Unpacking the challenges to Social Security, Medicare

Before we panic over Social Security let’s get the facts straight.

The current situation: Employees have 6.2 percent taken out of the first $90,000 of their pay for Social Security and 1.45 percent taken out of all their earnings for Medicare. This is matched by their employer (self-employed persons pay 15.3 percent total). With our “pay as you go” system the payroll taxes of today’s workers finance the retirement benefits of today’s senior citizens.

While we have fallen from 16 workers per retiree in 1950 to 3.3 today, the Baby-Boomers are still a large bulge in the labor force and the money paid into the Social Security trust fund annually exceeds expenditures.What’s coming? The Baby-Boomers are soon going to start retiring which means falling payroll tax revenue and rising Social Security benefits. By 2018 the payroll tax money paid into the trust fund will fall short of the annual expenditures.

From 2018 to 2027 the interest on the Treasury securities in the trust fund will cover the annual shortfall. Thereafter, the shortfall will come out of the trust fund’s principle until the principle is exhausted in 2042. (And there will be 2.1 workers per retiree.)

This is the “Intermediate” and most likely scenario. The driving assumptions are conservative: stable fertility rates (slightly below replacement level-perhaps we regret all those abortions), annual inflation of 2.8 percent, annual growth in real wages of 1.1 percent, unemployment of 5.5 percent and annual net immigration of 900,000 (hug an immigrant because he or she may be your retirement future!).

What does it mean? First, without any change in payroll taxes Social Security benefits will have to be immediately cut 27 percent in 2042 with more cuts thereafter. Second, even before the cut in benefits, the liquidation of the trust fund’s principle (Treasury securities) will have to be covered through higher federal taxes or higher federal debt or decreases in federal spending on other programs.

What can be done? A 15 percent bump in the payroll tax rate from 12.4 percent (employee and employer combined) to 14.3 percent will make the system solvent.

Alternative policy choices are to: a) raise the maximum earnings taxed (already being done but could be sped up); b) raise the eligible age for benefits (already being done); c) increase the percent of social security payments to the elderly to which Federal income taxes are applied (currently starts with 50 percent of all benefits for household income over $25,000) and d) change the benefit formula so it just keeps pace with inflation but not with rising real wages (proposed by the President, and ultimately means a 60 percent reduction in benefits for you young persons).

Is that all? Well, just one small item. The Medicare fund’s expenditures have exceeded payroll tax revenues as of 2004 and the fund will be exhausted as of 2018. To keep the Medicare fund solvent will require either a 108 percent increase in taxes or a 48 percent decrease in benefits (hospital insurance).

Where does it all leave us? If both funds are kept solvent then Social Security outlays will rise from 4.3 percent of GDP today to 6.6 percent in the lifetime of you students and Medicare outlays will rise from 2.6 to 13.8 percent of GDP.

So, if you favor increased government spending as a proportion of the economy, your wish will come true. And all of that is before anything is done about the 45 million Americans who currently have no health insurance (71 percent of whom are employed full-time or part-time).What about personal retirement accounts? President Bush has proposed letting young workers put a portion of their retirement into personal accounts since Social Security earns little more than inflation.

Given that the annual return on stocks over the decades has exceeded inflation by 6.5 percent, it sounds like a better deal than having government managed retirement funds. But it will be hard to sell politicians on removing tax revenue from a trust fund that is headed toward deficit.

Can we do nothing? Not until I’m dead, then you can do what you want. But also we should recognize that for one-third of Americans over 65 Social Security constitutes 90 percent of their income. The elimination of Social Security benefits would increase the elderly’s poverty rate from the current 10 to over 50 percent. Reductions in Medicare (and Medicaid) would be equally disastrous.

So, the sky is not falling, but a storm front is definitely approaching, and Henny Penny has every right to squawk…..

John Stapleford is a professor of economic development.