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Striking a Deal on Social Security

Article by Ike Brannon March 22, 2013 //   8 minute read

The Administration’s intimation that it would be open to a change in the way Social Security indexes benefits to inflation has been met with anger by Congressional Democrats, who aver that they would never agree to a deal that reduced promised benefits by any amount, even if it were a part of some grand bargain. In reality some fraction of them probably could be persuaded to sign off on some sort of Social Security reform as a part of some grand bargain, provided that the Republicans gave up something major in return, such as significant additional tax revenues. However, that’s a deal that can never happen, because Republicans view a modification in the cost of living index to be a minor concession that does little to improve Social Security’s long-run shortfall.

The political problem is that the Administration has agreed to the wrong change in indexation. Social Security has two different indexation issues: Not only do existing benefits for all recipients have to be adjusted every year to reflect changing prices, but inflation must also be taken into account when calculating the initial benefits of new retirees. And this is where the Administration should join hands with the Republicans: For it is possible to change the indexation formula for new retirees while protecting lower-income recipients and saving much more money at the same time. For this, Republicans would be willing to make concessions.

Indexing current benefits to inflation is straightforward, even if picking the correct measure of price inflation is a little contentious, but taking inflation into account when computing initial benefits is a bit more involved. The Social Security Administration calculates initial benefits by averaging a worker’s top 35 earning years, and then calculating benefits based on a very progressive formula: The monthly benefit equals:

  • 90% of the first $791 earned in the average month,
  • plus 32% of the next $3977 earned in the average month,
  • plus 15% of the next $5,000 earned in the average month, with no additional benefits accrued (or taxes paid) on incomes above this level.

The problem is that each year’s income must be inflation-adjusted in order to calculate a 35-year average. Unlike the way inflation is adjusted for current beneficiaries, SSA “deflates” nominal prices by adjusting earnings to reflect wage increases rather than price increases. Historically, wages have grown roughly one percentage point faster than prices, which means that the initial benefits for new retirees rise faster than prices. In other words, two people, retiring 10 years apart, with identical inflation-adjusted incomes, will receive different benefits, with the younger one collecting a little over 10% more than his older doppelganger.

Congress first mandated indexing initial benefits to wage growth during the Ford Administration, for reasons that are not entirely clear. It has been suggested that a short-sighted congressional staffer noticed that wages lagged prices the prior two years and assumed this would save money, not realizing it was ephemeral. Others contend it was an arithmetic error that went undiscovered until it became politically difficult to remedy.

A return to indexing initial benefits to prices would fix the entire Social Security shortfall, but that’s as likely to happen as removing the Social Security tax cap — i.e. not likely at all. However, it is possible to adjust the indexation of initial benefits so that upper-income households do not see their benefits rise as quickly as lower-income recipients via progressive indexation, a method first proposed by Harvard Professor Robert Pozen. Progressive indexation could insulate the bottom 30% to 40% of new beneficiaries from change (these are people who count on benefits for all or nearly all of their retirement income), while the top 10% to 15% of earners would have their wages indexed to prices. Everyone else would have their wages indexed by a combination of wage and price inflation dependent on their income. Such a plan could be phased in gradually over 35 to 50 years.

Progressive indexation alone would not completely erase the social security shortfall but it could eliminate 50% to 60% of it, depending on how soon it could to be phased in. Because it would put such a dent in Social Security’s shortfall, Republicans could probably be convinced to go along with using some of the myriad revenue raisers to pay down the debt.

Changing how we index Social Security benefits could be the key to achieving a comprehensive tax reform. The fundamental hurdle facing tax reform is that while Republicans and Democrats may very well be able to come to an agreement on eliminating various loopholes, deciding how to distribute the additional revenue between deficit reduction, lower tax rates, and new spending is going to be extremely difficult. Democrats won’t allow the top tax rate to fall and using the additional revenue gained from reducing personal deductions and credits to lower businesses taxes is politically impossible as well. Progressive indexation of Social Security may be the necessary inducement for Republicans to settle for a more modest tax rate reduction for middle-income earners, with the rest of the revenue going towards deficit reduction. Merely tweaking the cost of living index wouldn’t be nearly enough for Republicans to acquiesce to such a deal.

When Senate Republicans proposed progressive indexation in their discussions on Social Security reform in 2005, the main objection — described by NEC deputy director Jason Furman in this CBPP paper — was that such a change would, by the 22nd century, leave us with a completely flat Social Security benefit, which would leave Republicans well positioned to end the program. The current iteration of the Republican Party has been struggling to find a common agenda for the next election: Thinking it can look a century ahead in its strategizing is a mite generous, to say the least.

Republicans regard the notion that Social Security benefit growth is inviolable in the same way that most liberals see Grover Norquist’s tax pledge, I suspect. For the people at the top of the income distribution, Social Security benefits make up a small fraction of their retirement income, and telling future retirees that their benefits are going to be about the same, in inflation-adjusted terms, as the benefits for current retirees is not a threat to the social contract.

For liberals, the most unsettling thought about entitlement growth should be that, if left unchecked, it will soon threaten to crowd out a whole host of discretionary spending programs as well.