Long-term financial health

of Social Security and

options for reform
Polina Vlasenko, Ph.D.
Senior Research Fellow
American Institute for Economic Research
June 2016
polina.vlasenko@aier.org
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www.aier.org/research/reforming-social
-security
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Outline
Basic facts about Social Securitys
finances
Financial health of Social Security
what is the problem?
Ways to address the problem
Why reforms to Social Security are so
difficult to implement

Basic facts about Social

Security

Revenues come from

o
o
o
o

payroll taxes
applied to labor income
up to the taxable maximum
that is adjusted every year.

Payroll taxes

Payroll taxes (2)

Currently 12.4% of wages and
salaries
half paid by employer, half by employee
self-employed pay the full amount

For many families, Social Security

taxes represent the largest tax bill
they pay
Example:
a family of 4 with income $53,600

(U.S. median

income in 2014)
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paid at most $2,906 in federal income

Taxable Income
Only labor income is taxed
Tax applies to income up to the
taxable maximum (tax cap)
Tax cap in 2016: $118,500 per
person
Tax cap is adjusted every year by the
average wage index

Tax Cap - History

Source: Whitman and Shoffner, The Evolution of Social Securitys Taxable Maximum (2011)
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Tax Cap History (2)

Source: Whitman and Shoffner, The Evolution of Social Securitys Taxable Maximum (2011)
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Tax Cap History (3)

Source: Whitman and Shoffner, The Evolution of Social Securitys Taxable Maximum (2011)
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Summary: Social Security

taxes
Nearly everyone pays Social Security

taxes
For many, Social Security taxes
represent the largest tax bill in a year
Social Security taxes apply to about
86% of all earnings in the U.S. economy
In any given year, about 6% of workers
have income that exceeds tax cap

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Basic facts about Social

Security
Outlays consist mainly of Social
Security benefits:
Benefits depend on the history of
earnings
Benefit formula is designed to be
progressive
Benefits are reduced if claimed before
the full retirement age and increased if
claiming is delayed past the full
retirement age
Benefits are indexed to inflation
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Benefit formula
Average earnings of the best 35
earnings years
Only earnings taxed by Social
Security count
Non-wage income does not count
Income above tax cap does not count

Progressive formula:
90% replacement rate for low income (under
$10,300)
32% replacement rate for middle income
($10,300-$62,000)
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Benefits: full retirement age

Born before 1937: was 65

Born 1943-1957: is 66
Born after 1960: scheduled to be 67
People can claim benefits as early as
age 62, but benefits will be reduced by
as much as 30%
People can delay claiming benefits and
receive a benefit increase: 8% for every
year beyond the full retirement age, up
to the age of 70
No increase for delaying claiming past
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Indexation of benefits

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Summary: Social Security

benefits

Depend on earnings that were taxed;

tax cap acts as an indirect limit on
benefits
Benefit formula is progressive
higher replacement rate for lower
incomes
Full retirement age is rising to 67;
claiming benefits early reduces them
Benefits indexed to inflation, but
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Social Security is running out

of money

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How large is the problem?

Social Security benefits account for
about a quarter of the federal budget
outlays
Social Security benefits are projected
to rise relative to GDP and thus
relative to the federal budget
75-year actuarial balance: -2.68
percent of taxable payroll
Unfunded obligations (future
scheduled benefits net of taxes)
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What drives the problem:

demographics

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What can be done?

The problem is not going away:
demographic forces cannot be
altered quickly
Any reform will have to include:
Finding additional revenue, and/or
Finding ways to reduce outlays

No painless options some group(s)

will be adversely affected by any
reform measure
Many proposals exist; a recent report
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Options for reform

Pragmatic and practical choice:
package several reform measures so
that every major societal group is
seen as sacrificing something and
nobody is seen as free-riding at the
expense of others
Pragmatic option is not about
justice, fairness, or efficiency; it is
about what can be done given the
current method of making the
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Finding additional revenues

Increase the payroll tax:
2.7 percent increase if we do it now
4 percent increase if we wait until trust
fund runs out in 2034

Pros: simple, precedents exist

Cons: nobody likes tax increases,
Social Security tax is already the
largest tax for many, distorts
incentives for employers and
employees
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Finding additional revenues

(2)
Raise the taxable cap:
Example: raise the cap so that it covers
90 percent of all wages; this calls for the
cap at $275,000
Closes about 30 percent of the Social
Securitys financial shortfall

Other variations:
What about eliminating the cap
altogether?
Do we also change the benefit formula?
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What about taxing non-wage income?

Reducing outlays
Across-the-board benefit cut
If we do it today:
16.4% cut if applied to all current and
future beneficiaries
19.6% cut if applied only to future
beneficiaries

Nobody (sane) has proposed such

reform
If no reform is done, when trust fund
runs out the cuts will be automatic:
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Reducing outlays (2)

Raise the full retirement age
Tends not to affect when people
retire
Acts as a benefit cut when people
retire before reaching the full
retirement age
Example:
gradually increase the full retirement
age to 70 and the early retirement age
to 65
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Reducing outlays (3)

Change indexation of benefits
Use chained CPI instead of CPI-W
Closes about 10 percent of the
funding gap
Was proposed by the BowlesSimpson deficit reduction
commission in 2010 and in president
Obamas budget, but never adopted
The difference in benefits will be
small, but will accumulate over time
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Alternative price index slows the growth

of benefits

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Other proposals

Benefits means-testing

Reduce benefits for those who have high

enough income or wealth
Badly distorts incentives to work and to save
Social Security ceases to be the program
where everyone participates

Privatizing Social Security

Put a portion of payroll taxes into named
accounts that the owners can invest
OR invest a portion of the trust fund into stock
market
Increases risk borne by retirees
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An example: a package of
reforms

Proposal

Extent of funding
gap covered

Raise the taxable cap to

$275,000
Gradually raise the
retirement age from 67
to 70
Change the indexation of
benefits
Increase payroll tax 1
percent

Covers 30% of the gap

Covers 25% of the gap

Covers 10% of the gap

Covers remaining 35% of
the gap
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Why reforms are so difficult to

implement

Which reform option is best depends on

which interest group you ask
A conflict of interests is central to this type
of reform a decision about how to divide
limited resources
Reform is even more difficult when people
are asked for sacrifices today to avert a
future problem
This is why Social Securitys finances have
not been fixed yet, even though the
problem and the ways of fixing it have
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been known for two decades or more

Takeaways
Social Security is running out of
money
No painless reform options exist
Pragmatic solution: a package of
reforms that builds support by
spreading the pain
If nothing is done, a reform will
happen automatically, but not the
kind most people want
Ignoring the problem raises the costs
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More at AIER web site:

Reforming Social Security
The Federal Budget: Constraints Limit
the Options
Business Conditions Monthly
Cost of living calculator
Everyday Price Index

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Polina Vlasenko, Ph.D.

Senior Research Fellow
American Institute for Economic Research
polina.vlasenko@aier.org

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