Urgent Budget Choices, Part I: The Problem, and Fixing Social Security

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In our continuing series on the federal budget crises, Prairie Fire brings you the position of yet one more nationally recognized institution, the Committee for Economic Development. New readers are invited to retrace the steps of the previous parts of this series that began in the August 2007 issue. By Joseph J. Minarik The latest budget figures indicate that a short period of relief from the record high deficit of 2004 is over. A brief boom of tax receipts, fueled by excesses in the financial markets, has come to an end. We face decades of significant budget deficits, with a continuing intense war effort and a sustained high price of oil. A big drop in the value of the U.S. dollar relative to free-floating foreign currencies signals possible concern in world financial markets. Meanwhile, the retirement of the first of the baby-boom generation on early-retirement Social Security benefits begins now - in 2008, when the first of the "boomers," born in 1946, turn 62. This begins the budgetary strains of population aging. Thus, the time that the nation has to strengthen the budget before this demographic wave hits is almost gone. It is past time to face up to the deficit problem. This article starts by explaining the problem in more detail, and showing how modernization of Social Security could contribute to a solution. Two future articles will explain the roles of health care and taxes in the ultimate answer.

Persistent deficits

Under the most reasonable assumptions regarding expiring tax cuts, the war effort and other matters (including the problem of the alternative minimum tax, or AMT), and even with a strong economy, the budget will deteriorate. The most important measure of this deterioration for the long run is that the nation’s accumulated debt will grow faster than the economy - or in technical language, the debt will grow as a percentage of the gross domestic product, or GDP. It is as if, for a family, the home mortgage grows faster than the family’s income. Our public debt will grow faster than our capacity to repay it. That is unsustainable. Our policies must change - and the sooner, the better.

Deficits matter

Continuing large budget deficits can erode our prosperity for decades to come. In addition, large deficits could destabilize the economy, causing inflation and recessions. The economy grows when new ideas are developed, and when they are put to work through business investment in more, and more effective, factories and machines, and a smarter, better-educated work force. Budget deficits hurt by siphoning off funds from business investment, and from public investment in better schools and infrastructure. The "crowding out" of domestic investment was clear during the large changes in the deficit during the 1980s and the early 1990s, and the relief when the budget then swung into surplus. The only thing that can cushion the hit of big deficits on the economy is borrowing from abroad. But that is cold comfort because it leaves the nation increasingly mortgaged to those foreign lenders. Furthermore, the anxiety about the economy today is worsened because of fears that those foreign lenders will not continue to provide us with credit to finance those endless budget deficits. It is only natural that when any country's obligations to foreign investors grow faster than its capacity to repay, investors will begin to question the safety of those assets. This can trigger a "run" - that is, an attempt by many investors to dump their assets on the market at the same time, as has occurred in Asia, Russia and Argentina. To be sure, the United States is not Argentina or Russia; the dollar is the world’s preeminent reserve currency. But the massive U.S. debt has prompted other countries to begin to discuss alternatives to the dollar, such as the euro. OPEC members have talked about pricing their oil in euros. Both common sense and historical evidence suggest that the United States should be prudent and protect its international credit rating - just as any family should maintain its reputation and save for a "rainy day." Gambling that we will "grow out of the deficit" through "supply-side economics" is just too risky. So is assuming that future spending cuts will save the day - we cannot responsibly "starve the beast" today, on the assumption that someone else will cut spending later. The unavoidable truth is that large deficits today are really delayed tax increases on future workers. Our children and grandchildren must pay our unpaid bills - with interest. What will they think of us when they are forced to pick up our bar tab?

Searching for solutions

There are no easy options for cutting the budget. If policymakers refuse to cut homeland security, military spending, future Social Security benefits, Medicare payments and Medicaid expenditures, as they have in recent years, they have already (noting that interest costs are impossible to cut directly) placed off limits more than 70 percent of the budget. Extending popular expiring tax cuts eliminates further options. But "none of the above" is not an acceptable answer. We must take a different perspective. What do we need to do to fend off a "debt spiral" - an ever-rising cycle of deficits, more debt, higher interest costs and still larger deficits? The budget choices we face all appear to be untenable: cutting Social Security, cutting Medicare and raising taxes. But that is exactly the point. Current budget deficits are so large that none of these measures alone will suffice; all must be brought to the table to construct a workable solution. While reshaping Social Security or Medicare or raising additional taxes is unattractive, the real choice is between planned and rational policies now, or more rushed and severe steps down the road. Let’s start with Social Security.

The fiscal agenda: fixing Social Security

Social Security is of vital importance both in its own right and because it has substantial impact on the nation’s budget. The Committee for Economic Development (CED) issued its proposal 10 years ago, and we believe that its principles and policy recommendations are as pertinent today as they were then. We are concerned today that a misguided approach to Social Security might not only endanger the accomplishments of that program, but also miss an important opportunity to turn the budget around. Like most Americans, we believe that Social Security is one of the most successful social programs in U.S. history. The basic objective of Social Security - to protect the economic security of retirees - is fundamental. Social Security also provides an important safety net for survivors of younger workers and for the disabled. It provides financial security for those who live very long lives, with inflation protection that is virtually impossible to obtain from private-sector investments. The decline in poverty among the elderly is proof. Social Security fulfills all of these functions at minuscule administrative cost. These virtues must be preserved through any proposed reform. Still, because of the aging of the U.S. population, substantial change in Social Security is inevitable. With the baby-boom generation beginning to retire, the system’s current operating surplus will begin to decline, after which the trust-fund balances will be drawn down at a rapid rate. If no action is taken, the system will be forced to impose a very large, inequitable and economically inefficient increase in the tax burden on future workers and/or a very sharp and disruptive cut in benefits, somewhere between about 2020 (when Social Security tax revenues begin to fall short of benefits) and 2050 (when the Social Security Trust Fund is exhausted; these estimated dates are of course highly approximate). But the problems of the system should not be exaggerated. Under current economic and demographic assumptions, and with no additional sources of revenue, Social Security can continue to pay about 75 percent of currently promised benefits in perpetuity. In other words, Social Security must change; but we must not exaggerate the problem, and we must not undermine the fundamental role of this successful program. If we act now, and choose carefully, the changes in the program can be phased in gradually, and today’s workers will be able to adjust deliberately and successfully over a long period of time. Because Social Security is so politically sensitive, policymakers might procrastinate until crisis is imminent. But the cost of restoring balance to the program rises substantially each year that action is postponed. In fairness, current workers must be given advance notice about any significant changes in the system, so that they can make appropriate adjustments in their retirement saving and in their career plans that affect the number of years they will continue to work. Therefore, with every year of delay in taking action, more current workers must be excluded from a solution, making the ultimate choices ever more difficult. Social Security reform must not be oversold. Grand promises of an investment program that will build large personal-wealth nest eggs are not realistic. If Social Security is to continue to provide a safety net against inflation for the very old, the current defined benefit cannot be reduced too much. Similarly, if accumulations in Social Security private accounts are to be converted to annuities - which provide a guaranteed annual cash income so long as the owner lives - then those balances cannot also be bequeathed to the workers’ heirs. If too much reliance is placed on Social Security private accounts, rather than the traditional Social Security benefit, then modest-wage workers who happen to retire in years when the stock market is down could have inadequate retirement incomes. And coordinating private accounts with disability and survivors’ insurance will pose problems, because workers who pass away or become disabled by definition have had less than a full working life to accumulate balances in those private accounts to protect their dependents. All of these questions limit the potential role of private accounts, and require that the current Social Security-defined benefit be protected as much as possible. Furthermore, Social Security private accounts cannot be financed with borrowed money. If the federal Treasury puts money in private accounts with one hand, but borrows that money with the other hand, nothing will have changed - and in particular, the public debt will keep on growing at exactly the same rate. Just as bad, the nation will have missed an important opportunity to repair both Social Security and the overall budget. Borrowing today cannot be justified by hopes of Social Security savings decades from now; the overall budget will be in a shambles by then. Putting the costs "off budget" does not solve the problem, it merely moves it. We need to save Social Security and the budget the old-fashioned way: by paying the bills, one step at a time. The CED plan for reforming Social Security would address all of these concerns. It would preserve the current basic system, but modify its structure to restore solvency and increase national saving. In addition, it would give workers the opportunity to earn higher investment returns by establishing a "second tier" of privately owned personal retirement accounts, which would be financed without additional government borrowing. The changes in the basic system, to be phased in gradually, would include: *The initial benefit levels of upper- and middle-income workers, which currently rise with wages, would increase more slowly (but continue to rise in real terms - that is, faster than inflation). After a worker retires, his or her benefits would continue to increase with inflation. *The normal retirement age (NRA), which is now gradually phasing up to 67 (which it will reach in 2026), would gradually increase to 70 over a period of 30 years and be indexed to life expectancy thereafter. *The early retirement age, currently 62 years, would be increased to 65 over this 30-year period and subsequently similarly indexed. *The number of years of covered employment included in the calculation of initial benefits would be gradually increased from 35 to 40. *Benefits from the basic program in excess of contributions made by the worker would be subject to income tax (a part of benefits is taxable now for beneficiaries with significant other sources of income), with the additional revenues to be deposited in the Social Security trust funds. *A reduction in benefits for nonworking spouses from one-half to one-third of the worker’s benefit would be phased in gradually to improve equity between working and nonworking spouses. *To make coverage universal, all new state and local government employees would be required to participate, and current employees could choose to participate. CED also proposes the creation of privately owned personal retirement accounts (PRAs): *Both employers and employees would be required to contribute 1.5 percent of payroll to privately owned personal retirement accounts. (The self-employed would contribute 3 percent.) These mandatory accounts would receive preferential tax treatment similar to 401(k) plans, and would be subject to appropriate fiduciary regulations, including a requirement that accumulated funds be preserved for retirement. The Federal Thrift Savings Plan for government employees provides a general model for these accounts. This approach, we believe, provides a sound balance between the current role of Social Security and the need for financial soundness in the future. It also would remove the drain that Social Security would impose on the budget in the coming decades, and thus would solve a part of the overall budget problem. But this is only a part of the solution. Future articles will discuss further necessary steps to put the budget on a sound footing, so that our children and grandchildren can be free of the burdens current policy would bequeath to them. The Committee for Economic Development addresses national priorities that promote sustained economic growth and development. In its 65-year history, these activities have helped shape the future on issues ranging from the Marshall Plan in the late 1940s, to education reform in the past two decades, and campaign finance reform since 2000. For more information, visit www.ced.org.

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