Don’t Cut Social Security, Expand It

Josh Barro is the lead writer for the Ticker, Bloomberg View's blog on economics, finance and politics. His primary areas of interest include tax and fiscal policy, state and local government, and planning and land use.
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(Corrects chart description in third paragraph.)

With everyone in Washington experiencing sea-bass-induced euphoria, we're talking again about a "grand bargain" to replace the sequestration and shrink the federal budget deficit. And that means we're talking about using the chained consumer-price index, a lower and more accurate inflation measure, to modestly raise taxes and cut Social Security benefits over time.

Back in December, I wrote that applying chained CPI to Social Security is the wrong solution to our budget problems: It's just a way of dressing up a cut to retirement benefits at a time when retirement insecurity is rising. Despite its problems, Social Security is the best-functioning component of the U.S.'s retirement-saving system. Instead of cutting, the federal government should be expanding its role in retirement saving.

I'm always struck when people talk about Social Security as "just" an insurance program, when it's in fact the most important retirement-saving vehicle. The chart below, adapted from a 2012 paper by Boston College Professor Alicia Munnell, shows the financial situation of a "typical" pre-retirement household. These are the mean holdings of a household in the middle net worth decile among households headed by people age 55 to 64.

Source: Center for Retirement Research at Boston College

Social Security is dominant: Forty-nine percent of this household's wealth is in the form of the expectation of drawing government benefits in the future. The next largest slice, 23 percent, is accrued benefits in traditional pension plans. But that figure is skewed by a handful of workers who are lucky enough to participate in such plans; as of 2010, only 14 percent of U.S. workers were earning benefits in such a plan.

Private saving for retirement is woeful. This typical near-retirement household has just $42,000 in retirement accounts and $18,300 in other financial assets. For most Americans, Social Security isn't augmenting private saving; private saving is (just barely) augmenting Social Security.

And as both home equity and stocks were battered over the last few years, retirement insecurity worsened. Munnell and her colleagues estimate that as of 2010, 53 percent of American households were on track to be more than 10 percent below the amount of assets they would need at age 65 to maintain their standard of living in retirement, up from 44 percent in 2007.

No entity is better positioned to fix this problem than the federal government. Employers won't do it: They have been dropping their defined-benefit pension plans for good reasons. And with Americans working for an increasing number of employers over the course of a career, such plans become ever more inappropriate.

Individuals won't do it: Tax advantages of retirement-saving accounts don't seem to induce people to save enough on their own. And when people do use individual retirement accounts and 401(k) accounts, they're often hit by high fees and bad investment choices.

State and local governments won't do it, either: They're already under severe fiscal pressure, particularly due to rising health costs. Unlike the federal government, their obligation to approximately balance their budgets annually makes them unsuited to providing retirement security. Part of the way a government can shoulder the economic risks of retirement is by making deficit-financed payments when the economy is weak. For this reason, states and localities are right to work on reining in the cost of their employee pension plans, rather than expanding them.

Unlike every other player, the federal government is positioned to help. If we made it a priority, we could expand the retirement benefits that the federal government provides to Americans, in any of three ways.

One option is to raise Social Security benefits (for example, by indexing them to wages instead of prices) and raise the payroll-tax rate to finance the increase. The economic damage from such a tax increase would probably be minor. The payroll tax is highly efficient because it is broad-based and somewhat regressive. And the negative incentive effect from higher taxes would be blunted, because workers would be accruing more generous retirement benefits in exchange for their tax payments.

Another option is to finance Social Security sweeteners by cutting Medicare. The way we talk about this issue now is perverse: We are talking about the need to cut cash payments to seniors in order to finance ever more expensive health benefits for them, despite those health benefits' dubious value. Why not give seniors less health care and more cash? With the U.S. devoting an extra six points of gross domestic product to health spending compared with our peer countries, there should be room for much deeper cuts in Medicare than what President Barack Obama has proposed. If a key purpose of those cuts was to expand Social Security, political opposition from seniors might not be as fierce.

A third option is to create a new federal program of mandatory saving on top of Social Security. This could take the form of individual accounts or a comingled fund, where workers would have specific allocations linked to their contribution payments but wouldn't manage their own investments. This would have the advantage over the first option of avoiding a direct tax increase, but the economic impact of forced contributions would be similar to raising the payroll tax.

The default assumption in Washington is that Social Security needs to be cut to fix our long-term budget problems. But it's really a question of priorities. Social Security is, by definition, an efficient program: About 98 percent of its costs go out in the form of benefit checks, which the beneficiaries spend on whatever they value most. If we raise taxes on the people who would gain from increased benefits and cut in areas like Medicare, where the government buys a lot of things we don't really need, we can afford to augment the federal role in retirement saving and alleviate the problem of retirement insecurity.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.