The Nightmare in Our Future: Elderly Entitlements

Policy Reports | Social Security

No. 212
Thursday, January 01, 1998
by John C. Goodman and Dorman E. Cordell

Executive Summary

America's elderly retirement programs are based on pay-as-you-go financing. Taxes collected today are used to pay benefits to today's retirees. Each generation of retirees depends on the government to provide Social Security and health care benefits by taxing the next generation. But in America, as in most other developed countries, the number of taxpaying workers for every retiree is falling and is expected to continue falling. This implies that the tax burden for workers will continue to rise indefinitely into the future. As a result, our pay-as-you-go approach to elderly entitlements is on a collision course with reality.

Social Security Administration actuaries make projections about the future of Social Security that are contained in the annual report of the trustees. These projections are labeled "intermediate," "low cost" (optimistic) and "high cost" (pessimistic). Although people are encouraged to assume that the intermediate forecast is the most likely, many students of Social Security and Medicare believe that the pessimistic projection more closely reflects our recent experience.

Spending on Social Security currently takes about 11.5 percent of the nation's taxable payroll. If both parts of Medicare (Parts A and B) are also expressed as a percent of taxable payroll, they take about 5.5 percent. In the future both programs will require more:

  • By the year 2045, when today's 20-year-old college student will be eligible for Social Security, the fraction of employee earnings needed to pay Social Security benefits will be almost 50 percent higher than at present, according to the intermediate forecast.
  • We will need almost one-third of workers' incomes to pay Social Security plus all of Medicare.

Nor is this the worst that can happen:

  • Under the pessimistic forecast, by the time today's college students retire the Social Security tax burden will be almost twice its current level.
  • Almost 53 percent of the entire taxable payroll will be required just to fund Social Security and Medicare benefits already promised the elderly under current law.

Medicare pays only about one-third of elderly health care costs. The government also pays medical bills of the elderly through Medicaid (for the poor), the Veterans Administration system and other programs. When this additional spending is taken into consideration, the burden for future taxpayers will be even higher:

  • Under the intermediate assumptions, 40 percent of the income of workers will be needed to pay retirement benefits to today's college students.
  • Under the pessimistic assumptions, the amount will be more than two-thirds of workers' incomes!
Percent of Taxable Payroll Elderly Entitlements Will Take When Today's College Students Retire

Reformers tend to fall into two camps: those who want to preserve the current system's chain-letter structure and patch its defects, and those who want to reform the system in a fundamental way. The underlying strategy of proposals for patchwork reform is to cut benefits, raise taxes or both. However, almost every patchwork reform idea has severe drawbacks. Some countries have already chosen more fundamental reforms.

  • Britain allows employers and workers to opt out of the second tier of the state pension system by setting up private pension plans with benefits at least as generous as those promised under the government system.
  • Australia requires workers to contribute to privately managed retirement savings plans.
  • Chile requires workers to save for their own retirement by making regular deposits to private pension accounts, similar to American Individual Retirement Accounts (IRAs).
  • The Chilean system has been copied to one degree or another in Argentina, Bolivia, Colombia, Costa Rica, Hong Kong, Mexico, Peru and Uruguay, and it will soon be implemented in Ecuador and El Salvador.
  • Singapore requires employees and employers to contribute jointly to individual investment accounts, which may be used not only for retirement income but also to pay medical expenses, make the down payment on a home or send a child to college.

These privatized systems are fully funded, and each generation provides for its own retirement. The systems avert the long-term financial crisis inherent in a chain-letter approach. They also encourage saving, which in turn generates higher economic growth.

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