Tax and Social Security Reform: Thinking Outside the Box

Policy Reports | Social Security | Taxes

No. 275
Thursday, September 29, 2005
by Hans Fehr, John C. Goodman, Sabine Jokisch, Laurence J. Kotlikoff

Elderly Entitlements: The Case for Reform

"Over the next 30 years the number of elderly will double; the number of workers will rise by less than 10 percent."

The impending dramatic aging of the U.S. population (and an even more severe aging problem in Europe and Japan) will have a severe impact on the nation, particularly on its fiscal system. Throughout the developed world retirement and health care benefits for the elderly are paid primarily out of contemporaneously collected payroll taxes. Under these “pay-as-you-go” systems of finance, workers do not set aside funds to finance their own retirement benefits. Instead they pay taxes to support the current generation of retirees. When today’s workers reach their own retirement years, they will have to rely on the next generation of workers for their tax funded benefits. Unfortunately, pay-as-you-go funding arrangements are very vulnerable to changes in population demographics.

In the United States, a monumental shift will occur over the next 30 years — as 77 million baby boomers cease to work and pay payroll taxes, and instead retire and collect benefits. The number of elderly in the United States, Europe and Japan will more than double. At the same time, the number of workers available to pay for their elders’ government-guaranteed pension and health care benefits will rise by less than 10 percent.

As we noted in a previous NCPA publication,24 paying the elderly their promised benefits will require large tax increases, including sharply higher payroll taxes. For example:

  • In order to finance elderly benefits in the United States, the payroll tax will have to climb from 14 percent (the current pay-as-you-go cost rate) to 23 percent over the next 30 years, while the average income tax on wages will rise from 10 to 14 percent.
  • Thus the total tax on wages will rise from 24 percent to 38 percent by 2030 and to 40 percent by mid-century.

Higher taxes mean lower after-tax income for workers. But they also have another, highly damaging effect. Less disposable income means less saving; less saving means less capital formation; less capital formation means lower labor productivity; and lower productivity means lower real wages.

"International competition for capital will raise interest rates."

Ordinarily, one would expect an economy that is short of capital to turn to international capital markets. However, because the capital shortage in Europe and Japan will be even more severe than that in the United States, the other two regions will bid capital away from our country. Over the course of this century, the international capital shortage will raise real interest rates by 4.4 percentage points (440 basis points).

The emerging capital shortage will significantly reduce real wages per unit of human capital (labor productivity absent technological change). As Table I shows:

  • Real wages of U.S. workers will be 10 percent lower than otherwise by 2030 and 15 percent lower by the middle of this century.
  • By 2030, projected tax hikes combined with the decline in pretax wages will cause workers’ take-home pay to be about one quarter less than otherwise.
  • By mid-century, the American worker’s aftertax income will be almost one-third lower than otherwise.

"Living standards will fall."

As bad as these results are, the future for Europe — where fertility rates are much lower and prospective aging much more severe — is substantially worse.

  • In Europe, where the total tax on wages is already above 40 percent, the tax burden will rise to 60 percent by 2030 and approach a staggering 70 percent by mid-century.
  • Combining these tax rates with an 8 percent simulated fall in real wages, the expected reduction in take-home pay of European workers will be one quarter by 2030.
  • By mid-century, the relative fall in after tax wages will exceed 40 percent relative to what it would have been without the growing burden of elderly entitlements.
Table I - Economic Effects of Aging

"By mid-century, the standard of living of U.S. workers will be nearly one-third lower than otherwise."

Like Europe, Japan already has taxes on wages in excess of 40 percent, and its aging society will cause a doubling of the payroll tax over the next 50 years. As in Europe, the results will be devastating:

  • By 2030, the total tax on labor in Japan will approach 60 percent, and Japanese workers will face a one-fourth reduction in their take-home pay.
  • By the middle of this century, the effects of elderly entitlements will push the Japanese tax on labor to 70 percent and the aftertax wages of Japanese workers will be more than 40 percent lower than they otherwise would have been.

"Our projections are based on optimistic assumptions about fertility rates and health care costs."

In making these estimates, we assume that the fall in fertility rates will reverse over time and that women will eventually have enough children to replace the current population — the exact opposite of recent trends. We also assume that the growth of health care costs per beneficiary will match the rate of growth of per capita real wages — even though they have grown many times faster in recent years. As a result of these very conservative modeling assumptions, the results reported here err on the side of optimism. Reality is likely to be far worse.

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