Thursday, May 19, 2011

Solving the Budget Deficit—Step Four: Repairing Social Security and Medicare

Social Security and Medicare are funded by what people think of as their FICA taxes. The Social Security portion was intended to be self-sufficient, with benefits “funded” from the taxes without additional income required from general revenues.

More and more of the Medicare benefits have been implemented with the assumption that a substantial portion (75% for much of it) will be funded by general revenues. Because of the different assumptions which birthed these two programs, we’ll address them separately.

Social Security

The biggest problem—perhaps we shouldn’t call it a problem, but an issue—with Social Security is that we are living longer than actuaries originally planned for us. That is not the only issue. We are retiring earlier in larger numbers, which generates fewer years of contributions. As with any program around for three-quarters of a century, some inefficiencies and idiosyncrasies have cropped up. These can be easily resolved if we can get the big fix in place.

Here is an immutable formula that defines financing of retirement plans:

Benefit Payments + Expenses = Contributions + Investment Income

Expenses are not a problem. Social Security is a well-run, efficient operation. Investment income could be enhanced a bit with moderate risk—but that’s a fairly small thing, since the right hand of the general fund of the Federal government has been borrowing from the left hand of the “Social Security Trust Fund.”

To fix Social Security’s problem requires either a cut in benefit payments or an increase in contributions. We can cut benefit payments in three manners: (1) continue to increase the retirement age; (2) reduce benefits the same percentage for everyone across the board to achieve balance; or (3) tweak the benefit formula to minimally affect those beneficiaries who earned the least and significantly cut benefits for maximum wage earners.

It is always easiest for politicians to cut benefits for those far away from retirement. The thinking goes that they have more time to adjust to the changed circumstances. I’m a bit skeptical of the argument. I’d bet most people don’t really know what they’ll get from Social Security—despite Social Security sending annual statements to all workers twenty-five or older since 1999. [Recently the Social Security Administration suspended the statements due to “the current budget situation.”]

One of Social Security’s strengths is that while benefits tilt toward the working poor and away from those better off, they are not so skewed that people consider them unfair. Social Security is widely regarded by all income levels as a good program (which is not to say that people don’t want to make it better, based on their idea of what “better” means.) Changing the current balance by tweaking the formula strikes me as possibly being the straw that breaks the camel’s back.

We should continue to raise the retirement age from its current maximum of 67. The original age 65 normal retirement was adopted at a time when people couldn’t work after 65 because they were physically worn out. Some professions still wear people down to the point they can no longer work. The disability provision must address their situation. For the rest of us, our lifestyle at age 70 today is much more robust than the lifestyle of the 1930s 65-year old. We need to rapidly raise the retirement age and start that process for anyone who has not yet reached their normal retirement age (that includes me).

At the same time the normal retirement age is increased, we should increase the early retirement age. Maintain the current four-year differential for those currently eligible for early benefits. Thus, if someone’s normal retirement age is 70, they could start Social Security as early as 66.
To the extent raising the retirement age does not adequately address the funding shortfall, I suggest cutting benefits in two ways.

First, extend the number of years of averaging from thirty-five to forty in order to receive a full benefit. Start the increase with 2012 retirements and pop it up by one year every other year. For people who work forty years, it will have a very minor effect on their benefits. For those who choose to retire early, it will have a larger effect, eventually reducing benefits by up to 12.5%. Those who are permanently disabled would be unaffected by the change.

Second, provide those who work past the normal retirement age with greater benefits than those who retire earlier, but defer benefit commencement. A simple approach would be to eliminate their future FICA taxes—they have fully paid for their benefit.

If all of those changes are not sufficient to get Social Security back in balance, then cut benefits across the board for everyone: current beneficiaries, those currently working and those not yet born.

Unlike my solution to fix the general fund deficit, I do not think additional taxes are appropriate. One suggestion often touted is to remove the cap on which the OASDI (Old age security and disability income) portion of FICA taxes are paid as was done for the Medicare portion in 1994.

In all my years working with corporate executives I never heard one complain about their personal Social Security taxes. Many looked forward to and celebrated the day when they got their “raise” after they had reached the income threshold and no longer had the FICA tax withheld from their paycheck, but no seemed to think the tax was terribly unfair. If we eliminate the wage limit for FICA taxes, it will drive a wedge between rich and poor in a system that is to the poor’s advantage to maintain.

Congress designed Social Security to be fiscally neutral, and I think that is a good policy to keep. While I believe we should raise taxes on those with higher incomes, income taxes, which benefit the general operating fund, not FICA taxes are the place to raise them.

Next blog for Medicare.

~ Jim

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