Social Security Reform without Illusion: The Five Percent Solution

Policy Reports | Social Security

No. 272
Friday, December 17, 2004
by Andrew J. Rettenmaier & Thomas R. Saving

The Case for Reform Using Personal Retirement Accounts

“Without reform, Social Security and Medicare will consume all income tax revenues by 2070”

The 2004 Medicare and Social Security Trustees Reports show that programs for the elderly are on an unsustainable course. Expenditures exceed anticipated revenues, and the funding gap is projected to grow through time.

One way to assess the problem is to calculate the present value of the difference between expenses and revenues. This year, for the first time, the Trustees reported calculations for all the elderly entitlement programs, and the numbers are startling. Measured in current dollars:

  • Over the next 75 years, scheduled benefits exceed dedicated revenues by $33 trillion.
  • Looking indefinitely into the future, the present value of the additional revenues required by Social Security and Medicare totals almost $74 trillion.

What does it mean to have a $74 trillion revenue shortfall? It means that in order to pay benefits to current and future generations without using general revenues or cutting benefits, we need $74 trillion on hand right now, invested at the government’s borrowing rate. Because we don’t have $74 trillion invested today, next year the liability will be even larger. The year after that it will be larger still.

Figure I - General Revenue Transfers to Social Security and Medicare

“Currently, Social Security surpluses are spent on other programs”

Some have asserted that an immediate solution to the problem is unnecessary, because the Trust Funds are flush with surpluses that can pay benefits well into the future. But the Social Security Trust Funds are not flush with assets that can pay benefits like those in a conventional pension fund. They are more like IOUs the government has written to itself. Surplus funds are not invested in financial assets like stocks and bonds. Instead, the surpluses are credited to the Trust Fund but are spent on other government programs. Every asset of the Trust Funds is a liability of the Treasury. Summing over both parts of government, the assets and liabilities net out to zero. In order to pay benefits in future years, the government will have to tax, borrow or cut spending on other programs. [See Figure I.]

  • This year, for the first time in many years, the federal government will have to draw on general revenues to cover the excess of spending over revenues in the combined elderly entitlement programs; the funding deficit this year is equal to about 3.6 percent of federal income taxes.
  • In less than five years, the share of income taxes needed will double, and five years beyond that it will double again.
  • By 2020, the federal government will need more than one-in-four federal income tax dollars to pay benefits to the elderly, in addition to payroll taxes and other dedicated revenues.1
  • By 2030 (toward the end of the baby boomer retirement years) we will need more than half of all federal income tax revenues to pay for the deficits of Social Security and Medicare.
  • By 2040, we will need two-thirds of federal income taxes; by 2050, three-fourths.
  • And, by 2070, the elderly will need all federal income taxes (in addition to all payroll taxes), leaving nothing to pay for any other federal programs.

Clearly, we cannot sustain a pay-as-you-go system, under which promises made to today’s workers must be paid by future generations. Instead, we must move quickly to a funded system, under which each generation pays its own way. Perhaps the most compelling case for Social Security reform is the state of the Medicare program. Medicare’s unfunded liability is seven times greater than Social Security’s. A reformed Social Security system will ultimately lessen the tax burden, paving the way for much-needed Medicare reform.

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