Social Security: Long-Term Financing and Reform

The provisions of the Social Security Act (signed into law by President Franklin D. Roosevelt on 14 August 1935) were tailored to model a private insurance system and avoid any hint of socialism. Some degree of individual equity would be maintained, with those who paid in more receiving greater benefits upon retirement. OASI (Old Age and Survivors Insurance) would not be means-tested, reflecting American preferences against welfare. These provisions helped to make the Social Security Act the most successful and enduring of the New Deal programs— indeed, many analysts claim that Social Security is the most popular federal government program ever adopted. In truth, however, Social Security has never closely approximated a private insurance plan, and changes to the Social Security Act over the years have moved it ever farther from that model. Thus, while Americans still tend to think of Social Security as a system of ‘‘retirement insurance,’’ in fact almost 28 percent of the beneficiaries of OASI (which excludes disability benefits covered under the full program of Old Age, Survivors and Disability Insurance, OASDI) in 1997 were spouses or survivors of covered workers. Though the discussion that follows will focus on the aspects of Social Security that relate most closely to issues surrounding aging and retirement, it must be kept in mind that Social Security is a much bigger program with broader coverage, and any reforms must take account of the large percent of beneficiaries without normal work histories.

U.S. workers began to pay payroll taxes for Social Security in 1937, and the first benefits were paid in 1940. Over the years tax rates were increased, the percent of the workforce covered grew, and benefits were expanded. A substantial change was made in 1972, when automatic cost-of-living adjustments were added to benefits. The next few years experienced high inflation and slower real economic growth—together these raised program benefit payments and lowered tax receipts, generating the first crisis for Social Security when it was feared that receipts might fall below expenditures. This led to the first significant cutbacks in the program’s history, with inflation adjustments delayed, tax rates increased, and some benefit cuts for civil servants. By the early 1980s it was realized that these changes had not been sufficient. A commission was appointed (with future Federal Reserve Board Chairman Alan Greenspan at its head) to study the long-term financial situation of Social Security. One significant issue that had arisen was the aging of the U.S. population. This was compounded by the baby boom bulge created in the early postwar period when fertility rates (number of children per woman) rose and remained high until the baby boom bust of the 1970s, when fertility rates fell. Combined with rising longevity, this ensures that the baby boomers will create a relatively large number of elderly Social Security beneficiaries and relatively fewer workers to support them between 2015 and 2035. While the problems created by the baby boom receive most of the press, falling fertility rates and rising life expectancy are common experiences in all the major developed nations, leading to the social challenges that result from an aging population. Indeed, on current projections, Social Security will experience its greatest financial problems after all the baby boomers have died.

The Greenspan Commission published findings that resulted in the most significant changes made to Social Security since the addition of Medicare in 1965. These included higher tax rates, imposition of taxes on Social Security benefits, and phased increases in the normal retirement age. Most important, the 1983 revisions changed Social Security from pay-as-you-go to advance funding. In a pay-as-you-go (or paygo) system, current-year revenues are balanced against current-year expenditures. However, as the Greenspan Commission recognized, the aging of America created a special financing problem. During the late twentieth and early twenty-first centuries, OASDI was projected to run large annual surpluses, but sometime during the second decade of the twenty-first century, the program would begin to run annual deficits. Indeed, it was feared that the deficits would eventually become so large that it might be politically infeasible to raise taxes or cut benefits by the amount required to return the program to balance. For this reason, the paygo system was abandoned in favor of advance funding. In an advance funded system, near-term annual surpluses are accumulated in a trust fund that purchases special U.S. Treasury securities to earn interest. When program spending rises above tax revenues, interest earnings supplement revenues to maintain balance. At some point in the future, taxes plus interest earnings will fall below annual benefit payments; then the trust fund can sell its Treasury securities to make up the difference. In this way surpluses over the first three or four decades following the Greenspan Commission’s changes could be used to offset projected annual deficits during the final decades, ensuring long-term financial solvency.