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Peter A. Diamond, Peter R. Orszag

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Saving Social Security

Brookings Institution Press

Chapter One

Social Security is one of America's most successful governmentprograms. It has helped millions of Americansavoid poverty in old age, upon becoming disabled, or afterthe death of a family wage earner. As President Bush hasemphasized, "Social Security is one of the greatest achievementsof the American government, and one of the deepestcommitments to the American people." Despite its successes,however, the program faces two principal problems.

First, Social Security faces a long-term deficit, eventhough it is currently running short-term cash surpluses.Addressing the long-term deficit would put both the programitself and the nation's budget on a sounder footing.

Second, two decades have passed since the last significantchanges in Social Security. Since then, as our economyand society have continued to evolve, some aspects of theprogram have become increasingly out of date. The historyof Social Security is one of steady adaptation to evolvingissues, and it is time to adapt the program once again.

Restoring long-term balance to Social Security is necessary,but it is not necessary to destroy the program in orderto save it. To be sure, some analysts reject the view that Social Security'sprojected financial problems are serious enough to warrant any changesright now. Others, in contrast, exaggerate the difficulty of saving SocialSecurity to justify proposals that would shred the most valuable featuresof this exemplary program. Our view is that Social Security's projectedfinancial difficulties are real and that addressing those difficulties soonerrather than later would make sensible reforms easier and more likely. Theprospects are not so dire, however, as to require undercutting the basicstructure of the system. In other words, our purpose is to save Social Securityboth from its financial problems and from some of its "reformers."

In this book we present a plan for saving Social Security. Ourapproach recognizes and preserves the value of Social Security in providinga basic level of benefits for workers and their families that cannot bedecimated by stock market crashes or inflation, and that lasts for the lifeof the beneficiary. Our plan updates Social Security to reflect changes inthe labor market and life expectancies. And it eliminates the long-termdeficit without resorting to accounting gimmicks, thereby putting the programand the federal budget on a sounder financial footing.

Our plan to restore long-term solvency has three components, each ofwhich addresses one of the factors that contribute to the long-term deficitin Social Security: improvements in life expectancy, increased earningsinequality, and the ongoing legacy debt that arises from the program'sgenerosity to its early beneficiaries. Each component of our reform planincludes adjustments to both benefits and revenue to help close the long-termdeficit.

The first of these components is the life expectancy component. Lifeexpectancy at age 65 has risen by four years for men and five years forwomen since 1940, and it is expected to continue rising in the future.Increases in life expectancy make Social Security benefits more valuable torecipients, because the benefits are paid over more years. But for that veryreason, increases in life expectancy also raise the cost of Social Security.

Many observers have recognized that it makes sense to adjust SocialSecurity for the effects of increased life expectancy. Previous proposals todo this, however, have adopted the extreme view that all of the adjustmentshould occur through reductions in benefits. Instead, we propose abalanced approach in which roughly half the life expectancy adjustmentoccurs through changes to benefits and the rest through changes to payrolltaxes.

The second component of our plan addresses earnings inequality,which has risen substantially in the past two decades. Inequality of earningsacross workers in the labor force affects Social Security in severalways. For example, the payroll tax is levied on earnings only up to a certainlevel (in 2003 that level, the maximum taxable earnings base, was$87,000). In each year over the past two decades, about 6 percent ofworkers have had high enough earnings that some of their earnings wereabove the maximum taxable earnings base and therefore not subject tothe payroll tax. These higher-income workers have enjoyed disproportionatelyrapid earnings growth over that period, so that the share ofeconomy-wide earnings not taxed for Social Security has risen substantially.In 1983, when the last major reform of Social Security was undertaken,10 percent of all earnings were above the maximum taxable earningsbase. By 2002 that share had risen to about 15 percent.

In addition to having more of their earnings escape taxation by SocialSecurity, high-income workers have enjoyed increasing life expectanciesrelative to other workers. This increasing difference in life expectancytends to diminish the progressivity of Social Security (that is, its provisionof relatively more generous benefits to lower-earning workers) on alifetime basis. The life expectancy adjustments in the first component ofour plan are based on average increases in life expectancy for the entirepopulation. Since life expectancy for higher earners is increasing morerapidly than the average, an additional adjustment just for higher earnersis warranted.

To address the effect of earnings inequality on Social Security, our planagain includes a balance of revenue and benefit adjustments. First, wepropose gradually raising the maximum taxable earnings base until theshare of earnings that is above the base-and hence escapes the payrolltax-has returned to roughly its average level over the past twenty years.This change would gradually reduce the share of earnings not subject tothe payroll tax until it reaches 13 percent in 2063, roughly halfwaybetween its current level and its level in 1983. Second, to make SocialSecurity somewhat more progressive, and thereby offset the effects of disproportionatelyrapid gains in life expectancy among higher earners, wepropose a benefit reduction that affects only relatively high earners. Currently,about 15 percent of workers newly eligible for Social Security benefitshave sufficiently high earnings that a portion of those earnings fallsin the highest tier of the Social Security benefit formula. Our benefitadjustment for income inequality consists of a gradual, modest reductionin benefits that would affect only those with earnings in this highest tier.

The third component of our plan recognizes the legacy cost stemmingfrom Social Security's history. The first generations of beneficiariesreceived far more in benefits than they had contributed in payroll taxes.Beneficiaries in the earliest years of the program, for example, contributedfor only a few years of their career but then received full benefitsover their whole retirement. The decision to provide ample benefits tothese early beneficiaries is understandable: most of them had experiencedhardship during the Great Depression, many had fought in World War Ior World War II, and elderly poverty rates were unacceptably high. Butthose benefits did not come free: the iron logic of accounting requiresthat since those early retirees received more in benefits than they had paidin, later generations of retirees must receive less. In other words, the system'sgenerosity to early beneficiaries generated an implicit debt, whichwe refer to in this book...