The first bill this year to solve the Social Security financing crisis that is brewing, called the Social Security 2100 Act, retains and slightly increases benefits, and substantially increases the income rate, and other proposals have followed.
According to MarketWatch’s Alicia H. Munnel, maintaining current benefits and increasing revenues to pay for them is the correct approach. People do not have much else to fall back on, and the private retirement system covers about half of workers at any moment, and those lucky enough to have a 401(k) plan only have modest balances.
One response to this maintain-benefits position was that the Social Security 2100 Act involves a substantial increase in the payroll tax rate. Indeed, the legislation would:
1. Raise the combined OASDI payroll tax of 12.4% by 0.1 percentage point per year until it reaches 14.8% in 2043.
2. Apply the payroll tax on earnings above $400,000 and on all earnings once the taxable maximum reaches $400,000, with a small offsetting benefit for these additional taxes.
While maintaining benefits does require a big increase in revenues, there is a compelling reason not to rely solely on the payroll tax. The reason is that a substantial portion of today’s Social Security costs can be attributed to the program’s missing trust fund.
The 1935 Social Security Act set up a plan that bore a much stronger resemblance to a private insurance plan than to the system we know today. The legislation called for the accumulation of a trust fund and stressed the principle of a fair return. The 1939 amendments, however, fundamentally changed the nature of the program. They tied benefits to average earnings over a minimum period of coverage, and thus broke the link between lifetime contributions and benefits. As a result, early cohorts received windfall returns on their contributions.
Virtually all observers agree that the decision to provide full benefits to early cohorts was a wise one. Many of these people had fought in World War I and had endured the economic devastation of the Great Depression. Poverty rates among older people were at unacceptably high levels. Moreover, the recession of 1937 followed rapidly after the introduction of the Social Security system, making the accumulation of a substantial surplus undesirable on fiscal policy grounds.
The benefits paid to the early retirees did not come for free, however. If earlier cohorts had received only the benefits that could have been financed by their contributions plus interest, trust fund assets would be much larger than they are today. The assets in that larger fund would earn interest and that interest would cover a substantial part of the cost of benefits for today’s workers. Without it, payroll taxes must be substantially higher. Our estimate is that the required payroll tax rate under the current pay-as-you-go program is 3.7 percentage points higher than it would be if we had a trust fund paying interest.
No rationale exists to put the burden of the missing trust fund fully on the back of current and future workers through higher payroll taxes. Instead that burden should be shared more broadly by financing the burden created by the missing trust fund through the income tax.
Precisely how to accomplish this goal without losing the benefits of an earmarked tax would require deft drafting. But a discussion about the implications of the missing trust fund is one worth having.