A Win-Win Proposition
A way out of the impasse on Social Security reform.
BY ROBERT C. POZEN
Tuesday, May 3, 2005 12:01 a.m. EDT
Although President Bush's proposal for progressive indexing of Social Security preserves the scheduled benefits of all low-wage workers as well as all workers retiring before 2012, the critics have lambasted its "benefit cuts" for middle- and high-wage earners. These critics suggest that reductions in scheduled benefits can easily be avoided by raising payroll taxes.
Judging any reform plan relative to scheduled benefits is misguided. The schedule represents the benefits we have promised but do not have the money to deliver. That is why Social Security has a long-term deficit with a present value of $3.8 trillion. If the litmus test of a reform plan is not cutting scheduled benefits for any significant group of workers, then no viable plan to restore Social Security's solvency will pass muster.
Instead, any proposal to reform Social Security should be evaluated on three criteria: the benefit reductions relative to payable benefits (that can be financed by the current system); the purchasing power of future benefits relative to current benefits (for workers in similar positions); and the replacement ratios provided by proposed benefits (taking into account all sources of retirement income). Moreover, any plan for benefit reform should be compared with the precise increases in payroll taxes that would be needed to avoid the proposed reductions in scheduled benefits.
Let us take as an example a medium-wage worker who will earn $47,000 in 2012 when progressive indexing will first be implemented ($36,500 in 2005). The critics have already proclaimed that such a worker retiring in 2045 at age 65 would receive 16% less under progressive indexing than scheduled benefits--$16,417 rather than $19,544 per year. Is this reduction from the schedule a "benefit cut"? If Congress does not enact Social Security reform, the system will default in 2041 and benefit levels will automatically be reduced by roughly 27% for all workers by 2045. So judged relative to payable benefits, the $16,417 received by the median-wage worker in 2045 would actually be an increase in benefits. That sum represents $2,150 more in Social Security benefits than the $14,267 that the system can afford to pay in 2045 absent major reforms.
What about the purchasing power of that $16,417 received by the median wage worker in 2045 under progressive indexing? That worker in 2045 would receive a 14% increase in purchasing power as compared to a similarly situated worker today--from $14,384 in 2005 to $16,417 in 2045 (expressed in constant 2004 dollars). In other words, median workers would be able to buy 14% more in goods and services with their monthly checks from Social Security under progressive indexing in 2045 than they can with these checks today. That does not sound like a "benefit cut" in terms of real purchasing power.
A third criterion is the impact of Social Security reform on replacement ratios--the percentage of pre-retirement earnings replaced by post-retirement benefits. Under the current schedule for Social Security, the replacement rate would be 36% for a median-wage worker retiring at age 65 in 2045; under progressive indexing, the replacement ratio for that same worker would decline to 30%. However, the above replacement rates do not take into account any post-retirement income from private retirement plans like 401(k) plans, IRAs, and defined benefit plans. While statistics on participation rates in these types of plans are not comprehensive, they suggest that participation rates in 401(k) plans alone range from 50% to 75% for workers in middle income ranges. And both parties agree that any legislation to reform Social Security should include incentives for higher participation in private retirement plans, especially for median-wage workers and those in smaller companies.
Instead of applying these three criteria to evaluate plans like progressive indexing to reform Social Security, critics simply assert that "benefit cuts" from the schedule can be avoided by increasing the ceiling on wages subject to payroll taxes. For example, a news story on progressive indexing in the New York Times on Sunday stated: "By contrast, raising the ceiling on payroll taxes would maintain the system's solvency just as well, if not better [than progressive indexing] . . . ." Although the story contained an elaborate chart on "benefit cuts" for various groups of workers, it included little detail on what precise increases in payroll taxes would be needed to achieve system solvency.
The payroll tax rate of 12.4% currently applies to all earnings up to $90,000 per year. If Congress decided to close the whole long-term deficit of Social Security through payroll taxes, it would have to extend this 12.4% rate to all earnings (assuming minimal retirement benefits were paid in connection with these new payroll taxes). Thus, attaining solvency for Social Security in this manner would require one of the largest tax increases in the history of the United States for all high-wage workers.
Since such a huge extension of payroll taxes (at 12.4% to all earnings) does not appear to be politically viable, some commentators have suggested that the 12.4% rate be levied on all earnings up to $150,000 per year (which comes close to 90% of the overall wage base). Yet even such a large jump in the earnings base for the 12.4% tax would close only a third of the long-term deficit of Social Security. Moreover, this type of extension of the 12.4% rate would be extremely unfair to those workers earning between $90,000 and $200,000 per year. Most, if not all, of their earnings would be subjected to the 12.4% payroll tax, while most earnings of millionaires would not.
If Congress chose to raise payroll taxes as part of a reform package, a more workable structure would be a surcharge of 2.9% on all earnings above $90,000--loosely based on the structure of the Medicare tax. Compared to a 12.4% tax on an earnings base that would be increased to $150,000, such a 2.9% surtax would be fairer by spreading the burden. Nevertheless, such a 2.9% surtax would cut the long-term deficit of Social Security by only one-fourth--still requiring significant constraints on benefits in order for the system to reach solvency later this century.
More fundamentally, any increase in the payroll tax base must address the issue of political support for Social Security. Critics of progressive indexing have alleged that it will erode political support for the system among high-wage earners because their benefits would grow more slowly than under the current schedule. Yet these same critics are the ones urging substantial increases in payroll taxes for high earners. Will the political support of high earners be more likely to erode if they face a large hike in their payroll taxes for the rest of their working careers, or if they receive less than the current schedule of Social Security benefits when they retire in 20 or 30 years? The answer is obvious.
If Congress is attracted by a package of Social Security reforms combining a milder form of progressive indexing with a 2.9% surtax on earnings above $90,000, it must provide high earners with retirement benefits attractive to them. One possibility would be to devote 1.45% of the surtax to Social Security solvency, and to allow the other 1.45% to be allocated to a personal account invested in market securities. Since such an account would not divert existing taxes away from Social Security, it would not involve any increase in government borrowing. In short, the combined approach would let both parties win--Democrats would get a mix of higher taxes and progressive benefit changes, while Republicans would get personal investment accounts and constraints on benefit growth. And the solvency of Social Security would be restored for all American workers.
Mr. Pozen is chairman of MFS Investment Management.
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