4/7.5 = 1.65), but on all forms of income and not just wage income, would thus suffice to generate the Social Security tax revenues to fund fully the Trust Fund for the foreseeable future.

But one important proviso should be noted.  Such tax rates (of either 12.4% on all wage income, or 7.5% on all forms of private income) would generate the revenues required to fully fund the system based on current benefit payment projections.  However, with benefit payments tied to one’s history of tax payments, one would also need to change the benefit payment formulae to reflect the broader tax base.  Otherwise the benefits due would also change to reflect the higher amounts paid in.

Finally, as noted above, current Social Security benefit payments are low and really need to be increased.  While I do not have the data and models that would be required to work out fully some specific proposal, the figures here can give us a sense of what is possible. For example, a possible balance might be to broaden the tax base to include all forms of income, but then to reduce the tax rate on this not all the way from 12.4% to 7.5%, but rather to the halfway point of 10%.  But this 10% rate would then suffice to permit a one-third increase in overall benefits (10/7.5 = 1.333), which one should want also to concentrate on those of low to moderate income.  The overall tax rate would be cut, but in broadening the tax base to all forms of income one could support a significant increase in benefits.  Overall taxes paid would be higher (everything has to add up, of course), and while low and moderate income earners would mostly see a reduction in the taxes they owe, richer individuals would pay more.

3)  Require that 401(k) plan administration fees are paid for by the entity choosing the provider:  Turning from Social Security to private pension plans, where defined contribution plans (401(k) plans and similar) are now the norm, the key issue is to keep fees low.  Unfortunately they are extremely high, and take away a large share of the investment returns on the funds saved.

One cause of this is that the fees being received by the financial advisors are often hidden in various ways, and charged in different ways by different entities.  There is no standard, and average levels are not made publicly available to provide a basis for comparison. The fees charged will also vary sharply depending on the type of investment product being used (i.e. direct equities, mutual funds of different types, insurance products including annuities, various complex products, and more).  Finally, while individual fees might sometimes appear to be low, they are imposed at several layers in the investment process, and in total come to very high levels.  Not surprisingly, according to one survey 93% of the respondents dramatically underestimated what their cumulative 401(k) fees will come to.

Estimates for what the average fees in fact now are vary.  At the base will be the fees charged by a plan administrator, chosen by the firm of the employee and responsible for the record keeping, for allocating the investments as chosen by the plan participant, and so on. These fees will vary depending on the size of the firm and the deal negotiated on behalf of the employee, but one set of estimates are that these fees average 0.5% of plan assets annually in large firms (plan sizes of $100 million or more), 0.9% in medium size firms (plan assets of $10 million to $100 million) and 1.4% in small firms (plan assets of less than $10 million).

On top of these base administrative fees one will then have to pay the fees charged by the investment vehicles themselves.  Mutual funds are perhaps most common, and the expense fees on these (normally subtracted from the investment returns, so the amount being paid will not be obvious) average about 1.1%.  But they can range widely, from less than 0.1% for standard index funds, to over 2%.  On top of this, one has the cost of buying and selling the investments (whether mutual funds or equities or the other products), which some estimate may average 1.0%.  But these too can vary widely.

Finally, one may have individual fees on top of these all, which depend on the services being requested (whether investment advice, or entry and exit fees, or loan advances against balances in the worker’s pension accounts, and more).  These will vary widely, but one estimate is that the median might be an annual cost of about 0.7% of assets.

The total amount lost in fees each year can therefore easily be in the range of 2 to 3% of assets, and 2.5% is a commonly taken average.  Note also that these fees (or at least most of them) will be taken by the financial managers regardless of whether the investments perform well in any given year.

Over time, these fees will take for the financial administrators a large share of the investment returns that were intended for worker retirement.  A simple spreadsheet calculation, for example, will show that over a 40 year time horizon, where (for simplicity) equal amounts are set aside each year for retirement, with an assumed 5% real rate of return but financial fees of 2.5% a year, the financial cost will have taken away by the 40th year 45% of what would otherwise be the balance saved.  (It will not equal 50% because of the way compounding works.)  This is 90 times the total fees that would be charged by Social Security for the old-age support it provides, which as noted above is only 0.5% of benefits paid out.  Note that I am not arguing that the private fees should be the same as what the cost is for Social Security to administer the accounts.  Social Security is an extremely efficient system.  The specific share taken by financial fees will also depend, of course, on what is assumed for the rate of return and other parameters. But anything like 90 times as much is a lot.

Furthermore, many of the fees being charged on the private pension accounts will continue into the retirement years, so the final amount paid out in benefits will be even less.  Assuming there will be 20 years of retirement following the 40 years of work, with returns and fees continuing as before, the annual amount that could be paid out to the worker in retirement will be only 44% of what would be paid out if the fees were at the 0.5% (of benefits only) of Social Security, a reduction of 56%!

Fees are therefore hugely important, but the worker can manage (through the decisions they make) only some of them.  In particular, the basic plan administration fees for managing the accounts are made at the firm level.  When firms had defined benefit pension plans, these costs were included in what the firm covered.  They kept track of, or contracted out to some specialist, the individual payment obligations and other bookkeeping.  But when firms switched to defined contribution schemes, most commonly 401(k)s, the firms chose to incorporate the costs of the plan administration into charges against the individual account balances, thus shifting these on to the workers.  But the workers had no choice between plan administrators:  They were chosen by the firm.  And with the firm not bearing the cost, the firm might not worry so much about what the cost was.  Rather, they might choose a plan administrator based on how good they were at making sales pitches, or whether they did other work for the firm where they might extend a discount, or based on who provided the fanciest annual conferences for their clients (the decision maker in the firm) at some resort in Hawaii.

Some firms of course make a sincere effort to choose the best balance between plan administrator cost and performance, but others do not.  But to resolve this, a simple reform would be to require that firms pay the cost of plan administration directly from the firm’s accounts, and not out of the pension savings of the workers.  This would return to what had normally been done with the traditional defined contribution pension plans, where firms had an incentive to ensure plan administration costs were kept low.

4)  Require low cost investment options be included in 401(k) and similar schemes:  One can also keep financial fees down by investing in low cost investment options, such as simple and standard index funds.  The Vanguard S&P 500 Index Fund, and now even the Vanguard Total Stock Market Index Fund, each charge an annual expense fee of just 0.05%.  This is far below the 1 to 2% charged by most managed mutual funds.

Such low cost options are included in many 401(k) plans, but unfortunately not all.  Such options should be required in all.

5)  Provide an option of investing in “Social Security Supplemental Accounts”:  One very low cost investment option would be to invest a portion of one’s 401(k), IRA, and similar balances, into a supplemental account managed by Social Security, which would then be paid out along with one’s regular Social Security checks.  Accounts would earn a return equal to the long-term US Treasury bond rate, the same as existing Social Security balances do now.  The option would take advantage of the extremely high efficiency of the Social Security Administration.

With the far lower cost of Social Security relative to what private financial institutions in the US charge, the net return on such investments would be attractive.  Given historical long term bond interest rates and the differences in fees, the returns would be comparable to what might be earned in pure equity investments, but far less volatile.  And the returns would be far better than what on average has been earned in actual 401(k) and IRA accounts, given how they have historically been managed.

The Social Security Supplemental Account would be purely voluntary.  No one would be forced to put a share of their 401(k) or IRA assets into them.  But this would be an attractive option for at least a share of the plan assets, earning a comparable return (after fees) but with far less risk.  It would be especially attractive to middle class families who may have significant but not huge assets in their retirement accounts, who are seeking to ensure a safe retirement.

F.  Conclusion

The returns to economic growth have become horribly skewed since Reagan took office, but there is much that could be done to address it.  This blog post has discussed a number of actions that could be taken, and if the Republican (and Democratic) candidates are truly concerned about the direction of income inequality, there is no shortage of measures to consider.  And this is not an all or nothing set of actions:  While complementary and mutually reinforcing, taking some actions is better than none, and more is better than some.  Nor are they in general administratively difficult to do.  Most are straightforward.

But action is clearly needed.

 

Creating an Attractive Retirement Savings Option, While Funding Social Security for a Further Generation

Social Security Outlays, Revenues, and Deficit, CBO, 1985-2086

A.  Introduction

This post will present a reform which would create an attractive, and wholly voluntary, new retirement savings option, which would also fund the US Social Security system for an additional generation.  And it would do this without cuts in benefits or increases in Social Security or other taxes.  While not a permanent fix for funding Social Security (where the issue is fundamentally a result of longer life expectancies but a largely unchanged work life), it could extend the lifetime of the Social Security Trust Fund without reducing benefits or increasing taxes by a further two decades or more.

Social Security is the most successful US social program of the last century.  The poverty rate of the elderly was extremely high before Social Security.  Because of Social Security it is now greatly reduced, to levels similar to that of other population groups.  While the benefits Social Security pays are not generous, and are far below the support provided to the elderly among the other advanced economies of Europe, Japan, and elsewhere, Social Security benefits have been sufficient to provide a minimum safety net of income that has been adequate to keep most elderly out of poverty.

But there is a need to ensure Social Security will remain sustainable.  As shown in the graph above, annual Social Security benefits paid exceed the inflow from Social Security taxes.  While there is a Trust Fund, and it is currently a sizable 17% of GDP, the Congressional Budget Office projects that if nothing is done, this Trust Fund will run down to zero by 2035.

At that time, and if one restricts the options to the current structure, either Social Security tax revenues would need to be scaled up (by about 23%, raising the tax rate on wages from the current 12.4% to about 15.2%, if nothing is done prior to that point to prepare for it), or benefits would have to be scaled back (not to zero, but by about 19% in the CBO forecast).  Raising the tax rate to 15.2% is not a disaster, and simply reflects the very desirable longer life expectancies we now enjoy.  And such a wage tax would still be far less than the rates paid in Europe.

One could also cover the roughly 1% of GDP deficit in the flows (from the 2030s to about 2060) from general tax revenues.  There is no requirement that all the support to the Social Security system has to come from wage taxes.  And this 1% of GDP is only about one-third to one-quarter or less (the loss rises over time) of the revenues that have been lost as a result of extending the Bush tax cuts for all but the top 2% of Americans.  If we can afford the Bush tax cuts being extended, we can afford one-third or one-quarter of it to save Social Security.

But any tax increases are anathema to Republicans.  In this blog post, I will review a different type of approach, which would create an attractive and wholly voluntary new retirement savings option.  As an additional benefit, it would provide funding for Social Security that would likely suffice to extend the life of the Social Security Trust Fund by a further two decades or more, without resorting to higher taxes or cuts in benefits.

B.  The Impact of Investment Fees

Social Security is an extremely efficient program.  Its administrative costs in the retirement program side (keeping the benefits for the disability program separate) are only 0.6% of the amount paid out annually in benefits (see 2012 Trustees Report, Table II.B.1.).  This is tiny.  Social Security is efficient for two primary reasons.  The most important is that it is structured as a simple program.  Revenues are collected through the tax system by a tax on wages, and these funds are then invested straight into (and only into) US Treasury bonds.  Second, it operates on an enormous scale, and such a scale while keeping costs low is possible precisely because of the simplicity of the design.

In contrast, retirement accounts that are run through private fund managers are highly fragmented, are structured with multiple investment options where choices must then be made on how much to invest in each, where expensive financial professionals demand high fees to administer these funds and to make recommendations (and sometimes decisions) on the investment choices, and where the high fragmentation inhibits scale economies.  Profits among the fund management companies can also be high.

As a consequence, the total fees on 401(k)’s, IRAs, and similar directed retirement investment programs (defined contribution schemes) can be extremely high.  The fees are assessed at several levels, including (for 401(k)’s) at the level of the individual plan for some firm, and at the level of the investment management company (whether through a mutual fund, through investment vehicles sold by life insurance companies, or by direct investments in the markets).  The fees add up, and can easily reach 2% of assets annually and beyond, depending on the size of the company one is working for, and the nature of the investments being made (whether equities, bonds, life insurance company products, money market funds, and so on).

These high fees have a dramatic impact on reducing the returns on the investments being made.  Taking the example of a pure equity investment, the total return on investment in the S&P500 Equity Index over the 50 years 1962-2012 was 9.7% annually (in nominal terms).  Adjusting for CPI inflation of 4.1% annually over this period, the real return was 5.4% (note that the 5.4% is not a simple subtraction of 4.1% from the 9.7% due to interaction effects:  take my word for this, or review your High School algebra).  But after a 2.0% annual fee on assets, the return would be reduced from 5.40% to only 3.31% for someone who starts saving for retirement at age 45 and lives to 92 (or 3.30% for someone who starts saving at age 22).  In contrast, the Social Security administrative cost of 0.6% on benefit returns paid out would reduce a 5.40% pre-expense return to a 5.37% return after expenses for those who start saving at age 45 (or 5.38% for those who start at age 22).  [The figures here come from a spreadsheet analysis by the author.]

The difference in returns after fees is huge.  A 2% fee on assets is close to 100 times the equivalent cost (in terms of return on assets) of the Social Security cost of 0.6% on benefits paid out.  Put another way, the 2% fee charged by the private fund managers reduces the return that would have been earned on equity investments by close to 40% (i.e. reducing a $100 return to only $60) while the Social Security charge would have reduced the return by only 0.5% (from $100 to $99.50).

The proposal set out here is to take advantage of this far greater efficiency of the Social Security system, by allowing Social Security to offer an optional retirement savings vehicle, into which Americans can invest a portion or even all of the investments now in their IRA, 401(k), or similar retirement savings plans.  The savings accrued in this way would then provide an individual supplement to your regular Social Security check once you retire.  Taking advantage of this would be completely voluntary.  The funds would be invested, like all current Social Security funds are now invested, in long-term US Treasury bonds.  Because of the inherent low costs in the Social Security system, the returns would be attractive.

C.  The Proposal:  A Supplemental Social Security Account

Most Americans (among those with any retirement plan coverage at their place of work) have seen their pension plans shift over recent decades from the traditional defined benefit plan to defined contribution schemes, mainly 401(k)’s.  From almost nothing prior to the 1980s, over 80% of private sector workers now who have any pension plan coverage, only have a defined contribution plan.  All workers may also have IRA’s, which are similar in magnitude (in terms of total assets) as what are held in 401(k)’s and similar plans, although the IRA assets primarily come from roll-over of 401(k) investments when a worker switches jobs.

In IRA’s, 401(k)’s, and similar defined contribution schemes, the workers must choose what investments to place their assets in.  There may be restrictions on the choices (e.g. many companies will limit the investments to certain mutual funds with whom they have contracted), but the aim is generally to provide a reasonable range of choices to the individual.  Unfortunately, all the choices come with high fees, which as discussed above, can severely reduce the investment returns.

The proposal here is to add the option of investing one’s IRA, 401(k), or similar plan assets into a supplemental Social Security account.  An individual would be allowed to choose to invest some, or even all, of their existing assets or any new savings set aside annually (up to the limits set by tax law for retirement savings that benefit from specified tax advantages) into such a supplemental Social Security account.  These funds would be invested, like all funds in the Social Security Trust Fund, in long-term US Treasury bonds.  Social Security would keep track of the contributions so made, and of the earnings from the interest on the US Treasury bonds (it would be a simple computer code).  Upon retirement and when the individual chooses to start to draw their regular Social Security benefit (normally at age 66 currently, although with this moving up to 67, and where there is some flexibility around these ages with the Social Security payments adjusted accordingly), Social Security would then increase the individual’s monthly Social Security benefit payment by an amount that would reflect the accumulated savings (including interest) in that supplemental Social Security account.  The accumulated savings would be converted into an actuarially fair annuity, reflecting the then expected life expectancy for an individual at that retirement age.

Note that the interest which would be paid into these accounts would come from the US Treasury.  But there would be no additional cost to the US Treasury since the bonds sold into these accounts would be offset by an equal number which would not then need to be sold to others, whether rich people who buy such bonds or the Chinese government, or whomever.

Set up on an actuarial fair basis, and with the relatively tiny Social Security administrative costs (of 0.6% of benefits paid) taken out, as for all Social Security payments, there would be no net cost to Social Security either.  And each individual (on an actuarial basis) would receive back by the time they die an amount equal to what they saved under this scheme, plus the interest earned on these assets.

But while each individual would end up even, there would be a significant amount invested in and supplementing the traditional Social Security Trust Fund at any point in time.  The Supplemental Social Security Fund would initially build up rapidly, as once the scheme is enacted, many people (all current workers) could begin to contribute to their new supplemental Social Security accounts, while only after such contributions have been made and with some time lag would there be retirees drawing down on their accounts.  We will present some projections below, and see that the new Supplemental Fund would eventually stabilize as a share of GDP, and would not decline.

But first we will discuss whether individuals would find investing into such Supplemental Social Security accounts attractive, and then discuss what the scale of the investments into such accounts might be, given the size of total retirement savings going each year into IRA’s and 401(k)’s.

D.  Investing Into Supplemental Social Security Accounts Would Be Attractive

It is of course impossible to predict what future returns will be.  But what can look at what the returns have been for periods in the past, and it is reasonable to conclude that for sufficiently long periods, the returns will likely be similar (or at least the relative returns across different asset classes will be similar, and that is what is relevant to an individual’s decision on asset allocations).

For the numbers here, I have looked at the 50 year returns for 1962 to 2012, using the data assembled by Professor Aswath Damodaran of NYU.  As noted above, adjusting for inflation (based on the CPI) over this fifty year period, an investment in the S&P 500 equity index would have yielded an annual real return of 5.4% (including dividends).  An investment in 10-year US Treasury bonds over this period would have yielded an annual real return of 2.6%.  And while it appears that data on actual returns people have achieved on average in their 401(k)’s or IRA’s do not exist (such data would be hard to collect, as most individuals do not even know what their actual returns, net of additions to their accounts, really were), one can calculate what an average 401(k) return might have been based on a weighted average of what returns might have been by asset classes held in these accounts currently.  Using Investment Company Institute estimates of the 2011 weights, and applying these weights to the 50 year returns by asset classes, the weighted average 401(k) return would have been 3.7% in real terms.

Subtracting what fees could be on such investments, the net returns would have been:

1962-2012 S&P500 Avg 401(k) 10-Year Treasury Bond
Gross Real Returns, before fees 5.4% 3.7% 2.6%
Private Return after fee of:
     2.65% 2.6%
     2.0% 3.3% 1.7% 0.6%
     1.5% 2.2% 1.1%
     1.0% 2.7% 1.6%
Social Security Return: 2.6%

With the very low costs of the efficient Social Security system, one would have earned a real return of 2.6% a year over this period, equal (within round-off) to the returns on the 10-Year Treasury bonds these funds would have been invested in.  The before fee return on equity investments would have been higher, at 5.4%, but with a 2% fee on assets incurred annually, the net return would have come down to 3.3%.  With a 2.65% fee (and some 401(k) plans cost more than even this), the return would have been 2.6%.  And while a 3.3% return is better than a 2.6% return, the equity return is much more volatile.  One’s returns will depend on the luck of the period during which one was invested, which will depend on the year you were born.  And there can be periods of a decade or more when the equity returns are even negative.  This has happened three times in the US since the 1920s:  during the 1930s in the Depression, in 1974/75 during Nixon/Ford, and following the 2008 economic and financial collapse at the end of the Bush administration.

Most people therefore do not hold solely equities in their 401(k)’s or IRA’s.  In addition to equities, they hold bond funds, mixed bond and equity funds, money market funds, as well as contracts guaranteeing some stable return (usually issued by life insurance companies, and with normally very high fees).  As discussed above, an estimate of what the weighted average return might have been yields 3.7% (based on 2011 weights, but 1962-2012 returns for the asset classes).  The estimate can only be approximate.  But based on it, the returns after fees would have been only 1.7% at a fee of 2.0%, 2.2% at a fee of 1.5%, and 2.7% at a fee of 1.0%.  Most 401(k) plans will charge fees substantially higher than 1.0% (when all the layers of fees are accounted for), but it is only at this low rate that one would get a return similar to what one would get by investing into a supplemental account at Social Security.

The return on a supplemental account at Social Security therefore looks attractive.  One should expect that if such an option were made available, Americans would choose to invest a significant portion of their retirement assets into such an account, and possibly even all of their retirement assets.  The returns would be secure, relatively stable, and simple to manage.

E.  What Might Be the Level of Such Investments in the Aggregate?

The next issue to address is how much such investments might add up to.  One needs this in order to calculate what the impact might be on the size of the Social Security Trust Fund.

The truth is that one does not really know.  An option might be attractive, but few then sign up, or many do.  The numbers that will follow here are therefore speculative.  But they will provide some sense of the magnitudes involved.

Due to tax and other reporting requirements, there are good numbers on the stock of assets in IRA’s, 401(k)’s, and similar defined contribution (and other) pension plans.  These figures largely come from the US Federal Reserve Board Flow of Funds estimates, but are buried there with much other data, and a more convenient source of the retirement plan assets are provided by the Investment Company Institute.  As of the end of 2012, the ICI estimates total assets held in IRA’s came to $5.4 trillion, and total assets in defined contribution plans (mainly 401(k)’s, but also others) came to $5.1 trillion.  These two categories together thus came to $10.5 trillion of assets, 67% of 2012 GDP, that are invested according to the directions of individuals.   Total pension fund assets, primarily in defined contribution plans (including plans for government workers) and annuities, but excluding Social Security, came to $19.5 trillion as of the end of 2012, or 124% of 2012 GDP.

But while good figures are available on total assets in these plans, they are more sparse on annual flows into the plans.  Figures are available on IRA’s, where over the ten year period 1998 to 2008 (where 2008 is the most recent year available) gross new flows, including new contributions and from roll-overs, averaged a bit over $280 billion per year in the ICI numbers.  Assuming similar flows into 401(k)’s and other such defined contribution plans, but scaled to reflect their slightly smaller size ($5.1 trillion vs. $5.4 trillion), it would be reasonable to assume about $270 billion is flowing annually into such plans.  The two together would then be $550 billion a year, or about 3.5% of GDP.

One can only then guess what share of such flows might be attracted into the Supplemental Social Security accounts being discussed here.  With roughly a third of 401(k) assets in bond funds, and a further 9% in short term investments (mainly money market funds), it might be reasonable to assume that perhaps 30% of new flows into IRA’s 401(k)’s, and similar plans, would be attracted to Supplemental Social Security accounts.  Such accounts would be similar in nature to bond and money market investments, but with significantly greater returns due to the far lower investment fees of Social Security, combined with lower risk and greater security as these investments would be in US Treasuries.

While the 30% share is a guess, it is a reasonable bench-mark.  The actual flows could turn out to be significantly higher (particularly as an attractive new low-cost retirement savings option such as this might well lead to higher savings going into IRA’s and 401(k)’s), but it could also be lower.  A 30% share of $550 billion in annual flows would come to a little over 1% of GDP.

F.  Impact on the Social Security Trust Fund

Rounding down, I calculated what the impact would be assuming initial flows equal to 1% of GDP, and with the new retirement savings option entering into effect in 2015.  One then also needs, for the period of the projection (now to 2086), estimates of GDP growth, population growth, and real wage growth.  I used the projections made by the CBO for their long term Social Security projections, cited above, where over this period real GDP would grow at an annual average rate of 2.25%, and population would grow at an annual average rate of 0.58%.  I assumed real wages would on average grow at the rate of per capita GDP, or 1.66% annually.  Real wages have grown at a slower rate than per capita GDP since the 1980s and the Reagan “revolution” (as was presented and discussed in this earlier post on this blog), but it is assumed this cannot go on forever.   Finally one needs for the projections an assumption on the return to investments in long-term US Treasuries.  For this I assumed that the returns going forward would match the 2.6% real return of the 50 year period 1962-2012.

The spreadsheet then calculated the savings going into the Supplemental Social Security accounts of each age group, changing over time based on real wage growth and population growth.  I assumed workers would retire at 67, begin work at 22, and die at 92 (on average), with the savings converted into an annuity upon retirement at 67 with level payments (but reflecting accumulation at the real rate of interest of 2.6% on the assets in the accounts).  Note that the life expectancy of an assumed 92 is the life expectancy of someone who has reached the age of 67, and not the life expectancy at birth.  And while this life expectancy is less than 92 now, the projections are very long term, and were kept simple in part by not including variable life expectancies.

Each individual would then accumulate assets in the accounts, from savings plus the interest earned, until age 67, and would then draw down the accumulated assets through an actuarially fair annuity which would pay out a fixed amount (in real terms) each year until they die (which on average was assumed to be age 92).  For each individual, the amount paid in, including accrued interest, would then match the amount paid out.  But there would be a positive balance in the Supplemental Social Security Trust Fund accounts at any point in time, which would supplement the traditional Social Security Trust Fund.  The traditional Social Security Trust Fund would remain unchanged.

The resulting path of the new Supplemental Fund would be as follows:

Social Security Trust Fund, Traditional & Supplement, 2015-2086

The Supplemental Fund would at first grow, both in real terms and as a share of GDP, as initially all the age groups would be paying into the accounts while no one would be taking out funds until time had passed.  The amounts being taken out would then grow over time.  With the constant growth rates being assumed for GDP, real wage growth, and population growth, and the return of 2.6% in real terms on the investments, it is perhaps not surprising that the Supplemental Fund rises as a share of GDP and then flattens out.  From about 2055 onwards (40 years from the start), it would remain constant at about 24% of GDP.  And it is important to note that the Supplemental Fund would not decline as a share of GDP, but remain flat.

The traditional Social Security Trust Fund is projected to decline, due to the annual negative net cash flows shown in the graph at the top of this post, and will reach zero in 2035 according to the CBO projections.  It would continue to fall, and at an increasing rate over time (due to interest on what would then be negative assets) if nothing is done to make up for the annual shortfall.  The Supplemental Fund would not affect this path.  However, the Supplemental Fund would provide funding to the Social Security system, and when combined with the traditional Social Security Trust Fund, the overall fund would not now fall to zero until about 2058.  That is, it would extend the life of the Social Security Trust Fund by about a generation (23 years) before Social Security taxes or some other taxes would need to be raised to provide the scheduled benefits to Social Security recipients.

G.  Conclusion

The Supplemental Social Security accounts would be completely voluntary and would present an attractive option for retirement savings due to the low cost and high efficiency of the Social Security system.  It would also provide funding to the Social Security system which would extend the life of the Social Security Trust Fund, before something would need to be done, by a generation.  And the Supplemental Fund would not build up and then come down, putting additional stress on the Social Security system, but would rather build up to about 24% of GDP (under the assumptions made above) and then stay there.

The Supplemental Social Security accounts would also not be a Ponzi scheme.  Each individual would get back (on an actuarial basis) exactly what they put in, with interest.  For the economy as a whole, the fund would rise (to 24% of GDP under the particular assumptions made on growth) and then stay there.  And the interest being paid would come from the US Treasury.  Since the US Treasury would be paying the interest to others anyway, the shift to the Supplemental Social Security fund would not present any additional burden on the US Treasury, but would rather be neutral.

But it needs also to be recognized that a scheme such as this would not represent a permanent fix to the traditional Social Security system.  It would provide significant funding to Social Security, which would extend the life of the Trust Fund, but would not solve the underlying deficit that has arisen due to longer life expectancies with an unchanged (since 1990) Social Security payroll tax rate.  As noted above, the gap is not large, at about 1% of GDP, and is far less than the tax revenues lost as a result of the Bush tax cuts.  But perhaps by 2058 the country will be mature enough to recognize that the most successful social program of the last century in the US is worth paying for.