The Best Way to Pay for Social Security

While everyone is asking how we'll pay for health care reform and for the spiraling costs of Medicare, the good folks at the Employee Benefit Research Institute have been figuring out how'll we pay for Social Security, that other freight train destined to hit taxpayers in the next decade. You remember Social Security, don't you? We obsessed over its looming bankruptcy during the first year of George W. Bush's second administration. Then we stopped obsessing, and the problem went away.

Okay, so it didn't really go away. In fact it got worse. The system is now projected to become a drain on general tax revenues beginning 2016--or as early as 2013, if the economy and other factors turn out worse than expected. We're going to have to lower benefits or raise taxes or both to make the system solvent. There's no other way to do it.

The new EBRI research shows that it won't really cause a huge amount of pain. We just have to get to it.

To understand the tables below, you need to know that Social Security faces a total shortfall equal to 2% of national wages. So the EBRI research weighs the impact of each tax increase or benefit cut by the percentage of national payroll the reform would fill in. Any new tax or benefit rollback in excess of 2% solves the problem in one swoop. Anything less than 2% will need more swoops--additional tax hikes and benefit cuts--to get the job done.

One way to fully fund Social Security is to apply payroll tax to all wages. (That's the first entry in "Figure 3" below.) At the moment, taxes cease after your income hits $106,800. That covers the 2% gap with 0.19% of national payroll left over to have a party to celebrate.

The problem with this tactic is philosophical. If you tax all wages but don't figure those wages into future retirement benefits , you've broken the promise that makes Social Security so popular. That promise: we'll tax you now but pay you benefits later in return. If you add taxes with no commensurate increase in promised benefits, Social Security becomes just another tax-Peter-to-pay-Paul program, certain to be popular with Paul, but likely to lose Peter's support.

A way to solve that problem is to tax all wages but raise benefits accordingly. That fix adds up to 1.84% of payroll, which gets you most of the way there. (The second line in the chart above.) Surprisingly, increasing the age of eligibility for full retirement benefits, even to 70, only fills 0.6% of the 2% hole. (See below.) Besides, I find postponing retirement age to be distasteful-like moving the goal posts back in the middle of the game.

My favorite tactic is to tinker with the complicated formula Social Security uses to calculate benefits in such a way that future benefits rise at the rate of inflation rather than the rate of wage growth, as it does now. The adjustment is invisible because it still creates benefits that are nominally higher year after year, and the pain is gradual because it phases in slowly. And it's more than good enough: it adds up over time to 2.3% of the national payroll. (It's noted in the middle of the table below.)

But that's just my opinion. One of these days, our representatives are going to have to vote on this. What would you like to see happen?