The New York Review of Books

Peter G. Peterson’s two-part article on Social Security was published in the December 2 and December 16 issues of The New York Review. We here publish two critical comments on Mr. Peterson’s article along with his reply.—The Editors

A Calmer Look at Social Security

Peter Peterson’s obvious good intentions and apparent lack of a “vociferous constituency”¹ have lent his two-part article on Social Security an aura of accuracy and intelligence that it does not deserve. Peterson has overstated the system’s financial problems, has found a link between the expansion of Social Security and the decline in the nation’s productivity that cannot be substantiated, and has used this purported link as a basis for advocating draconian benefit cuts. His analysis and recommendations must not go unchallenged.

1. The Magnitude of the Problem: No Crash for Social Security

The first step in understanding the Social Security financing situation is to separate the problems of the Old Age, Survivors, and Disability Insurance (OASDI) program from those of the Hospital Insurance (HI) system. The future financing requirements of HI are extremely uncertain, since rapidly escalating hospital costs have caused both public and private health insurance programs to become increasingly expensive. Restoring long-run balance to the HI system will undoubtedly require fundamental reform in the way we provide hospital care. For this reason, the National Commission on Social Security Reform and others have focused their attention on the OASDI portion of the program. The answer is not, as Peterson suggests, to accept past rates of increase for HI expenditures and then cut the OASDI program by an amount equal to four times its own deficit in the year 2000 in order to transfer those funds to the Hospital Insurance program. The next step, which is useful for sorting out the financing problems in the OASDI program, is to divide the future into three separate time periods—1983-1989, 1990-2014, 2015-2060.

1983-1989. Between now and 1989, the OASDI program is projected under the Trustees’ most pessimistic economic assumptions to run a deficit of about $200 billion (see Table 1 on page 42).

Table 1

If the economy performs somewhat better, the shortfall may be close to $75 billion. In any event, when the interfund borrowing authority expires in July 1983, the OASI trust fund, the largest of the Social Security trust funds, will be unable to pay all benefits on time. Even if interfund borrowing were extended, all three funds, OASI, DI, and HI, together will be exhausted by mid-1984. The immediacy of the projected short-fall has caused many to characterize the Social Security program’s short-term problems as catastrophic and the press constantly refers to the impending “bankruptcy” of the system. In fact, the magnitude of the deficits forecast for the next seven years is relatively manageable, roughly 4 to 10 percent of annual outlays, and numerous options are available for restoring solvency. More importantly, the reasons for the current deficits are well understood and future problems of this type can be avoided by modifying the indexing procedure.

The most appropriate point from which to trace the origins of the current financing problems is 1977, since legislation passed in that year dramatically revised the Social Security financing and benefit provisions to restore fiscal balance to the program. However, payroll tax rates were established on the traditional assumption that the rate of growth of taxable wages would equal the rate of increase in prices plus an additional amount for productivity growth. This was a perfectly reasonable assumption, since it reflected the performance of the US economy over the entire postwar period. After 1977, however, the traditional relationship between prices and wages reversed and price increases exceeded wage growth. The projected balance in the trust funds is extremely sensitive to the relationship between these economic variables. The rate of wage growth determines the rate at which revenues grow, while the rate of increase in prices determines the rate at which benefit expenditures increase since benefits are indexed to the consumer price index. Moreover, the rapid inflation was accompanied by high unemployment which further worsened the financial outlook, since fewer people contribute revenue to the trust funds and more people, finding themselves unemployed, are likely to take early retirement.

Since the current financing problems can be traced to past experience with overly optimistic assumptions, the obvious question is whether the $75 to $200 billion deficit projected for the next seven years is realistic. Table 2 (on page 42) compares forecasts of productivity growth and the unemployment rate underlying the intermediate (II-B) and pessimistic assumptions (III) from the 1982 Trustees’ Report and two independent forecasters, Chase Econometrics and Data Resources, Inc.

Table 2

Generally, the projections of the private forecasters fall somewhere between the intermediate and pessimistic assumptions, although considerably nearer the former. Hence, planning on a deficit somewhere between $75 billion and $200 billion for the next seven years seems like a very reasonable strategy.

1990-2014. In marked contrast to the next seven years, the outlook for OASDI financing is relatively favorable for the period 1990-2014. The primary reason is demographic. The low fertility rates during the late 1920s and the 1930s will be reflected in a considerable reduction in the rate of increase in the population over age sixty-five during the 1990s. As a result, the ratio of workers to beneficiaries, which has declined continually since 1940, is estimated to remain stable for the next twenty to thirty years at its current level of roughly three to one. With a stable ratio of workers to beneficiaries, even modest productivity gains will reduce the cost of Social Security as a percent of payroll.

If an upsurge in productivity occurs and wages rise by 1.5 percent more than prices, as assumed under the intermediate (II-B) economic assumptions, then revenues will exceed outlays over the entire period and the trust funds will accumulate surpluses rapidly, reaching 177 percent of the annual outgo by 2010. On the other hand, if the realwage differential is closer to 1 percent, as under the pessimistic assumptions, then outlays will slightly exceed revenues—an average of 12.9 percent versus 12.4 percent of taxable payrolls—and no balances will accumulate.

The future costs of the system and the total of trust-fund balances could be made considerably more predictable by revising the procedure for indexing benefits. As noted earlier, the OASDI program is thrown into deficit when unanticipated inflation and low wage growth cause outlays to increase more rapidly than revenues. This type of instability can be avoided only by linking post-retirement cost-of-living adjustments directly to the growth of wages. For example, indexing retirement and disability benefits by the rate of wage growth minus 1.5 percent would provide the same benefits as the current price indexing of benefits under the intermediate (II-B) assumptions. This reform would not only eliminate the short-run instability, but would also lock in the economic assumptions to insure the buildup of reserves during the 1990-2014 period.

2015-2060. The third period is characterized by rapidly rising costs as the baby-boom generation starts to retire. At the same time, the growth in the labor force slows markedly, reflecting the precipitous decline in the fertility rate which began in the mid-1960s. These two factors cause the ratio of beneficiaries to workers to increase dramatically. Assuming that the fertility rate will rise gradually from the current level of 1.8 to a long-run rate of 2.1 (the intermediate assumption), the Social Security Administration projects that the number of beneficiaries per 100 covered workers will rise from 31 in 1982 to 50 by 2035. If the fertility rate declines to 1.7 (the pessimistic assumption), then the number of beneficiaries per 100 workers will increase to 67 by 2035.

With a pay-as-you-go system the increase in this crucial ratio produces a substantial increase in costs as a percentage of payrolls. The question is, what is a reasonable estimate of the magnitude of the long-run problem? Is Peterson’s assertion that “to close the deficits in the Social Security system under the ‘pessimistic’ projection would take a payroll-tax rate of above 44 percent in 2035” even remotely realistic?²

Let us assume for the time being that the pessimistic demographic assumptions are borne out. Under these assumptions, the projected tax rate for the OASDI portion of the program for the year 2035 is 24 percent of payrolls. In order to bring the total to 44 percent, HI outlays must rise to 20 percent of taxable payrolls. Outlays for HI today account for only 18 percent of total expenditures under the Social Security program; it is difficult to believe that we will allow the HI program to grow to a point where the cost for hospital insurance (20 percent of taxable payrolls) roughly equals the total cost to support the aged, disabled, their dependents and survivors (24 percent of payrolls).

Moreover, the pessimistic demographic assumptions are not consistent with other forecasts. The pessimistic projections are based on the assumption that fertility rates will decline from the 1980 level of 1.83 to an ultimate long-run rate of 1.7 by 2005. The intermediate assumption is that fertility will increase gradually to a long-run rate of 2.1. Of the two assumptions, the evidence tends to support the higher. First, until October of this year, the Census Bureau’s “middle” series assumed a long-run fertility rate of 2.1. Although the Census now assumes that fertility rates will remain fairly steady, increasing slightly from 1.83 to 1.96 in 2000 and then decreasing to 1.90 births per woman in 2050, the fertility rate has increased over the last five years and the data on expected births indicate that young women continue to expect to have more than two children over their lifetimes. Thus, even with the downward revisions of the projections, current Census data appear more consistent with the intermediate than with the pessimistic assumptions. In addition, most observers, including Peterson, acknowledge that the conventional assumption for Social Security projections of net immigration of 400,000 persons a year may substantially understate the number of people entering the country each year.³ When illegal as well as legal immigration is considered, the working population is likely to be substantially larger than the fertility assumptions alone would indicate.

If the intermediate demographic assumptions are the more realistic over the long run and the system is stabilized by linking post-retirement indexing directly to wage growth, then the projected cost of the OASDI portion of the program is 15 percent for the year 2035, and current estimates of the costs for the HI program for the same year run around 11 percent. Thus, the cost for the entire Social Security program, assuming no major reform of Medicare, would be about 26 percent, that is, 13 percent for the employer and 13 percent for the employee. This compares to current rates of 6.75 each for the employer and employee.

It is important to note, however, that the 26 percent tax rate would be levied on a much smaller portion of the worker’s total compensation than is taxable today. According to the Trustees’ projections, the ratio of cash wages to total compensation is estimated to decline from 84.2 percent in 1980 to 67.4 percent by the year 2035.⁴ Since the payroll tax is levied only on cash wages, the expansion of fringe benefits reduces the tax base and boosts the percentage of taxable payroll required for paying benefits. If fringe benefits remain a constant percentage of total compensation, then the required tax rate for the OASDI portion of the program in the year 2035 would be 12 percent and for HI another 9 percent. In other words, in terms of the tax base we have today, the total required tax for OASDI and HI in the year 2035 would be 21 percent, or 10.5 percent each for the employee and the employer.