The most recent report issued by the trustees of the Social Security Trust fund states absent changes in policies Social Security benefits will be automatically cut by 17 percent in 2033.
The debate over how to prevent an abrupt reduction in Social Security benefits mandated under current law could become the defining economic and political debate of this generation.
· Failure to prevent large automatic cuts in Social Security benefits to current retirees would lead to a substantial increase in poverty among older households.
· An abrupt benefit cut would lead to declines in spending and a recession.
· Democrats and Republicans sharply differ over whether Social Security reform should emphasize reductions in benefits or increased revenues.
· The Social Security short fall impacts the budget and the future debt to GDP ratio.
· Some proposals to prevent automatic benefit cuts and reduce the Social Security shortfall involve deep cuts to discretionary programs spending.
· A recent proposal called for using funds from the elimination of tax incentives for private retirement saving to reduce the Social Security shortfall.
· Social Security reform proposals are intrinsically related to private pension savings reform proposals because many households have failed to save for retirement and are highly dependent on Social Security.
This memo explores economic impacts of an abrupt benefit cut, the causes of the projected benefit cut, and policy proposals to address the problem.
Economic impacts of abrupt cuts to Social Security benefits:
Empirical research using several different surveys has consistently found that elderly households in retirement are highly dependent on Social Security.
A study from the Office of Retirement and Disability Policy in the Social Security Administration, which relies on three separate surveys, found that roughly half of the elderly population get 50 percent of their household income from Social Security and that around one quarter of the elderly population gets 90 percent of their income from Social Security.
The reduction in household income from a 17 percent Social Security benefit cut for a person with 50 percent of their income from Social Security would be 8.5 percent. Many Americans, including likely all Americans dependent on Social Security, are already living paycheck to paycheck. An automatic reduction of Social Security benefits of this magnitude would substantially increase the poverty rate for older Americans.
The economic impact of the abrupt impact in Social Security benefits would not be limited to people receiving benefits. The policy change would be observed by all households. Most households, especially households nearing retirement, would attempt to respond to the likelihood of lower benefits by reducing spending and increasing saving, although some households currently living paycheck to paycheck would maintain their current consumption level.
The reduction in spending would lead to a sharp drop in national income. Consumption levels would remain low even after the recession ended.
Cause of pending benefit cuts:
Current laws governing the Social Security trust fund and the overall U.S. deficit mandate an automatic cut in Social Security benefits triggered by the elimination of assets in the trust fund.
The perceived cause for this automatic benefit cut, a lack of cash in the trust fund, is a falsehood. The Social Security Trust fund is not a “lock box” with cash. The fund or lock box contains IOUs between the Treasury and the Trust fund.
A recent Wall Street Journal article on the pending automatic cuts to Social Security benefits quotes Andrew Bigg, a Senior Fellow at the American Enterprise Institute.
“Having a trust fund does not make it easier for us to pay benefits. It commits the government to pay benefits, but it doesn’t make it easier,”
“This is not gold sitting in Fort Knox in any way at all.”
The pending Social Security benefit cut is not the first time the Social Security system faced a financial crisis. A 1983 overhaul led to years when the Social Security took in more than it paid out.
The Trust fund gave the cash back to the government and the government gave the Trust fund non-tradeable bond or IOUs that earned interest. The funds the Treasury received from the Trust fund reduced the amount it had to borrow to fund the government.
In 2021, Trust fund payments exceeded receipts from the payroll tax and the Trust fund started redeeming bonds to maintain full benefits. The Treasury obtained funds for Social Security benefit and all other government programs by borrowing from the public.
The trust fund is projected to run out of Treasury bonds in 2033. Payroll taxes will not cover the full benefit. Hence, under current law there will be automatic benefit cuts.
Andrew Duehron, in a recent Wall Street Journal article notes that Congress and the future president could maintain current benefits by allowing the Treasury to continue to raise funds for the Trust fund without redeeming bonds. However, fiscal hawks in Congress would argue that Social Security payments and discretionary payments are fungible and that both should be subject to the annual budget process.
Interested readers wanting to learn more about the interaction between Trust funds and the overall government budget could look at this CBPP article.
Policy Responses:
One set of policy responses to the pending cuts in Social Security benefits, like the one used in 1983, is to shore up the Trust fund by either increasing revenues or reducing future benefits.
Traditionally, Democrats have advocated for higher taxes on Social Security while Republicans have advocated for budget cuts.
Some candidates and policy makers now advocate for adjustments to spending or taxes in other parts of the budget to free up funds for maintaining or even enhancing Social Security benefits.
Proposals to increase trust fund revenues:
The current payroll tax funding Social Security and Medicare is capped. The payroll tax is not applied to income over $168,000, in 2024. The payroll tax is only applied to wage income and is not applied to investment or business income.
A bill offered by Senator Sanders and others would eliminate the Social Security shortfall by increasing taxes on more affluent Americans. Two provisions of the bill will result in increased revenue.
· All income over $250,000 per year will be subject to the Social Security payroll tax.
· The bill would impose a 12.4 percent tax on investment income and business income, sources of income which are currently not subject to the payroll tax.
The bill’s authors claim that the bill will not increase taxes for 93 percent of all Americans.
One purpose of the new taxes is to force the rich to pay more for this program. It is also important to note that the ultra-wealthy with most of their wealthy in unrealized capital gains would not be substantially impacted by this proposal.
Moreover, Social Security has broad support because of the perception that the payroll tax was a payment for future benefits. The use of taxes on the rich to eliminate the shortfall alters this quid-pro-quo and could undermine support for the program.
An immediate large infusion of additional tax revenue into the Trust fund would allow the Trust fund to pay out all benefits. It is projected the additional taxes stipulated in this bill could extend the life of the Trust fund for 75 years.
Proposals to alter benefits:
The traditional Republican approach to Social Security reform involves altering benefits for younger workers. The proposed reform measures would not affect people currently in retirement and would be phased in for workers nearing retirement age.
The October 2024 Presidential debate helped clarify where Republican candidates now stand on entitlements – Social Security and Medicare. Two candidates, Haley and Christie favor a higher retirement age for young adults now entering the workforce and for means testing Social Security benefits. Haley also called for adjusting the rules governing the Social Security cost of living adjustments. A proposal offered by Senator King and Senator Cassidy described here also gradually increases the age for claiming Social Security benefits.
Proponents of a higher retirement age argue that young workers will have time to save more for retirement. However, the current system is failing most middle-income people. My own research reveals that student borrowers who are having trouble staying current on their student loans will be more likely to disburse funds from their retirement plan prior to retirement.
One way to motivate Social Security benefit reductions is to couple reductions in future Social Security benefits for young workers with better incentives for private retirement savings. Readers interested in this approach should consider Ghilarducci and Hassett Ghilarducci and James, and Munnell and Biggs.
The proposals for a higher retirement age applied to new entrants to the workforce offered by Haley and Christy would not prevent the automatic benefit cuts in 2034 mandated under current law because savings from future cuts for young workers would not have been realized. Under current law, there will be automatic benefit cuts if there are no IOUs in the Trust fund and payroll taxes are lower than required benefits.
It would be possible to link future benefit cuts with a law preempting the mandatory Social Security required under current law. In the short term, budget deficits would balloon relative to current law but in the long term when the current working age population is retired benefits and debt would fall.
Former Vice President Mike Pence has long favored the use of current Social Security payroll taxes to create private accounts. The theory behind the implementation of private accounts is that the economy could grow at a faster rate because of the increase in private saving would increase investment. However, the diversion of current payroll taxes from the Trust fund to private accounts would increase the Social Security shortfall and increase the mandatory benefit cut under current law.
The private account proposal would also have to involve unlinking Social Security benefits to the state of the Trust fund. The combination of new private accounts with a repeal on mandatory benefit cuts because of the trust fund shortfall would lead to indefinitely higher government deficits and trend growth in the debt to GDP ratio, unless of course there was substantial additional economic growth created from the reform.
Offsetting Social Security shortfalls with cuts to the other parts of the budget:
As noted by Andrew Biggs, the Trust fund obligates the government to make benefit payments but does not provide or maintain cash for the payments.
The existence of Trust fund surpluses reduced the amount of funds the government has to borrow to fund the general deficit.
The Trust fund surpluses no longer exist. Many Republicans, including some who participated in the Republican 2024 primary debates favor cuts to discretionary spending to offset the Social Security shortfal
Annual debates about the level of government spending and taxes have become quite contentious leading to 10 government closures since 1980 with the most recent closure in 2018—2019 lasting 35 days.
The use of one budget controlling both annual spending and Social Security benefits gives fiscal hawks substantial leverage in negotiations, with their position being cut certain programs or Social Security benefits must be reduced. Many of the proposed budget cuts considered each year including programs that provide nutrition and health care to low-income and middle-income households.
Most of the Republican proposals to fund Social Security from savings on other parts of the budget deal leave in place popular tax expenditures including tax expenditures for private 401(k) plans and IRAs. Two economists Munnell and Biggs observe that current tax incentives for 401(k) plans largely favors higher-income people who would continue to save for retirement without tax incentives and that these tax incentives would be better used to reduce the Social Security funding gap.
Tax and budget numbers indicate that any effort to reduce the Social Security shortfall through savings from cuts to other parts of the budget would have to consider a broad range of taxes and spending programs, not just the ones impacting basic needs of low and mid income households.
Concluding Remarks
The successful Social Security overhaul in the 1980s involved efforts to shore up the Trust fund. Certainly, reform of the Trust fund by either adding revenues or modifying benefits will be part of the current discussion on pending automatic budget cuts. However, there are many differences between the current economy, demographic projections, and political environment than the ones which existed forty years ago. Efforts to fix Social Security will also require reconsideration of both the inter-relation between the Trust fund and the overall general federal budget and the inability of many households to take advantage of tax incentives for private retirement savings.
Authors Note: A paper detailing the tax and spending changes that I would make to simultaneously secure the Social Security system, increase private retirement saving and limit future government deficits will be available by the end of the summer of 2024. In the meantime, please consider Seven Mistakes Made by Financial Advisors.