Sunday, October 24, 2004

Why Is Social Security a Campaign Issue?

Last week was not a good one for Social Security as a campaign issue. On Tuesday, Senator Kerry's campaign speech in Wilkes-Barre (and related materials) suggested a profound disregard for the issue. President Bush said very little there on Friday about the need for reform and his principles for accomplishing it. In the briefest possible statement, here is why Social Security should be a campaign issue.

At present, the Social Security actuaries project an unfunded obligation of $10.4 trillion in the Old-Age, Survivors, and Disability Insurance (OASDI) program. This number comes directly from the 2004 Trustees Report released in March. (See Section IV.B.5 and Tables IV.B.7 and IV.B.8 in particular.) This is the present value of the projected payments less the present value of projected revenues for the system over the infinite horizon. It is the most comprehensive way to measure the hole in the system's finances.

Note that this is the unfunded part of the obligations--it is over and above all of the payroll taxes (12.4 percent of taxable payroll) and income taxes on benefits that go to support the program under current law. If this gap were to be closed through payroll taxes, it would require them to be raised by 3.5 percentage points, immediately and permanently, with the additional surpluses over the next few decades saved (in Treasury bonds) to finance annual deficits that are projected to grow to about 6 percentage points of payroll over the next 75 years.

This $10.4 trillion unfunded obligation is sometimes referred to as implicit debt, to distinguish it from the federal government's explicit debt issued in the form of Treasury bills, notes, and bonds held by the public. At present, implicit debt from Social Security and Medicare is several times larger than the government's explicit debt. Is having so much implicit debt a problem? I think so, and the reason is that, just like explicit debt, we accrue interest on implicit debt.

As an example, suppose that I made a promise to pay you $100 (in today's dollars) in 20 years. At a real interest rate of 3 percent per year (the long-term rate assumed in the Trustees Report), that obligation has a present value of 100/(1.03^20), or $55.37. I have implicit debt of $55.37 today. What happens if I don't do anything to reduce that obligation this year? Next year, with only 19 years left, the obligation will have a present value of 100/(1.03^19), or $57.03. As you would expect, the present value of the implicit debt grows at the interest rate each year, just like the value of explicit debt would if we issued more debt to cover the interest payments due each year.

So if we have an implicit debt of $10.4 trillion, and the real interest rate is 3 percent, then next year, the implicit debt will grow by 0.03*10.4 trillion = $312 billion, up to $10.7 trillion, if the assumptions underlying the projection stay the same. Why does this matter? Primarily, it matters because both the President and Senator Kerry have repeatedly stated (see the two speeches in Pennsylvania linked above) that they will not cut benefits for those at or near retirement age. (The Senator's statement may be even more encompassing, including benefits at any time in the future. I cannot tell for sure from his public statements.) This, in turn, means that each year that elapses without reform causes the burden of financing the unfunded obligations to be shifted away from one more birth cohort that crosses the threshold of being "at or near retirement." The more we wait, the larger the burden on future generations, and the higher that 3.5 percentage point surtax would have to climb.

If I were running the show, both Social Security and Medicare (which has even larger unfunded obligations) would be reformed so that under current law and reasonable economic and demographic assumptions, they are projected to have zero unfunded obligations. This means changing current law to reduce future benefits, raise future taxes, or both. It means revisiting the issue periodically to ensure that unfunded obligations never stray too far from zero due to changes in projection assumptions or the program's experience.

In some upcoming posts, I'll outline the way I would do it, as well as offer some critiques of what the candidates and their parties have (and have not) said about the issue.


Anonymous said...

Two questions:

1. I checked a debt calculator at random and it said the outstanding public debt (presumably what you mean by "explicit debt") is ~7.4 trillion. That, while smaller than the $10.4 trillion you mentioned, is not "several times" smaller. Can you clarify?

2. What do you think of the argument that the tax base will expand as boomers withdraw funds from their retirement accounts, providing enough additional revenue to bail out Social Security/Medicare that way?


Patrick Sullivan said...

I have been over into the future. And I have seen how it might work:

In a nutshell, the first tier is something like a negative income tax. The second is funded by contributions from those who work; 9% of income up to a maximum of $40,000 Canadian.

INVESTED in equities by an independent board of professionals:

The CPP Investment Board was created by an Act of Parliament on December 4, 1997. Directors were appointed to the board in October of 1998 and the first meeting was held in November of that year.

In March of 1999, we began receiving funds from the Canada Pension Plan and invested these in stock index funds. Later that year, the board appointed a president and chief executive officer.

The management team was put into place during 2000 and 2001. Several key policies and procedures were approved by the board including the business plan, investment strategy and the risk management policy.

In 2001, we began to expand our investments by entering the private equity market.

The third leg of the stool is private individual accounts, like our 401ks. Voluntary, but the government actively encourages them.

Andrew said...

To answer ASG's questions (Anonymous post above):

1. The Treasury lists the daily amount of the public debt here. Of the $7.4 trillion, about $4.2 trillion is held by the public and the rest is held by other governmental accounts. The $10.4 trillion in the post is Social Security's unfunded obligations. Including Medicare's unfunded obligations would put the total in the $60-$70 trillion range. (See Tables II.B12, II.C17, and II.C23 of the 2004 Medicare Trustees Report, totalling up the unfunded obligations and those paid from general revenue.)

2. I think that the argument being made here is that people currently owe a substantial amount of deferred taxes on withdrawals that they will take during retirement from the IRAs, 401(k)s, and other retirement savings vehicles. That these revenues were large and not incorporated into future revenue forecasts was an argument popularized by Michael Boskin a while ago. The last paper I saw on this, critiquing it, was this one, by some authors at the Brookings Institution. The bottom line seems to be that there is not enough money there to close the Social Security and Medicare financing gaps, and that the impact of those taxes may already be incorporated in CBO's forecasts.