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Ed Lotterman: Social Security's tragic paradox

The hubbub about the fiscal cliff has died down temporarily. But in a few weeks we will be back at it, and the misunderstandings and misrepresentations on both sides will be worse than in the round just ended.

The lull gives us time to step back and examine Social Security, the largest of the “entitlement” programs that both parties agree needs some reform.

There is a tragic paradox in Social Security's current situation. The program itself is not fiscally sustainable, but it would not take large changes in benefits and taxes to fix that.

Compared with fixing Medicare, Social Security is easy. But while we can make the program sustainable in government budgeting or accounting terms with modest changes, we already have failed irrevocably in our ability to solve the underlying economic challenge beneath Social Security that we have faced for half a century. We needed to manage our affairs so that real resources would be available to meet the needs of the 80 million-strong baby boom cohort when it retired. We screwed things up and it is too late to do anything about that.

Consider some basics about Social Security itself. With estimated outlays of $825 billion in fiscal year 2013, it is the largest single federal spending category. By comparison, national defense will take $700 billion and Medicare $530 billion.

Adjusted for inflation, the Social Security outlay for 2013 will be up 21 percent compared with 2009, the last fiscal year of the George W. Bush administration. It will be up 74 percent from the level it was 10 years ago. For defense, the corresponding numbers are up 6 percent and 73 percent; for Medicare, up 23 percent from 2009 and 112 percent from 2003.

Note that for Social Security, unlike defense and Medicare, neither Bush nor President Barack Obama nor any of the corresponding Congresses did anything to increase individual outlays. There has been no change in the benefit formulas. Nearly all the growth in inflation-adjusted outlays has come from increases in the number of beneficiaries. (The fact that initial benefits are calculated by indexing to average national wages rather than the slower-growing CPI accounts for a bit of the increase.) A fraction of the increase in beneficiaries results from higher rates of people being approved for disability benefits, but the large majority comes from simple retirements.

The first baby-boomers could claim retirement benefits five years ago, when someone born on Jan. 1, 1946, the official start of the baby boom, could claim reduced benefits at age 62. The number of retirees will continue to climb appreciably for more than the next decade.

If sharp increases in the number of beneficiaries is driving large increases in spending, why didn't we plan for this? The answer is that we did.Demographers at the Census Bureau and Social Security Administration have known for a half-century about how big the retiree population would be between 2010 and 2030. They and academics were writing papers about this back in the 1960s and 1970s. Informed members of Congress also were concerned. In response, in 1977, Congress passed higher FICA tax rates to be phased in over the years.

More important, soon after Ronald Reagan was inaugurated in 1981, he appointed a blue-ribbon panel headed by Alan Greenspan to recommend changes to put the program on a sound financial footing over the entire period of baby boomer retirements. (Reportedly, Greenspan took on the job of reforming an institution to which he himself is ideologically opposed to demonstrate his loyalty to the new administration and thus increase his chances of being named to chair the Federal Reserve, a job he already then coveted.)

The commission included key members of Congress including Sens. Bob Dole, Daniel Patrick Moynihan and John Heinz in addition to well-qualified experts on retirement issues. Its report was largely adopted by the president, the Republican-controlled Senate and Democratic-majority House of Representatives in the Social Security Reform Act of 1983.

The act phased in additional tax increases, which reached their current levels in 1990, lowered the age at which benefits for surviving children ended and, over time, raised the normal retirement age from 65 to 67.

The rate increase was the most important, changing the program from one in which its “trust funds” were mere checking accounts to ones that were to accumulate substantial balances while the baby boomers were still working. These would then be drawn down during the period in which the boomers were drawing benefits.

This key provision was a huge land mine that Congress detonated almost immediately, but its danger was so poorly understood by the general public that there have been no electoral consequences even to date.

These changes were calculated to make Social Security sustainable in an accounting sense for at least 75 years. But by 2000 it was clear this would not pan out.

The key problem is that revenues, tied directly to wages, depend greatly on the rate at which wages grow into the future. The commission assumed that they would grow by at least 1.5 percent a year after inflation. This was a safe assumption, based on the U.S. economy's performance from 1945 to 1980. But real wages only grew 1.1 percent a year from 1983 to 2005 and less since then.

Moreover, the commission assumed that the annually adjusted limit on earnings subject to FICA taxes, $113,700 for 2013, would be high enough to cover 90 percent of all earnings from labor. Based on past experience, that was also a prudent assumption.

The planners did not anticipate that U.S. income distribution would become increasingly unequal, with a high proportion of overall household income increases coming in the form of returns to capital, in other words, interest, dividends and capital gains, and not to labor. None of these are subject to FICA taxes.

Moreover, a high proportion of the increase in labor earnings went to the small fraction of the population with incomes already over the FICA earnings cap. This increased income was also exempt. The upshot was that by the early 2000's, the proportion of total labor earnings on which Social Security taxes were paid had fallen from more than 90 percent to 85, percent and it has since fallen a bit more.

It is those economic changes, slower growth in real wages overall and a higher proportion of growth in all income coming in forms to which FICA taxes did not apply, that account for the fact the retirement trust fund will run out by 2035. Thereafter, ongoing Social Security revenues are projected to be enough to cover only 75 percent of promised benefits. It is not that no one ever thought about the problems of baby boom retirement, but rather that the economy has performed in an unexpected way that has been adverse for the program's finances.