Why the Fiscal Cliff Deal Should Have Included Social Security

Social Security may not add to the deficit, but it does add to the national debt. Fortunately, it's easy to fix this.

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The U.S. Capitol is pictured on Dec. 31, 2012.

Yesterday’s deal to avoid the fiscal cliff offers quick fixes for the country’s most urgent financial problems but will also add almost $4 trillion to the deficit over the next 10 years. Cuts in discretionary spending and entitlements have therefore become even more essential, but the fiscal cliff deal has postponed negotiations over spending for at least another couple of months.

Moreover, one major government program is likely to be omitted from those discussions: Social Security. Although much attention has been paid to ending the temporary reduction in Social Security payroll taxes, little has been said about modifying the program’s benefits. Indeed, these are likely to be kept off the table entirely during future negotiations over spending cuts. This omission is usually justified on the grounds that Social Security does not contribute to the deficit. However, the program does add to the growth of the national debt.

How can Social Security have no deficit and yet add to the national debt? Chalk that up to the Social Security Trust Fund. Money that workers pay into the system goes largely to fund benefits for people who have already retired. Any surplus goes into the Trust Fund – now more than $2.7 trillion – which invests in government bonds. In 2010, however, the amount that Social Security took in fell short of the amount needed to pay benefits. That gap is growing and is projected to surpass $100 billion a year before the end of the decade.

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This shortfall can be covered by taking money out of the Trust Fund. But every time that’s done, the government has to redeem some of the bonds in the Fund for cash. It gets that money by selling other bonds to the public. And while bonds in the Fund represent money that the government owes to itself, and therefore don’t count toward the national debt, bonds sold to the public do add to the debt. Since Social Security will likely continue to pay out more in benefits than it takes in, the government will have to make up the difference with additional public borrowing.

Fortunately, the funding gap could be eliminated and the Social Security system could be brought back into balance with five minimally painful nips and tucks (AARP has analyzed some other possible fixes, as well). Here’s what can be done:

Tweak the formula for initial benefits. The amount that each retiree initially receives is calculated based on salaries and wages over 35 years. If someone has worked for fewer years, the years needed to reach 35 are simply counted as having zero income. Lengthening the period to 38 years would reduce benefits slightly while preserving them for people who worked the longest. Amount of the funding gap eliminated: 13%

Adjust eligibility for lengthening life spans. Since Social Security was created, the life expectancy for 65-year-olds has increased by more than three years. But the age for full benefits is being increased by only two years – from 65 to 67 in 2027 (retirees would still be able to take reduced benefits at an earlier age). More could be saved by adjusting the retirement age to reflect future increases in life expectancy, which would raise the age for full benefits to 68 by 2049. Amount of the funding gap eliminated: 23%

Switch to a different cost-of-living adjustment. Benefits for people who are already retired are increased each year in line with the cost of living. The inflation measure that is used, the Consumer Price Index, is slightly higher over time than an alternative index, known as the Chained CPI. Switching from the CPI to the Chained CPI would almost invisibly rein in the growth of benefits (my column three weeks ago discusses this further). Amount of the funding gap eliminated: 23%

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Increase the payroll tax cap. The Social Security payroll tax exempts income above a certain cutoff. This prevents benefits from becoming ridiculously large for millionaire retirees (because of the earnings-based benefit formula). But it also means that the payroll tax is regressive – it is higher in percentage terms for average workers than it is for the richest. Historically, the payroll tax fully included 90% of workers. Today, though, only 84% of workers are fully taxed. Raising the cap from $110,100 to $215,000 would again fully cover 90% and make the tax a bit less regressive. Amount of the funding gap eliminated: 36%

Trim benefits for the affluent. The previous four fixes would almost restore Social Security to its original financial footing – by adjusting for longer life spans, longer working lives and greater income inequality, as well as using a more accurate inflation measure. Taken together, these changes would eliminate 95% of the funding shortfall. The remainder could come from trimming benefits for the most affluent. Reducing benefits by up to 12% for the richest 20% of the population using a sliding scale by income would close the last 5% of the gap.

What is most important, some commentators argue, is that Social Security should be preserved as a self-financing program rather than starting to rely on general tax revenue. Their argument is that broad popular support for Social Security depends on it being viewed as the equivalent of a pension plan rather than as a welfare program. Fixes made now that are scaled or slowly phased in can keep the program financially sound for the rest of the century – and stop it from contributing to the national debt as well.