Wednesday, May 4, 2005

Social Security Debate Update

Here is an interesting contribution to the SS debate, by Berkeley Econ professor Brad DeLong. Writing in Slate, DeLong analyzes the president's recent comments on SS with regards to his thoughts on progressive indexing and private accounts. Acknowledging that the president's comments were based on Democrat Robert Pozen's thoughts on how SS should be reformed, and while he doesn't come right out and say it, DeLong is less than thrilled with the concept of progressive indexing. This is largely because he fears that this approach will turn the program into a plan that benefits only those with incomes under the national average, thereby undercutting popular support.

This is certainly a worthy consideration as we debate reform, but I believe DeLong fails to recognize that many middle and upper class members of our society already anticipate that SS will not be the source of significant financial support in their retirements that it was for their parents. In this regard, perhaps DeLong's fears are already becoming reality prior to any reform.

There are, however, other interesting thoughts in DeLong's piece that merit attention. One of these is something he states, and another is something that he does not state. Lets take his statement first:

As everyone knows, Social Security has a problem: The current level of dedicated Social Security taxes is very unlikely to bring in enough money to fully pay the benefits currently specified by law beyond the middle of this century. Social Security taxes will have to go up, Social Security benefits will have to be cut below currently projected levels, or other tax revenues will have to be earmarked to pay Social Security benefits.

Interesting wouldn't you say? As Stanley Kurtz in NRO points out, I'm not sure that everyone does acknowledge the problem, as many anti-reformists have spent significant time arguing that we don't have to do anything. So it is good to see a liberal member of the academy acknowledge this fact.

What Mr. DeLong alludes to however, is event more interesting. Here is the quote:
Now let's look at Pozen's numbers for those retiring in 2075. Pozen would keep the replacement rate at 49 percent for the working poor—those making half the average income. But the replacement rate for those making more would be cut: At the average income, the replacement rate would go from 36 percent to 26 percent; at one-and-a-half times average, from 30 percent to 17 percent; at the Social Security maximum, from 24 percent to 12 percent. Pozen's proposal gradually turns Social Security from a program in which benefits rise with incomes to one in which nearly everybody's benefit is roughly the same: about $1,900 of today's dollars a month. These are ferocious benefit cuts for those at or above average incomes—an across-the-board benefit cut of about one-seventh would do as much for Social Security's overall finances. But that's the point. Pozen's central aim is to keep the poorest one-third of beneficiaries from bearing any of the burden of future benefit cuts..............Pozen's proposal caps the maximum Social Security retirement benefit at roughly $22,500 dollars a year (adjusted for inflation). Bush's private-accounts plan—which would allow people to contribute 4 percent of their wages—makes retirees repay the taxes they diverted into private accounts out of their standard Social Security benefit. Medicare premiums are already deducted from your Social Security check. Deduct the claw-back for the private-accounts diversion as well, and by late in this century the odds are that—at least for the upper middle class—the standard Social Security check would be zero. Social Security would no longer be a universal program: It would be a program in which the half of America that is richer and more powerful and more likely to vote sees large chunks of its money going in and nothing coming out.

It seems to me that through this statement, DeLong is projecting that the return on private accounts should be quite good, especially relative to the return available for middle and upper income folks in the current SS system. Here is an illustration of what I'm talking about.

Using DeLong's numbers lets say that a worker entered the workforce and was making the maximum salary subject to SS taxation. Further lets assume that our worker contributed the full 4% of her wages for a career that lasted 40 years. Finally lets make two other assumptions. First, our worker achieved no return on her investment due to a flat stock market, and upon retirement received the maximum benefit of $1,900 a month, in today's dollars which keeps the analysis simple and conservative. Oh, one more assumption; our worker's retirement effective tax rate (the rate she pays on all income after going through the various income categories) is 24%, which would put her in the top tax bracket. Here are the numbers:

90,000 * .04 = 3,600 * 40years = $144,000 saved in a private account.

Now lets assume our worker expects to live 10 years and removes $14,400 a year which is taxed at an effective rate of 24%. Her tax owed would be:

14,400 * .24 = $3,456

If this tax were taken on of the monthly SS payment it would be $288 per month. Far less than the maximum benefit of $1, 900 per month that this worker based on her income would receive. So if DeLong is to be believed, the only possible way that the tax owed on private account withdrawals could exceed the SS benefit would be if the private account had achieved excellent returns over the previous 40 years.

This is a problem?

Oh sure, you'll note that DeLong also deducts the worker's Medicare premium from the monthly SS benefit to whittle away the $1,900. This however is a mistake that clouds the argument. The premium is not a tax that the worker gets nothing in return for, it is the cost of the worker's healthcare and as such has very real value for the worker. So we cannot subtract this premium from the SS payment and make the statement that our worker ends up with zero due to private accounts.

So in conclusion, one can still be against progressive indexing and private accounts as solutions to SS on solid philosophical ground. To do so however one must also acknowledge that a problem exists, and about the only other alternative is to raise taxes. When you consider that we cannot continue to raise taxes for every social program without at some point doing serious damage to our economy, you begin to realize that there is merit to Bush's ideas.

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