Government Spending on the Elderly: Social Security and Medicare

Studies | Federal Spending | Health | Social Security

No. 247
Friday, November 30, 2001
by John C. Goodman and Matt Moore


Efforts to Save the Current System

Figure VIII - Social Security Actuarial Deficit as a Percent of Taxable Payroll

If we decide to keep the current system, we will either have to increase taxes, cut benefits, cut other government spending or incur increasing debt in an attempt to pass our burden onto future generations. A number of people have suggested we do each of these. What follows is a brief summary of some of the proposals.

"Raising taxes would work only if Social Security were converted to a funded system."

Raising Taxes: The 2 Percent Solution. The 2001 Social Security Trustees Report says Social Security's 75-year actuarial deficit can be eliminated by an immediate and permanent payroll tax increase of 1.86 percentage points. Such an idea is sometimes called the "2 percent solution."

But according to Boston University Professor Larry Kotlikoff, even if we accept the reasoning behind this idea, what we really need is a 7 percent solution.18 That's because the Social Security Trustees Report discloses only about a third of the system's actual long-run fiscal imbalance.19 [See Figure VIII.] According to Kotlikoff:

  • To ensure promised benefits not just for 75 years but indefinitely, the payroll tax would have to be raised by 4.7 percentage points.
  • Using more realistic assumptions for life expectancy would raise the needed tax increase from 4.7 to 5.4 percentage points.
  • Using more realistic wage assumptions raises the needed tax hike to 5.9 percentage points.
  • Using more realistic assumptions for additional factors like fertility and net migration may require a 7 percentage point immediate and permanent tax hike, putting the total tax rate at 19.4 percent.

But even this does not solve the problem unless the surpluses are invested in real assets. If the larger revenues generated by the increased payroll tax are spent on other programs, as they have been in the past, the funds will be unavailable to pay benefits. Put another way, the "2 percent/7 percent" solution works only if we begin to convert from a pay-as-you-go system to a funded system.

Raising the Retirement Age. The "normal retirement age" is currently set at 65; but for those born in 1938 and later, the retirement age will increase by two months each year until it reaches 67 for anyone born after 1960. Some want to go further, increasing the retirement age to 70 and indexing it to increases in life expectancy. The Social Security Advisory Board estimates this would pay 32 percent of the program's long-term deficit.20

But there are several problems with this idea. First, even though life expectancies overall are increasing, minorities have shorter life expectancies and raising the retirement age will hurt them disproportionately. For example, the life expectancy at birth for an African-American male is 64.6 years.21 Even with a normal retirement age of 65, an African-American male can expect to pay taxes over his entire working life and die a few months before qualifying for benefits. With a retirement age of 70, his likelihood of receiving benefits becomes even lower. Second, asking blue-collar workers who toil long years at physically demanding jobs to work even more years may be unreasonable. Almost everyone who talks about raising the retirement age to 70 is wearing a white collar.

"The long-term deficit in Social Security is 3 times greater than what the trustees estimate."

Finally, raising the retirement age ignores the trend toward earlier retirement. Americans are leaving the workforce earlier, at an average age of 62.2 years, down from 64 years in 1973.22 If this trend continues, raising the retirement age means widening the gap between the actual age of retirement and the age at which full Social Security benefits are paid. It begs the question of how most people are going to fund their retirement expenses.

Reducing or Eliminating Benefits for Higher-Income Workers. Some have suggested means testing benefits and even eliminating benefits for higher-income earners. After all, why should millionaires receive Social Security? However, there aren't that many millionaires. So in order for means testing to reduce benefit payments significantly, it must reach much lower levels of income. For example, the Social Security Advisory Board says means testing can reduce Social Security's long-term deficit by 89 percent, but only with benefit reductions for families with annual incomes as low as $40,000.23

"Patchwork reforms do not address the underlying structural problem."

Taxing Untaxed Wages. Only about 84 percent of all covered earnings are taxed.24 Does it make sense to tax the other 16 percent? There are reasons not to. For example, about half of untaxed income is in the form of fringe benefits such as health insurance and pensions. These are not taxed because government has an interest in encouraging private health insurance and private pensions. The other half of untaxed wages consists of income above the maximum taxable wage, which is $80,400 in 2001. But applying FICA taxes to all income would lead to very high marginal tax rates for wealthier taxpayers and might not produce any extra revenue. The highest-income taxpayers already face a 42.5 percent marginal tax rate (39.6 percent income tax rate plus 2.9 percent Medicare payroll tax). Add Social Security payroll taxes and the marginal tax rate would be about 54.9 percent. As mentioned earlier, the economic disincentives associated with higher marginal tax rates encourage evasion and discourage investment and growth.25

Taxing Benefits. Some have suggested raising taxes on Social Security benefits as one way to offset some of Social Security's financial shortfall. Social Security benefits are already taxed under current law:

  • Taxes are imposed on up to 50 percent of benefits for single retirees with modified adjusted gross incomes over $25,000 and for couples with incomes over $32,000.
  • Single retirees with incomes above $34,000 and couples with incomes over $44,000 must pay taxes on up to 85 percent of their incomes above this threshold.

Moreover, the Social Security benefits tax is only nominally a tax on benefits. In reality, it uses Social Security benefits as an excuse to tax other income and does so in an inefficient way. For example, if a retiree is below the first threshold, there is no tax. However, above the threshold, each dollar of interest, dividends or wages increases taxable income by $1.50. So if the retiree is in, say, the 28 percent tax bracket, the additional tax on a dollar of income is 42 cents ($1.50 x 0.28) - in essence a 42 percent marginal tax rate.

"The Social Security benefits tax is in reality a tax on other income."

If a retiree is above the second threshold, each additional dollar of income raises taxable income by $1.85. Thus the retiree is in the 28 percent tax bracket and the tax rises by 52 cents for each additional dollar earned - effectively a 52 percent marginal tax rate. Moreover, if the income is wage income, each additional dollar also faces payroll taxes, increasing the marginal tax rate to 64 percent!26

As noted above, higher marginal tax rates are extremely wasteful. And extending the current approach to reach more retirees would impose a huge economic cost relative to any possible benefit.

There are of course more efficient ways of taxing benefits. For example, some or all of Social Security benefits could be included in the taxable income of retirees. This approach would subject benefits to taxation without raising marginal tax rates. But it also would diminish the retirement income of many of the very people Social Security was created to help.

Reduce Benefits for Future Retirees. There are several different ways to reduce benefits for future retirees. As discussed above, one way is to raise the retirement age. Another is to reduce the annual cost-of-living adjustment (COLA), the formula Social Security uses to increase benefits to adjust for the effects of inflation. Reducing the COLA would mean that benefits would rise less each year, leading to lower benefits for future retirees in real terms. A third idea is to alter the formulas the government uses to calculate benefit amounts so that retirees would get a smaller benefit each month.27 However, balancing the system through benefit cuts alone eventually would require cuts of nearly one-third.28


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