Tuesday, May 10, 2005

Social Security Reform Saga - Part III (Benefits)

Following up on previous posts, today’s topic is benefit changes as a means to address Social Security reform. As an alternative to raising taxes, benefits can be reduced. There are many ways to accomplish this, and some are more devious than others.

Whenever we have a change in government benefits, there is first of all a terminology problem. Some groups (you can figure out who) want to call nearly every change a cut. So, for example, if we had previously grown spending on a particular issue by 5 percent, and we instead grow it by 3 percent, this is a “cut”. For those groups that believe in spending more and more, this applies to virtually every change in government funding, despite the fact that we are spending more than we spent last year.

One option being discussed today involves the manner of indexing benefit growth. A recent memo by the Congressional Research Service (April 22, 2005) helps to explain what is meant by “progressive indexing” of benefits. Basically, it works like this. Our current benefit structure is based on wage indexing. In other words, we increase the amount of future benefit levels based on the growth in wages that we measure over time. Due to such factors as greater worker productivity, wage growth generally exceeds inflation. (This is good, as it means we have more purchasing power and we can buy more stuff, assuming increasing tax rates don’t offset this growth. It also means that retirement benefit will tend to reflect the growth in the standard of living you have come to expect over your working career.)

Once you become eligible for Social Security benefits, your benefits then grow by an inflation-adjusted rate. This ensures that you have basic purchasing power parity over the term of your retirement.

The “progressive indexing” proposal wants to change the way that the preretirement benefits are calculated by moving away from wage indexing and toward price indexing, but only for upper income workers. Though the differences are small, over the long term it reduces the size of the benefit for average and upper-income workers, while leaving lower-income workers the same.

This can be understood by looking at the concept of replacement rates. These rates measure the percentage of the income history of the Social Security recipient that will be replaced by the benefit to be received. For so-called low-wage workers, social security replaces about 55 percent of career average earnings. Those with average wages get 41 percent, and those with the maximum get 27 percent. Given that tax rates are proportional for the first $90,000 of income (in 2005), that means the low-wage worker is getting a better deal than the upper-wage workers. Some of the upper-wage worker’s taxes are being redistributed to help out those with lower earnings.

If the benefits growth for average and upper income workers are changed, this disparity will grow. The CRS estimates that by 2080 (which will be long past the time I have reached room temperature) the replacement rate for the average wage worker will fall from 39 percent (as projected under current rules) to only 16 percent. Eventually (after say 100 years or so), they also note that the effect of changing indexing combined with wage growth rates could eventually mean all citizens get the same social security benefit, regardless of income.

It is hard to predict stable operations of a system for 75 or 100 years. We all know that no one has a crystal ball that clear. But changes in benefit structures need to be considered carefully for their political effects. The Social Security system has long been viewed as an entitlement that was bought and paid for over time by everyone’s payroll tax contributions. It has never been viewed as a welfare program. Even those who favor government growth, including Congressman Charles Rangel (D NY), don’t want to turn Social Security into welfare. Yet these same folks object strenuously to any proposal that turns retirees into owners of even a portion of the retirement funds. They instead want to keep them in a dependent status – getting whatever the government tells you that you can receive. You can’t have it both ways, though. Reducing the growth of future benefits selectively can, over time, turn Social Security into something quite different than it is now.


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