The 2004 Medicare and Social Security Trustees Reports

Studies | Health | Social Security

No. 266
Friday, June 04, 2004
by Andrew J. Rettenmaier & Thomas R. Saving, Ph.D.


Social Security

Figure I - Projected Social Security Costs and Revenues Percent of Taxable Payroll

"They will require almost $74 trillion for all future years."

Social Security is in many ways easier to evaluate than Medicare. Because the dollar value of benefits are based on worker earnings histories, Social Security's costs can be estimated once earnings and tax revenues are forecast. In contrast, Medicare benefits are tied to health care consumption rates, rather than past earnings. Technological advances, institutional changes and tastes for health care play an important role in (and introduce greater uncertainties into estimating) the program's total cost. Also, Social Security, Old Age and Survivors Insurance and Disability Insurance are funded by payroll taxes and taxes on benefits. Medicare, however, is funded by a more complicated combination of payroll taxes, taxes on Social Security benefits, premium payments and general revenue transfers.

Social Security's funding requirements are commonly summarized by plotting its annual revenues and costs as a percentage of its tax base. As Figure I shows, the system's revenues are relatively stable, growing from 12.71 percent of payroll this year to 13.39 percent in 2080, with the modest rise attributable to increased revenues from the taxation of Social Security benefits.3 Costs will start growing rapidly when the first of the baby boomers become eligible for early retirement in 2008, and will continue until 2031 when the last of the baby-boomers reach the normal retirement age. While the program's current tax revenues exceed costs until 2018, in every subsequent year, the program faces a deficit that continues to grow forever.

Traditionally, media reports have summarized Social Security's financial health by the year in which the Trust Fund will be exhausted. This year, the exhaustion date is projected to be 2042. However, as Figure I indicates, the program will require transfers from the rest of the federal budget beginning in 2018. These transfers will be made until 2042 in exchange for previous transfers Social Security has made to the rest of the budget. Since 1983, Social Security's surplus funds have been credited to the Trust Fund, as a sort of intergovernmental loan, along with (notional) interest payments on the Trust Fund bonds. These transfers will continue until 2018, when surplus funds run out, and transfers back to Social Security begin. These past surpluses were not used to buy financial assets in the marketplace, however. Instead, they have either been spent on other government programs or used to reduce the federal debt held by the public. As a result, the Trust Funds are actually an accounting record of past transactions rather than a financial reserve the federal government can use to pay benefits.4 The 2004 annual reports' summary states, "Since neither the interest paid on the Treasury bonds held in the HI and OASDI Trust Funds, nor their redemption, provides any net new income to the Treasury, the full amount of any required Treasury payments to these trust funds must be financed by increased taxation, increased Federal borrowing and debt, and/or a reduction in other government expenditures."5

Table I - Composition of Social Security's Unfunded Obligations

Table I summarizes the difference between Social Security's annual revenue and expense for the indefinite future in 2004 dollars.6 Historically, a 75-year horizon has been used to assess the program's financial position. However, that type of calculation understates the true magnitude of the problem. For example, it includes all the taxes paid by people who will retire in year 76, but ignores the benefits these taxpayers will expect to receive in return. Deficits beyond the 75th year are large and growing, and ignoring them understates the financial burden Social Security will impose on coming generations. For that reason, Table I shows the present value of the program's total costs less tax revenues calculated for an infinite horizon.

The first row in Table I shows that current participants will receive $12.7 trillion more in benefits than they will pay in taxes in all future years. That this current generation of participants will receive more in benefits than they will pay in taxes is not surprising, and in and of itself is no cause for alarm. Current participants are defined as workers and retirees 15 years of age and above in 2004. This generation is made up of those already retired, who are collecting benefits and contributing little if any revenue; those who are soon to retire and will begin collecting benefits while only paying taxes for a short time; and all other workers - down to those just entering the system, who will pay a lifetime of taxes before collecting any benefits.

Beginning in 2005, the next generation of participants will begin work. The members of this new generation will pay taxes over their entire work lives before collecting benefits.7 Yet as the second row of Table I shows, future generations will pay only $800 billion more in taxes than they receive in benefits instead of the $12.7 trillion required for solvency.8 Thus, the system as it stands now is $11.9 trillion short.

"The $1.5 trillion Social Security Trust Fund balance does not provide new revenues to the Treasury."

Table I next reports that the Social Security Trust Fund has a value of $1.5 trillion. As noted above, this Trust Fund does not provide new revenues to the Treasury. Instead, it represents the government's commitment to raise taxes or borrow or divert funds from other programs. From Social Security's perspective, the program is underfunded by $11.9 trillion less the $1.5 trillion in the Trust Fund, which produces the conventional measure of the unfunded obligation of $10.4 trillion. However, when viewed from the perspective of the Treasury, which must provide the funds to cover future shortfalls, the unfunded obligation is the full $11.9 trillion.9

Because we can forecast the amount and timing of revenue and expense flows over the next 53 years, government can implement policy changes that will provide the missing funding. To make the system solvent for coming generations, we need revenue increases or spending reductions or both. For example, a permanent 4.0 percentage point increase in the payroll tax rate today would produce a solvent system (excluding the Trust Fund from the calculation) - but only if government invests the proceeds of the new tax in assets that earn a real rate of return of at least 3.0 percent.

However, the government's ability to save surplus revenues is limited. It is not reasonable to expect the government to hold and direct financial or real assets of the magnitude necessary to bring about system solvency. The government would have to raise today's payroll tax to 16.4 percent and begin to buy real assets, like shares in General Motors, IBM, Microsoft and Exxon. Eventually, this new pension fund would hold assets in an amount equal to the entire output of the United States' economy. Such an accumulation held by the government is unprecedented in our country's history. Moreover, these funds could not be credited to the Trust Fund, then diverted to other federal programs or used as substitutes for other taxes, as they are now.


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