Privatizing Social Security

Studies | Social Security

No. 217
Wednesday, July 01, 1998
by Laurence J. Kotlikoff


Social Security's Long-Term Fiscal Imbalance

Figure III - Social Security's Actuarial Deficit as a Percent of Taxable Payroll

As noted above, Social Security's Trustees Report discloses only about a third of the system's long-run financial imbalance. [See Figure III]. There are two main reasons: the trustees use too short a planning horizon, and they use overly optimistic economic and demographic assumptions.

Effects of using a more realistic time horizon. In forming their estimates, the trustees instruct the Social Security actuaries to look only 75 years into the future. Although 75 years may seem a reasonable projection horizon, Social Security is slated to run major deficits in all years beyond this horizon. The use of the 75-year projection period explains, in part, why Social Security's finances are again deeply troubled after having been "fixed" by Alan Greenspan, Robert Dole and the rest of the Greenspan Commission in 1983. Each year that passes brings another major deficit year within the 75-year projection window, and 15 years have now passed since the Commission met.

The highly respected actuaries of the Social Security Administration have examined the system's long-run finances without truncating their analysis. Yet the trustees have failed to include so much as a footnote containing their actuaries' findings in their lengthy annual reports. This dereliction of duty, which merits Congress' attention, would be less troublesome if the nontruncated results were close to the truncated results. They are not. Based on the truncated planning horizon, the actuaries tell us we need to raise the Social Security payroll tax rate by 2.2 percentage points starting now and continuing for the next 75 years.6 In so doing we'll be able to pay all benefits that come due over those years.

"To guarantee benefits on an ongoing basis, not just for the next 75 years, would require increasing the Social Security payroll tax by 4.7 percentage points - a 38 percent increase."

But how high must the immediate and permanent tax hike be to guarantee the payment of promised benefits not just for 75 years, but on an ongoing basis? The answer, according to Steve Goss, Deputy Chief Actuary of the Social Security Administration, is 4.7 percentage points - more than twice the tax hike being disclosed by the trustees! Since the current Social Security employer/employee payroll tax rate is 12.4 percent, raising the rate to 17.1 percent would represent at 38 percent tax hike.

As painful as a 38 percent tax hike would be, even it would likely fall short of what is really needed to sustain Social Security without cutting benefits. The demographic and economic assumptions used by the actuaries appear to be overly optimistic on at least two important counts. First, they assume a slower growth in life span than the U.S. has experienced in recent decades. Second, they assume higher future real wage growth than recent experience would suggest is realistic.

Effects of more realistic projections of life expectancy. Life expectancy for Americans born this year is 76 years. The intermediate projection assumes that, over the next 45 years, life expectancy will rise by only three years, to 79 years - which is Japan's current life expectancy. So the Social Security Administration would have us believe that it will take America another 45 years just to reach the current Japanese life span! In assessing this prognosis, we should bear in mind that the last time U.S. life expectancy grew by three years, it took only 20 years - from 1977 to the present.

Leading demographers, including Professor Ronald Lee of the University of California at Berkeley, project much more rapid growth in life expectancy. Indeed, the mid-range of Lee's projection indicates a 10-year rather than a five-year life-span extension between now and 2070. This is twice the increase forecast over this period by Social Security. Assuming Lee is right, the immediate and permanent tax hike needed rises from 4.7 to 5.4 percentage points.

Effects of more realistic wage growth assumptions. Since 1975 real wages have grown at only .4 percent per year, although the growth rate in this decade has been almost twice as high. The Social Security actuaries assume a .9 percent per year growth rate in real wages over the next 75 years. In conjunction with an extra five years of life, lowering the real wage growth assumption to .4 percent would raise the needed tax hike to 5.9 percentage points - a 48 percent increase relative to its current value!

This increase in the payroll tax would push the Social Security tax rate to 18.3 percent. But that's only if it is enacted immediately. If the government waits, say, another 10 years, it will have to raise the tax rate by another .8 percentage points to 19.1 percent to generate the same amount of tax revenue in terms of present value. If it waits 20 years, a tax rate of more than 20 percent will be needed.

Effects of other factors. Additional factors including fertility and net migration could impact Social Security more than the trustees are projecting. For example, the actuaries' high-cost projection assumes that all critical factors will be worse than those assumed in the intermediate projection discussed above. Under the high-cost assumptions (which are very close to Lee's with respect to life-span extension and assume .4 percent future real wage growth), we will need a 7 percentage point tax rate hike right now and forever to pay for Social Security's benefits on an ongoing basis. This would put the tax rate at 19.4 percent.


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