At long last, we are finally starting to get some meaningful details about President Bush's Social Security reform proposal. Inevitably, this is already starting to change the debate on this issue. Up until now, all we have heard is that Bush wants to establish some sort of private accounts as part of Social Security. But we have heard nothing about how such accounts do anything to solve Social Security's long-term financing problems.
Obviously, private accounts per se accomplish nothing unless accompanied by some reduction in future benefits for those with the accounts. Indeed, without benefit cuts, the creation of private accounts will worsen Social Security's financial woes because the Bush plan contemplates diverting Social Security taxes into the accounts.
I have heard more than a few people discuss Social Security reform as if the private accounts will magically fix Social Security without any necessity of reducing benefits. Indeed, they are adamant that there not be any cut in benefits whatsoever, now or any time in the future.
Obviously, such a position is ludicrous. The whole point of creating private accounts has always been as part of a trade-off. Workers would lose future Social Security benefits, which is what stabilizes the system's finances, and the income earned on the accounts will compensate them for this loss.
In order to induce people to make this trade-off, Bush strongly emphasizes that the status quo is unsustainable in the long run. He points often to the fact that the Social Security trust fund will be exhausted in the year 2042. At that point, current projected revenues from the payroll tax will only cover about 75 percent of promised benefits. The implication is that benefits will either have to be cut across the board by 25 percent or the payroll tax rate will have to rise by about 4 percentage points.
In other words, reforming Social Security now is less risky than doing nothing, as Democrats favor. When they scare people with benefit cuts, Democrats are in effect promising something that cannot be delivered. As many workers have discovered in recent years, bankruptcy of private businesses often leads to a loss of pension benefits.
What is always left out of this scenario is that the Social Security tax begins falling as a net contributor to federal revenues in 2008, when the surplus of Social Security taxes over benefits will peak at 0.8 percent of the gross domestic product. After that, this figure gradually falls to zero in 2018 and becomes negative thereafter. By 2045, the shortfall between Social Security taxes and benefits will equal 1.7 percent of GDP.
What this means is that long before the trust fund is exhausted, income taxes will have to rise by an amount equal to difference between current Social Security revenues and benefits. In other words, income taxes will have to go up by about 2.5 percent of GDP between now and the date the trust fund is exhausted in order to redeem the bonds it holds, which will be cashed-in to pay benefits over and above Social Security taxes.
But on the date the trust fund is exhausted, taxpayers will have paid off their debt to the trust fund. Thus, income taxes could theoretically fall by 1.7 percent of GDP on that day. If the payroll tax had to rise by the same amount, most taxpayers would be unaffected. Their income taxes would go down by exactly the same amount that their payroll taxes went up. More likely, Congress would simply authorize general revenue financing for Social Security, which is what happens when the trust fund is drawn down anyway. In short, absolutely nothing would change in terms of either taxes or benefits on the day the trust fund is exhausted.
What this means is that there is no apocalypse in 2042 in which anyone's benefits will suddenly be cut or their taxes sharply raised. The implicit tax increase will take place gradually long before that date, and Congress will never allow benefits to be cut that way. It would only take a matter of hours for it to authorize general revenue financing should there be no changes to the Social Security program over the next 37 years.
Still, it is highly undesirable to raise taxes by the equivalent of 2.5 percent of GDP over the next several decades to pay Social Security benefits. That would be equivalent to raising income taxes by 34 percent this year. This is the real reason to reform Social Security, not because of looming bankruptcy, which will never be allowed to happen.
It may be politically useful to use apocalyptic rhetoric to sell a controversial Social Security reform plan. But the real reason to do it is to prevent a massive income tax increase, not because anyone's benefits are threatened by inaction.