Social Security: The Past, the Present, and Options for Reform

By Susan B. Anders and David S. Hulse

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Social Security currently provides a substantial portion of retirement security for the majority of elderly persons in the United States. According to the Congressional Research Service (CRS; Report 94-27, digital.library.unt.edu/govdocs/crs), approximately 50% of recipients have household incomes from all sources, including Social Security, of $25,000 or less. For more than one-quarter of recipients, Social Security provides more than 90% of their retirement income.

Private pension coverage has increased since the inception of Social Security, and Social Security Administration (SSA) statistics indicate that in 2002, 41% of Americans aged 65 or older received retirement benefits from sources other than Social Security. According to the EBRI survey, however, 18% of workers whose employers offer a retirement savings plan don’t participate, and less than 40% of workers have an individual retirement account (IRA). Only 69% of current retirees and 62% of current workers report saving at all for retirement, and fewer than half of those respondents have saved more than $25,000 on their own.

The original designers of the Social Security system were focused on ameliorating the desperate economic conditions faced by older Americans in the early 1930s. When the Social Security Act of 1935 first became law, the U.S. unemployment rate had reached 20%. The 1935 Act provided unemployment insurance and welfare programs, in addition to old-age pensions. In fact, the pension coverage was a relatively minor aspect of the original Social Security plan (Henry J. Aaron and Robert D. Reischauer, Countdown to Reform: The Great Social Security Debate, the Century Foundation Press, 1998), although it has since become the program’s major focus. According to the AICPA’s 2005 report Understanding Social Security: The Issues and Alternatives (second edition), Social Security was an important factor in reducing the poverty rate among the elderly from 35% in 1959 to 10% in 2003, the lowest of any adult group. The median net worth of Americans age 65 or older was twice that for the entire population, according to the 2000 Census (Shawna Orzechowski and Peter Sepiella, Net Worth and Asset Ownership of Households: 1998 and 2000, Current Population Reports P70-88, 2003, www.census.gov/prod/2003pubs/p70-88.pdf.).

The pension aspect of the Social Security program was originally designed as a prepayment plan, with benefits tied to contributions. Soon after inception, however, benefits were increased beyond originally envisioned levels, and the program became a “pay-as-you-go” system, with current workers’ taxes supporting current retirees’ benefits. Given a ratio of current workers to current retirees that declines over time, such a funding arrangement creates serious problems. Today, many experts expect that the Social Security system is going to run out of money in the future. The estimated deadlines vary depending on the assumptions made by the analysis, but it is widely expected that Social Security will not have the funds available to continue to provide expected benefits within about 25 years.

The poor economic outlook for Social Security is not a recent development, nor has it only recently been recognized. A major attempt at improving its fiscal soundness was made in 1983, when Congress increased the payroll tax rate and raised the retirement age to 67, creating an expected surplus through the year 2065. Several factors have affected the revised deficit projections, including the continuous forward shifting of the measurement period, the growth in the disability caseload, and changes in forecasting methodology; these bring the peak in the surplus forward by about 25 years.

The potential solutions will cause economic hardship to some important groups, and implementing any will require substantially more attention from policymakers and more communication to the public. Research has shown that Americans tend to favor reform options that affect their own demographic group the least (Susan B. Anders, “Social Security: An Opinion Survey of the Issues and Alternatives,” Journal of Accounting and Finance Research, Fall II, 2001). Any proposal to reform Social Security must consider the program’s history, address the current funding problems, and plan for implementation and transition.

A Brief History of Social Security

The United States was in the throes of high levels of unemployment and poverty when Congress passed the Social Security Act of 1935. The 1935 Act was not the first attempt to provide a social safety net for workers. Retirement programs for specific groups of Civil War veterans and state and local government employees were initiated in the latter half of the 19th century. According to the SSA, in the early 20th century federal workers in hazardous occupations were covered by social insurance, and many states had enacted early workers’ compensation laws. Many other industrialized countries had already adopted government-sponsored social security systems by 1930 (C. Eugene Steuerle and Jon M. Bakija, Retooling Social Security for the 21st Century: Right and Wrong Approaches to Reform, the Urban Institute Press, 1994).

President Franklin D. Roosevelt initiated the proposals that led to the Social Security Act of 1935 following the bank failures and loss of private savings resulting from the Great Depression (Steuerle and Bakija). The original social insurance programs incorporated into the 1935 Act included old-age retirement benefits, welfare programs, and unemployment insurance. Many modifications and additions have been made to Social Security since the original law was passed, including the disability insurance program in 1956 and the Medicare program in 1965.

Social Security payroll tax rates have increased steadily each decade, from 2% in 1940, to 9.6% in 1970, to 15.3% in 2000. In 1983, in recognition of the longer life expectancies of retirees, Congress raised the retirement age from 65 to 67, to be phased in for workers turning age 65 between 2003 and 2025. Additionally, as of 2000, retirees between age 65 and 69 no longer suffer any reduction in benefits if they continue to work. Exhibit 1 summarizes some of the quantitative changes to the system over the past 65 years.

Benefits were increased substantially in 1939 and 1950. Benefits were originally tied to contributions, but by 1975, retirees were receiving benefits that far exceeded the payroll taxes paid by themselves and their employers (Aaron and Reischauer). In 1972, new revenue forecasting methods led Congress to increase benefits, but an error in the projections, as well as a downturn in the economy, led to deficits rather than surpluses. By 1982, the trust fund was essentially “bankrupt” (Charles F. O’Donnell and Robert Strittmatter, “Social Security Trust Funds and the Federal Budget,” The CPA Journal, April 2000). Congress addressed the problem by cutting benefits and raising payroll tax rates in 1983. According to the SSA, the average annual benefits paid to retirees in 2006 are approximately $11,870 for single individuals, $19,775 for one-earner couples, and $23,735 for two-earner couples.

The number of people who participate in the Social Security system has also increased greatly beyond the original program, which initially covered about 50% of all workers. Between 1946 and 1983, the categories of covered jobs were gradually expanded to include agricultural workers, federal and state government employees, and members of the armed forces, among many others. Currently, 96% of all civilian workers hold jobs covered by Social Security (Aaron and Reischauer).

The Current Social Security System

Social Security taxes for employed individuals are usually 7.65% of earnings, payable by both the employee and the employer for a total of 15.3%; the general consensus among tax scholars is that the employee bears the economic burden of the employer’s share of the tax through a reduced real wage or salary (Daniel Shaviro, Making Sense of Social Security Reform, the University of Chicago Press, 2000). Of this 7.65%, 5.3% is earmarked for the old age and survivor’s insurance (OASI) portion of Social Security, 0.9% is designated for disability insurance (DI), and the remaining 1.45% is allocated to the Medicare system (HI). The Medicare portion of the tax is imposed on all earnings, but the other 6.2% of the tax is not assessed on earnings in excess of $94,200 (in 2006; adjusted annually based on growth in average earnings). For self-employed individuals, the tax rates are doubled (e.g., 10.6% for OASI, 15.3% in total), reflecting the fact that the individual is effectively both the employer and the employee.

Because it is affected not only by changing demographics but also by the rising expenditures and costs of the U.S. healthcare system, the Medicare portion of the Social Security system faces funding problems that are likely more severe, complex, and imminent than those of the OASDI portion. Medicare will be ignored for the rest of this article, which will focus on Social Security’s retirement benefits.

Social Security benefits are generally based on an individual’s primary insurance amount (PIA), which, in turn, is based on that individual’s average indexed monthly earnings (AIME). In brief, AIME is computed by adjusting each year’s covered earnings (i.e., earnings not in excess of the maximum OASI base) for growth in average earnings between the time they were earned and age 60. The 35 highest years of adjusted earnings are averaged, and the result is divided by 12 months to yield AIME. The PIA based on this AIME increases as AIME increases, but it does so at a decreasing rate. In 2006, the PIA is 90% of AIME below $656, plus 32% of AIME between $656 and $3,955, plus 15% of AIME in excess of $3,955. The PIA is subsequently adjusted for inflation (rather than growth in average earnings), and it is adjusted downward or upward for individuals who begin receiving Social Security benefits before or after attaining full retirement age, respectively. Full retirement age had been 65 but will gradually increase to age 67 by 2022.

Exhibit 2 depicts the relationship between AIME and the PIA. Note that higher-AIME individuals receive larger monthly Social Security benefits than lower-AIME individuals, but this represents a lower percentage of their AIME. Because Social Security taxes are levied at a flat rate, this means that, all else being equal, lower-income AIME individuals receive a better “return” from the system than higher-AIME individuals. Note also that there is not a direct link between payroll taxes paid into the Social Security system and benefits received from it; the link is indirect at best. The effect of an additional dollar of Social Security taxes paid on future Social Security benefits received depends on many factors.

For married individuals, Social Security benefits are generally the larger of the benefit based on their own earnings history or 50% of the individual’s spouse’s benefit. For two-earner couples, this usually means that the spouses receive benefits based on their own earnings histories, while one-earner couples receive aggregate benefits equal to 150% of the earning spouse’s benefit. Widows’ Social Security benefits are generally the larger of the Social Security benefit based on their own work history or 100% of the benefit that the deceased spouse had been receiving.

The Social Security Trust Fund

The Social Security trust fund is an account that the federal government maintains on its books. Its balance is increased by Social Security taxes collected, and decreased by Social Security benefits paid. For the past several years, the trust fund balance has run an increasing surplus, because payroll taxes have exceeded Social Security benefits, as illustrated in Exhibit 3. This excess has been invested in a special type of interest-bearing federal bond that is held only by the trust fund.

In their 2005 annual report, the Social Security trustees project the trust fund will reach its maximum balance in 2017, and will then decline to zero by 2041. This projected fund balance has been the impetus behind much of the concern regarding the long-term solvency of the Social Security system. The declining Social Security trust fund balance is only part of the problem; pressures on the rest of the federal budget will occur long before 2041.

After the trust fund reaches its maximum balance, the bonds it holds will have to be redeemed, as the trust fund’s outflows would otherwise exceed its inflows. As a result, non–Social Security federal tax revenues will be needed to pay off the bonds. The forecasted maximum trust fund balance and exhaustion are based on the trustees’ intermediate (i.e., best guess) assumptions regarding mortality, retirement patterns, and other relevant factors, all of which are uncertain. The trustees also make predictions based on high-cost (more pessimistic) and low-cost (more optimistic) assumptions. The projected years of maximum and zero balances are 2013 and 2030 based on the high-cost assumptions, versus 2022 and “never” based on the low-cost assumptions.

Social Security inflows and outflows are required by law to be excluded from the general federal budget totals (O’Donnell and Strittmatter). The federal government first presented a “unified” budget in 1969, which turned a pre–Social Security deficit of $1 billion into a surplus of $3 billion. The Social Security trust fund became “off budget” again under the Omnibus Budget Reconciliation Act of 1990.

The trust fund has much political significance, but it has little or no economic significance, because it is merely an artifact of government bookkeeping (Shaviro). That is, the federal government has several revenue sources, including personal and corporate income taxes, Social Security taxes, and excise taxes, and it makes various expenditures, including national defense, Social Security benefits, and interest on the national debt. For political reasons, Social Security taxes and benefits are linked via the trust fund (perhaps reflecting a public consensus that the two should be roughly equal), but very few other revenue items and expenditure items are linked in such a way. The fact that Social Security taxes, rather than some other revenues (e.g., income taxes), are credited to the trust fund ultimately has no real economic significance, whatever its effect on government policy.

This is a subtle point and can take some time to appreciate, but many Social Security reform proposals focus heavily on the trust fund bookkeeping outcome and less heavily on the government’s real cash inflows and outflows. The trust fund should not be given too much significance unless we, as a society, believe that Social Security taxes and benefits should be roughly equal (which makes it of political significance).

Problems Facing Social Security

The Social Security system is set up as a pay-as-you-go system, which is markedly different from private retirement plans (Steuerle and Bakija). Current workers make contributions into the system, via a payroll tax, that provide for the support for current retirees. The policy of building large reserves was abandoned without controversy in 1939, when the original levels of benefits envisioned in the 1935 Act were substantially increased by anywhere from 20% to 75%. Currently, approximately 80% of Social Security receipts are transferred to current beneficiaries (Aaron and Reischauer). The remaining 20% is “invested” in government securities. Questioning the soundness of a pay-as-you-go system is beyond the scope of this article; however, that design is in a large part responsible for the economic problems facing Social Security.

It is apparent from Exhibit 1 that fewer and fewer workers are providing the support for more and more retirees. In 1945, there were 50 workers for every retiree; in 1950, there were 17 workers for every retiree. By 1960, this ratio had declined to 8.6 workers for every retiree. Currently, there are 3.3 workers for every retiree, and this ratio is expected to decline to only 2.2 by 2025, at which time 22% of the population will be eligible for Social Security retirement benefits (Aaron and Reischauer).

Americans are living longer after retirement, which is a positive development, but one which requires more years of benefits than were expected when the system was designed. The life expectancy in 1990 for males who reach age 65 is 15 years longer than it was in 1940, when benefits were first paid; for females, it is almost 20 years longer. The Social Security system also encourages early retirement, which results in an early termination of contributions, an early payout of benefits, and a longer payout of benefits (although the amount of each monthly payment is reduced). Approximately 25% of men retire at age 62 (Aaron and Reischauer). According to the EBRI survey, about 34% of current workers plan to retire before age 65, while 66% of current retirees actually retired before age 65.

Another problem attributed to the Social Security system is that the promise of its benefits may discourage personal retirement savings. The Social Security funds have also been invested in low-yield treasury bonds, which may exacerbate the pay-as-you-go nature of the program by preventing potential reserve accumulation. Additionally, the Social Security trust fund has been used for government purposes other than retirement distributions, which means that the funds were not really “invested.”

It is often believed that the financing problems facing Social Security are due to the approaching retirement of the baby boom generation. However, the longer-term problems should not be overlooked. According to the 2005 trustees’ report, the unfunded obligation in the Social Security trust fund is expected to become increasingly negative over the next 75 years, long after the baby boom generation is deceased.

As the Social Security funds available for distribution decrease, personal savings and private pension plans will have to provide a greater percentage of retirement income. Unfortunately, the personal saving rate in the U.S. has declined from 10.4% in 1984 to 1.4% in 2003 (Marshall B. Reinsdorf, “Alternative Measures of Personal Saving,” Survey of Current Business, Bureau of Economic Affairs, November 2004). The percentage of workers covered by more-costly defined benefit plans has also dropped, while defined contribution plans, which shift the investment risk to the employee, have grown in popularity (Annamarie Lusardi, Jonathan Skinner, and Steven Venti, “Pension Accounting and Personal Saving,” The CPA Journal, September 2003). Many traditional defined benefit plans have converted their benefit formulas to become “cash balance” plans, which define benefits in terms of a stated account balance, rather than in terms of average or final pay (Reinsdorf).

Private pensions also face funding problems, as employers have relied on rising investment values, rather than contributions, to cover retirement liabilities. The Government Accountability Office (GAO) reported that pension plan underfunding grew from $39 billion in 2000 to more than $450 billion in 2004, according to AccountingWeb reports. A study by Watson Wyatt Worldwide indicated that 11% of large companies have either terminated or frozen their traditional pension plans. Some employees have watched their pension plans shrink or even evaporate as companies like Enron have become entangled in business and accounting scandals, and companies like United Airlines have entered bankruptcy.

Income Redistribution Within Social Security

One aspect of the current Social Security system that is frequently overlooked is the various ways in which it redistributes income. One may agree or disagree with this income redistribution, but it is important to appreciate its presence when evaluating reform proposals. For example, the “return” that one obtains from the Social Security system (i.e., taxes paid in versus benefits received) reflects any net income redistribution to or from that person. Many commentators lament the low return that some individuals receive from Social Security and argue that a particular reform proposal would provide a better return, without acknowledging that much of this increased “return” would derive from eliminating some of the income redistribution.

One direction in which income redistribution occurs is from higher-income to lower-income workers, as noted above and illustrated in Exhibit 4. Lower-income workers therefore tend to receive a better “return” from Social Security than higher-income workers. This redistribution is partially offset by a second type of redistribution, from those with shorter life-spans to those with longer life-spans. Demographic groups that tend to have shorter life-spans include lower-income individuals, males, and some racial minorities.

A third form of income redistribution is from younger generations to older generations, as shown in Exhibit 5. Older generations tend to receive a better return because, during the recent decades that represent their working years, Congress increased their future benefits more quickly than the taxes they paid.

Finally, income is redistributed from unmarried individuals and two-earner couples to one-earner couples. Recall that the nonearning spouse in a one-earner couple receives a Social Security benefit equal to 50% of the earning spouse’s benefit; that is, 50% more than a similar unmarried worker or worker in a two-earner couple. In addition, benefits will tend to be received for a longer time for a one-earner couple because there is a chance that the nonearning spouse will outlive the earning spouse and collect survivor’s benefits. There is no survivor to collect such benefits with an unmarried worker, and survivor’s benefits tend to be greater for surviving spouses who did not work than for those who did work. Exhibit 5 also provides evidence of this type of income redistribution.

Policy Considerations

The current Social Security system and proposals to reform it embody several, often competing, policy considerations. Perhaps the foremost of these is ensuring a minimum level of retirement income so as to mitigate poverty among the elderly, who are among the most vulnerable members of society. Social Security benefits alleviate the burden on other social assistance programs that lower-income elderly might otherwise avail themselves of. Other social policy considerations include the various ways that Social Security redistributes income, such as from higher-income to lower-income workers. Recall also that the current Social Security system is designed to redistribute income from unmarried individuals and two-earner couples to one-earner couples.

The issue of nonworking spouses is ignored in most discussions of Social Security reform, and it involves difficult choices (Karen Damato, “Spousal Benefit Is Social Security Wild Card,” The Wall Street Journal, March 3, 2005). For example, should spouses who did not work during most or all of their potential working years in order to raise children be entitled to a Social Security benefit? If so, who should pay for it? These social policy and distributional questions are especially important when considering proposals that would more directly link benefits to contributions, for example, through private individual accounts.

Several other important policy considerations relate to the economic effects of Social Security:

• Evidence suggests that wage-related taxes, such as Social Security, reduce labor supply for some workers, such as a married couple’s secondary earner, which has a negative effect on the broader economy.
• There is evidence that the availability of Social Security benefits induces some workers to retire earlier than they otherwise would, further reducing the labor supply.
• There is widespread concern about the low U.S. savings rate in recent years. Social Security taxes collected are mostly used to pay for current benefits and are not saved, because they are “lent” to the U.S. Treasury to help finance the federal budget deficit. Some believe that the Social Security system should be reformed so as to increase national savings (e.g., proposals for individual accounts).
• The administrative costs and burdens are important to consider. Depending on the particular reform option and its details, the administrative costs could be as low as 0.1% to more than 1% of the system’s assets. Over a working career and a retirement period of several decades, this difference could result in substantially different retirement benefits.

Like the income tax system, where trade-offs among fairness, economic effects, and administrative considerations are often necessary, the policy considerations for the Social Security system frequently compete. For example, a reformed system that more strongly emphasizes individual accounts may have desirable economic effects, but it may also have higher administrative costs and increase the risk of poverty in old age.

Finally, one should keep in mind that the Social Security system cannot be thought of in isolation from the remainder of the government’s activities. It may be that some policy objectives are desirable but are more effectively addressed outside the Social Security system. For example, poverty among the elderly might be better addressed by programs similar to those targeted at the non-elderly poor, focusing Social Security on a narrower set of policy objectives.

The Government Accountability Office has suggested that reforms to Social Security should be instituted as soon as possible to avoid serious problems in the overall economy, not just the retirement system (Social Security Reform: Early Action Would Be Prudent, Report to House of Representatives Committee on Ways and Means, March 9, 2005, No. GAO-05-397T). Comptroller General David M. Walker made five major points:

• Addressing Social Security’s long-term financing problem is critical to the financial well-being of millions of Americans.
• Focusing on trust fund solvency leads to a false sense of security, because trust fund assets are neither marketable nor readily convertible into cash.
• Social Security is only one of several programs creating a burden on future generations. The decline in private pensions further exacerbates the social welfare funding issues.
• The sooner reforms are instituted, the less drastic they will need to be.
• No one reform proposal can satisfy all parties. Each proposal has positive and negative aspects, and the various proposals should be evaluated as packages.

The GAO has suggested that reform proposals be analyzed using three basic criteria: the extent to which a proposal achieves sustainable solvency; the relative balance between individual equity and income adequacy; and how easily a proposal could be implemented, administered, and explained to the public.

Proposals to Reform Social Security

Many serious proposals to reform the Social Security system have been offered by economic experts and scholars. The most recent legislative proposals have been summarized in the AICPA’s Understanding Social Security: The Issues and Alternatives (2005), and that discussion will not be replicated here. Instead, this discussion will focus on broad types of proposals.

Historically, the options for reform have generally fallen into three categories—reducing benefits, increasing revenues, and increasing the return on Social Security trust fund assets—or some combination thereof. The recommendations for reducing benefits and increasing revenues could be implemented without changing the character of a hugely popular and successful program. On the other hand, the U.S. economy and society have changed significantly since 1935, and it may be appropriate to make some major, fundamental changes in the system and move toward advance funding of retirement obligations (Gary Burtless, “Social Security’s Long-Term Budget Outlook,” National Tax Journal, September 1997).

None of these proposals is without administrative and political difficulties, and hardships borne by some particular group. Reducing benefits places the burden of reform on current (and future) beneficiaries. Increasing revenues shifts the burden to current workers and taxpayers. Increasing the return on assets creates increased economic risk, as well as administrative complexity, but could improve retirees’ future benefits. Evaluating these proposals is complicated by the fact that most of today’s workers will also be tomorrow’s beneficiaries, so the distinctions among various proposals’ effects are more subtle than they first appear.

Although many proposals focus on only two or three specific actions, the most viable approach may be a combination of changes, as recommended by the GAO. The specific provisions of each of these broad ideas vary depending on the policy objectives of its proponent; however, a general synopsis can be made.

Reducing Benefits

Benefits could be reduced in a number of ways. Monthly benefits could be reduced by decreasing the primary insurance amount (PIA) for a given average indexed monthly earnings (AIME) or by reducing cost-of-living adjustments. Some suggest targeting reductions toward higher-income retirees, or other means-testing of benefits. Benefits could also be reduced by raising the retirement age or taxing Social Security benefits in full. Many of the benefit-reduction options are among the simplest and least costly to implement. If future beneficiaries expect lower benefits, they may decide to work longer or save more, both of which would have positive effects on the economy. An obvious criticism of broad-based benefit reductions is that they would violate one of the original goals of the Social Security program, namely, reducing poverty among the elderly. Additionally, if one believes that Social Security should provide workers with a reasonable “return” on their payroll taxes, benefit reductions would exacerbate the already low returns to single and high-income retirees illustrated in Exhibit 4 and Exhibit 5.

For overall benefit reductions to fully alleviate future funding problems, they would have to be enacted as quickly as possible. An immediate 12.6% reduction in benefits would eliminate the predicted shortfall. Without reforms, assuming that the current level of benefits continues to be paid through 2041, benefits would first have to be reduced by 27% in 2042, and again by 32% in 2078.

Raising the normal retirement age, or an early retirement age, or both, would have effects similar to across-the-board benefit cuts. Social Security currently provides a substantial incentive for early retirement, even though life expectancies have greatly increased and the physical demands of work have decreased since 1935. Under current law, the normal retirement age will gradually increase from 65 to 67, but it could be amended to increase even further, although none of the current major proposals include this option. The early retirement age of 62 has never been changed. Unlike straight benefit cuts, an increase in the retirement age would disproportionately affect beneficiaries with shorter life expectancies and those who already suffer from serious health problems.

The use of the Consumer Price Index (CPI) to compute cost-of-living adjustments (COLA) has long been controversial, and some research indicates that the CPI overstates the real inflation rate (Richard W. Johnson, “Distributional Implications of Social Security Reform for the Elderly: The Impact of Revising COLAs, the Normal Retirement Age, and Taxation of Benefits,” National Tax Journal, September 1999). Reducing the CPI, and therefore the COLA, could have the same effect as reducing benefits or increasing the retirement age. The burden for this reform would fall on future beneficiaries. However, reducing the COLAs would not affect the calculation of a worker’s initial benefit, which is based on historical wage growth (Burtless). Reducing COLAs would mean that the reduction in benefits would be increasingly larger as one lives longer.

Reducing benefits for high-income recipients, or other forms of means-testing, would preserve benefits for those most in need. However, reducing benefits for those receiving the highest level of benefits would not be as effective as it sounds, because high-income individuals could already be receiving a low level of Social Security benefits, and would continue to receive the same low level under this reform. Similarly, requiring means-testing creates the problem of defining “means”—for example, income or wealth—and then further specifying how to measure it. It would also effectively be a hidden tax on such individuals, which raises issues of fairness.

Taxing Social Security benefits is similar in effect to means-testing based on income. Social Security benefits have been partially taxable for higher-income taxpayers since 1983. One approach to fully taxing Social Security benefits would be to follow the annuity model and tax recipients on benefits received in excess of their payroll contributions, which would avoid double taxation, on the original earnings and again on the benefits.

Increasing Revenues

Approaches to increasing revenues generally involve one of the following: increasing the Social Security tax rate, increasing the upper limit on taxable earnings, using general tax revenues, or bringing state and local government workers into the system. Such revenue-increasing reforms could be implemented within the current pay-as-you-go system, could begin in the near future, and would not require any major transitions. Some of the options, however, would place the reform burden on current workers by increasing their tax liabilities and lowering their future returns, or would recharacterize Social Security as a welfare program.

The payroll tax rate has historically been increased when the Social Security system faced increasing benefit outflows, as illustrated in Exhibit 1. An immediate increase in the 12.4% payroll tax to 14.3% would eliminate the currently predicted deficit. Raising the payroll tax rate, however, places more of the burden on current workers and employers, as well as low- to moderate-income workers.

Another option is to raise or eliminate the ceiling on wages subject to the Social Security tax, which was previously done for Medicare. According to Social Security’s own predictions, immediately eliminating the taxable-earnings ceiling would eliminate the anticipated deficit. Increasing the ceiling, however, would shift the burden to high-income workers.

As discussed above, the Social Security trust fund is really just a bookkeeping description, and exists separately from the rest of the federal budget only on paper. Because the trust fund has been used in the past to cover outflows for expenditures unrelated to Social Security, some reformers have suggested that it now makes sense to use other revenues to cover the Social Security shortfall. Opponents of this option are concerned that using general revenues would reduce public support for Social Security as a retirement plan, and would recharacterize it as a welfare program.

One other proposal for increasing revenue is to bring the remaining state and local government employees, who are not currently covered by Social Security, into the system. If these employees have spouses who are covered by Social Security, or if they have part-time jobs that are covered, then they are already eligible to receive benefits. Unfortunately, this option is not estimated to raise much additional revenue.

Increasing the Return on Assets

The final approach focuses on increasing the return on Social Security assets, which would entail much larger, systemic changes to the program than do the benefit-reduction and revenue-increase options. In one proposal, an independent commission would be charged with investing a portion of the public trust funds in index or mutual funds. In another option, separate individual accounts would be maintained by the Social Security Administration, and workers would have the opportunity to direct a portion of their own investments. One of the most controversial alternatives would entail the complete privatization of the retirement system, with individually owned and controlled private accounts.

Many workers would realize greater retirement income under any of the “privatization” options. To the extent that benefits result from private investment earnings, they would not be dependent on real wage increases or labor force growth (Burtless). Proponents also argue that privatization of the retirement system would increase national saving.

Opponents of the private investment options are concerned about the ability of government officials to properly manage a large retirement fund, as well as about the effect of such an enormous infusion into the private capital markets, although it may instead be an enormous reshuffling if the government were to borrow additional monies to continue paying benefits to current retirees. Under any of the proposals to increase the return on retirement assets, the administrative and transition costs would likely be much higher than they would be for reducing benefits or raising revenues. Transitioning is also a major concern, and most supporters envision providing these options for younger workers only.

Investing a portion of Social Security funds in private capital markets. The simplest approach to increasing the return on Social Security assets would be for a portion of the trust fund assets to be invested in private capital markets, rather than in government bonds, without abandoning the pay-as-you-go system. Even after adjusting for risk, the equity market has historically outperformed the bond market and would provide a higher return for beneficiaries (Edward M. Gramlich, “Different Approaches for Dealing with Social Security,” American Economic Review, Vol. 86, No. 2, May 1996). The investments would be directed by professional managers for the fund as a whole, which would keep administrative costs to a minimum and spread the economic risks across several generations. Because individual accounts would not be created, transitioning between generations would not be a major concern.

There are several arguments against this option. First is the concern over added risk to the Social Security system and further diminution of the trust funds to pay administrative costs. Second is the difficulty of separating politics from the investment choices and the management of the fund. Third is the effect on the equity markets and the economy from an investment of this magnitude. The federal government would likely be the largest shareholder in many companies, and future politicians may find it irresistible to avail themselves of this means of influence.

Publicly held individual accounts. In this approach, individual accounts within the Social Security system would be established for workers. Individuals would be able to direct a portion of their contributions to be invested in a restricted selection of investment options. The accounts would continue to be held by the Social Security system, and earnings would be added to an individual’s regular Social Security benefits (Gramlich). Proposals for publicly held individual accounts generally call for mandatory supplemental employee contributions to create the private investment funds.

Advantages of individual accounts include the decentralization of investment decisions, thus mitigating the political problems caused by such an inflow of funds into private capital markets. Individuals may also feel an ownership in the Social Security system and take a greater interest in providing for their own retirement. Requiring contributions to personal accounts that are held in trust for a specific individual may be more politically acceptable than raising taxes to finance someone else’s retirement.

Allowing individuals to direct their own investments would, of course, expose their personal accounts to economic risk. Payroll taxes would have to be increased to establish the individual accounts. There would probably be pressure on Social Security to provide a minimum guaranteed benefit to offset poor individual investment decisions or economy-wide downturns. Additionally, the political influence on the markets would not be completely eliminated, as some oversight or approval of investment choices would have to be made to reduce risk for the individual accounts.

Complete privatization. The most radical reform option is to completely do away with the Social Security system and require individuals to contribute to personal accounts held by private investment companies (Gramlich). Account owners would have greater discretion over their choice of investments, and any balances remaining in at death could be passed on to heirs. This approach would increase workers’ connection to their retirement benefits, thereby encouraging individual responsibility and saving. Complete privatization would also eliminate the subsidization of one-earner couples (Laurence J. Kotlikoff, “Privatizing Social Security at Home and Abroad,” American Economic Review, Vol. 86, No. 2, May 1996).

Complete privatization presents the most serious transition problems. The current generation of workers is currently paying for its parents’ retirement, and would have to pay for its own retirement if its children would not be contributing to a pay-as-you-go system. Completely private accounts would increase the risk to the individual, and remove the safety net that was the original purpose of the Social Security system. Retirement incomes for low-earners would no longer be enhanced by Social Security’s progressive benefit schedule.

On the other hand, the U.S. economy is quite different from what it was when Social Security was enacted into law. Similarly, individuals may be much more knowledgeable about investing and retirement options today. The relevant political question is whether Americans would support the eventual termination of such a popular social program in favor of more individual control over their retirement funding.

The Future of Social Security

Social Security is facing serious funding problems, due to its pay-as-you-go design, the declining ratio of workers to retirees, and the increasing length of retirement. It is widely expected that within about 25 years Social Security will no longer have the funds available to continue to provide the current level of benefits. The much-publicized Social Security “trust fund” is merely a bookkeeping account that has little or no economic significance. While many proposals to reform Social Security exist, the authors do not seek to promote any particular agenda, but rather to better inform readers of the major issues surrounding the Social Security debate.

The original social insurance programs incorporated into the Social Security Act of 1935 included old-age retirement benefits, welfare programs, and unemployment insurance, and were later expanded to include the disability insurance program and the Medicare program. Currently, the Social Security taxes that one pays and the benefits that one receives are linked only indirectly, which is quite different from private retirement plans. Due to the benefit calculation methodology, the system redistributes income in many ways. As a result, the “return” obtained from Social Security varies among beneficiaries.

The current Social Security system and proposals to reform it embody several policy considerations, such as ensuring a minimum level of retirement income so as to mitigate poverty among the elderly. These social policy and distributional concerns are especially important when considering reform proposals, which generally embody conflicting goals.

Historically, the options for reform have generally fallen into three categories: reducing benefits, increasing revenues, and increasing the return on Social Security trust fund assets. Benefits could be reduced and revenues could be increased without changing the character of the program. It may, however, be time to make fundamental changes in the system. Although many proposals focus on only two or three specific actions, the most viable approach may be from a combination of different reforms, as recommended by the Government Accountability Office.