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

Advantages of Reform

“After 2037, the payroll tax can be reduced. ”

The most important reason to reform Social Security is to avoid significantly higher taxes in future years and painful cuts in benefits. There are also other advantages.

Benefit of Reform: A More Secure Retirement. Just as the current system’s problems compound over time, the benefits of reform also grow. After about three decades, the reformed Social Security system will finance itself, and workers’ payroll taxes and contributions can be reduced. By contrast, without reform, future workers and retirees almost certainly face tax increases that will gradually rise to 50 percent above the current rate, or future retirees will face benefit cuts that gradually rise to a third of benefits.

Benefit of Reform: Taxes During Retirement. Individual deposits and payroll taxes invested in PRAs will be treated like Roth IRAs, in which contributions are made with after (income) tax dollars and withdrawals are tax free.

“Couples will split their contributions to personal accounts. ”

A common assumption behind conventional IRAs and 401(k) accounts is that people will be in a lower tax bracket after they retire. If so, they gain by being able to defer taxes until the time when their tax rate is lowest. However, because of the Social Security benefits tax, many lower- and moderate-income families face higher tax brackets after they retire.15 As a result, deferring taxes may actually increase their lifetime tax burden. The solution is to allow people to pay taxes during their working years and withdraw funds tax free during their retirement years. According to a recent study on the subject by Boston University Professor Lawrence Kotlikoff, “Every income group would benefit from taking advantage of this form of taxation. But it is especially beneficial to low- and moderate-income families who, if they save on a tax-deferred basis, can expect to face higher tax rates after they retire.”16 Since the employer contribution to the PRA is made with pretax dollars, the amount attributable to the employer’s contribution will be taxed upon withdrawal, at ordinary income tax rates.

Benefit of Reform: Accommodating Modern Family Life. Given the changing patterns of marriage and divorce it is important that a couple’s retirement savings be shared in some way. Today 50 percent of first marriages and 60 percent of subsequent marriages end in divorce. “Earnings Sharing” is one avenue by which both parties in a marriage share in the assets accumulated during the duration of the marriage. This would require dividing all of a couple’s contributions to personal accounts when they are contributed — crediting half to the husband and half to the wife. If they divorce, each spouse would retain ownership of his or her account.17

Benefit of Reform: Paying for Long Term Care. Long-term care expenditures are one of the most important retirement policy issues on the horizon for families and state-level policymakers. Many families do little to prepare for the costs of providing long term care for aged relatives. At the same time, long term care accounts for one-third to one-half of total Medicaid expenditures in most states, and Medicaid is one of the fastest growing components of state budgets. Getting long-term care spending under control will go a long way toward restraining state-based Medicaid spending.

Our reform plan will allow retirees to use their PRA balances, above the amount required for the minimum annuity, to purchase long-term care insurance and to pay for long term care directly. Tax free withdrawals also can be used for health care expenses for debilitating, end-of-life diseases.

“Prepaying retirement benefits will reduce taxes and increase incomes for future generations. ”

Benefit of Reform: Greater Economic Growth. One of the primary benefits of prepaying retirement benefits is the increase in the nation’s means of production resulting from higher savings. Investing funds in PRAs in the manner we recommend will create more saving and increase the nation’s capital stock. These higher savings will not be realized if the funds deposited in PRAs come from additional borrowing from the public. Increasing the nation’s means of production requires reducing the government’s debt, both explicit (in the form of government bonds) and implicit (in the form of elderly entitlement promises). Relying on borrowing to fund PRAs will lead to individualizing Social Security but not necessarily to higher savings.

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