Wednesday, December 29, 2010

New article: The Right Way to Balance the Budget

I have a piece co-authored with AEI's Kevin Hassett and Matt Jensen in the Wall Street Journal today. The article is based on a working paper we've written that looks at how other OECD countries have sought to close their fiscal gaps and which approaches have and haven't tended to succeed.

The Right Way to Balance the Budget: The experience of 21 countries over 37 years yields a simple truth: Cutting spending works, and raising taxes doesn't.


The federal debt is at its highest level since the aftermath of World War II—and it's projected to rise further. Simply stabilizing debt levels would require an immediate and permanent 23% increase in all federal tax revenues or equivalent cuts in government expenditures, according to Congressional Budget Office forecasts. What's clear is that to avoid a crisis, the federal government must undergo a significant retrenchment, or fiscal consolidation. The question is whether to do so by raising taxes or reducing government spending.

Rumors have it that President Obama will propose steps to address growing deficits in his next State of the Union address. The natural impulse of a conciliator might be to split the difference: reduce the deficit with equal parts spending cuts and tax increases. But history suggests that such an approach would be a recipe for failure.

In new research that builds on the pioneering work of Harvard economists Alberto Alesina and Silvia Ardagna, we analyzed the history of fiscal consolidations in 21 countries of the Organization for Economic Cooperation and Development over 37 years. Some of those nations repaired their fiscal problems; many did not. Our goal was to establish a detailed recipe for success. If the United States were to copy past consolidations that succeeded, what would it do?

This is an important question, because failed consolidations are more the rule than the exception. To be blunt, countries in fiscal trouble generally get there by making years of concessions to their left wing, and their fiscal consolidations tend to make too many as well. As a result, successful consolidations are rare: In only around one-fifth of cases do countries reduce their debt-to-GDP ratios by the relatively modest sum of 4.5 percentage points three years following the beginning of a consolidation. Finland from 1996 to 1998 and the United Kingdom in 1997 are two examples of successful consolidations.

The data also clearly indicate that successful attempts to balance budgets rely almost entirely on reduced government expenditures, while unsuccessful ones rely heavily on tax increases. On average, the typical unsuccessful consolidation consisted of 53% tax increases and 47% spending cuts.

By contrast, the typical successful fiscal consolidation consisted, on average, of 85% spending cuts. While tax increases play little role in successful efforts to balance budgets, there are some cases where governments reduced spending by more than was needed to lower the budget deficit, and then went on to cut taxes. Finland's consolidation in the late 1990s consisted of 108% spending cuts, accompanied by modest tax cuts.

Consistent with other studies, we found that successful consolidations focused on reducing social transfers, which in the American context means entitlements, and also on cuts to the size and pay of the government work force. A 1996 International Monetary Fund study concluded that "fiscal consolidation that concentrates on the expenditure side, and especially on transfers and government wages, is more likely to succeed in reducing the public debt ratio than tax-based consolidation." For example, in the U.K's 1997 consolidation, cuts to transfers made up 32% of expenditure cuts, and cuts to government wages made up 21%.

Likewise, a 1996 research paper by Columbia University economist Roberto Perotti concluded that "the more persistent adjustments are the ones that reduce the deficit mainly by cutting two specific types of outlays: social expenditure and the wage component of government consumption. Adjustments that do not last, by contrast, rely primarily on labor-tax increases and on capital-spending cuts."

The numbers are striking. Our research shows that the typical successful consolidation allocates 38% of the spending cuts to entitlements and 25% to reductions in government salaries. The residual comes from areas such as subsidies, infrastructure and defense.

Why is reducing entitlements and government pay so important? One explanation is that lower social transfers spur people to work and save. Reducing the government work force shifts resources to the more productive private sector.

Another reason is credibility. Governments that take on entrenched, politically sensitive spending show citizens and financial markets they are serious about fiscal responsibility.

While tax hikes slow revenue growth, policies that credibly reduce government spending in the long run boost economic growth by more than their simple effects on deficits might imply. Any attempt to address the federal government's budget shortfall that relies on less than 85% spending cuts runs too large a risk of failure. The experience of so many other countries shows that it's crucial for the U.S. to get this right.

Mr. Biggs is a resident scholar, Mr. Hassett is the director of economic policy studies, and Mr. Jensen is a research assistant at the American Enterprise Institute.

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Tuesday, December 21, 2010

CAP’s Social Security Hits and Misses

From AEI's Enterprise Blog

The Center for American Progress has released a Social Security reform plan authored by senior fellow Christian Weller. The plan, outlined in a paper titled "Building It Up, Not Tearing It Down: A Progressive Approach to Strengthening Social Security," is a solid and well-thought-out contribution to the Social Security reform debate. It is encouraging that while so many people sit on the sidelines and criticize without offering their own alternatives, others from both ends of the political spectrum are willing to put their ideas on the table.

CAP's plan includes a large number of modest benefit increases—many of which I could support—including stronger protections against poverty for low earners; increased benefits for survivors and the very old; streamlined divorcee benefits; and benefits for caregivers. The plan addresses solvency through a smaller number of larger changes, such as progressive benefit reductions for high earners (those in the top 30 percent of the lifetime earnings distribution, though lower earners could be affected if they collect auxiliary benefits based on a high-earning spouse); eliminating the current $106,800 cap on the employer side of the payroll tax; reducing annual Cost of Living Adjustments by around 0.3 percentage points; and investing around 25 percent of the Social Security trust fund in stocks.

Overall, it's not a badly constructed plan given the priorities of the designers. That said, two factors stand out as being behind-the-times in terms of Social Security reform plans coming from either side of the aisle.

The first is the plan's reliance on the equity premium—that is, the higher average returns produced by stocks over bonds—to keep Social Security solvent. In general, the Congressional Budget Office has not "credited" Social Security plans that include stocks with higher returns. CBO argues that higher stock returns are merely a return for higher risk, so crediting stock returns without accounting for stocks' greater risk would be misleading. As CBO put it here:

Although the government can reallocate the risk of stock holdings, it cannot eliminate it. If the government buys stock from private investors, it merely shifts risk from those investors to taxpayers and program beneficiaries. If stock prices drop, the government and the public in general have suffered the loss. Risk is not reduced simply because the government can borrow to avoid raising taxes or cutting spending in the current period. Government borrowing is a decision to tax or cut spending in the future rather than a means of avoiding taxation or spending cuts altogether. Nor is risk diminished by the government's ability to indefinitely hold a stock whose price has declined. A drop in the price of a stock is not a temporary aberration; it reflects the market's judgment that the value of the stock has declined permanently. An investment in private securities is no less risky when it is made by the government than when it is made by a mutual fund. Therefore, risk is costly to both the government and individuals.

For that reason, CBO risk-adjusts equity returns back to the government bond interest rate. This is particularly important in the CAP plan, since nearly one-quarter of the reduction in the 75-year funding shortfall derives from assuming higher returns on trust fund investments. If CBO follows the practice it used in scoring personal account plans, CAP's proposal would fall well short of 75-year solvency. Ironically, CAP categorizes trust fund investment as "Upgrading the structure to align with modern economic insights," just as budget scoring and financial theory have turned against equity-heavy portfolios.

Second, the CAP plan ignores a trend in Social Security reform over the past 15 years to aim not merely for solvency over 75 years, but so-called "sustainable solvency," which ensures that the program isn't running large annual deficits as it approaches the 75-year mark. The 1983 reforms, for instance, were solvent for 75 years but not sustainably solvent, with the result that current workers face large benefit cuts if and when the trust fund runs out. CAP doesn't estimate the annual cash flows for its proposal, but I estimate that in its 75th year the CAP plan would run a deficit of around 2.2 percent of payroll, versus a deficit of around 4.3 percent of payroll under current law. CAP's plan would reduce those annual deficits, but not nearly as much as most other Social Security reform proposals.

This means that within a decade or two, policy makers and the public would again face the need to fix the program, just as doing so becomes more difficult. There is nothing wrong with future generations revisiting Social Security policy—indeed, they should revisit it to keep the program current with economic realities and public goals—but there is no reason to force future citizens to revisit Social Security reform from the position of mounting deficits. I suspect that if we saw the annual cash flows of the plan it would look like more of a holding action on Social Security finances – at least relative to most other plans – and less like a permanent solution. While a permanent solution isn't necessary, it is necessary to acknowledge how much of the problem a plan truly solves when policymakers and the public are weighing the costs and benefits of alternative approaches.

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Jed Graham on Domenici-Rivlin and Bowles-Simpson

Over at Investors Business Daily's blog, Jed Graham – the author of the recent book "A Well-Tailored Safety Net" – offers a number of critiques of the Social Security reforms proposed by the two recent debt commissions. Understandably, Graham feels his own approach, termed "Old Age Risk Sharing", would do better. In a number of ways he's right.

Graham argues that the Domenici-Rivlin plan relies too heavily on new revenues, which – given the general scarcity of cash and the abundance of programs looking to get their hands on it – seems right to me.

Graham argues that Social Security doesn't offer a significant bequest opportunity to those who die young (although, to be fair, it also offers survivors benefits that can be very valuable).

Graham also argues that the Bowles-Simpson plan goes too far in reducing annual COLA payments, which has the result of reducing benefits most for the oldest retirees. I basically agree here: substantively, if your goal is to maintain the purchasing power of benefits I think what you'd need is essentially a chain-weighted version of the CPI-E, which tracks purchases by the elderly. This would produce annual COLAs around 0.1 percentage point lower than current COLAs calculated using the CPI-W, versus the Bowles-Simpson proposal which would cut COLAs by around 0.3 percentage points per year.

Moreover, I also think a case can be made for COLAs that are higher than inflation. The reason is that most of retirees' non-Social Security retirement income isn't inflation-adjusted, so a rising Social Security payment would help keep total purchasing power of retirement income constant over time. My pet idea here is to increase benefits along with wage growth rather than prices (nominal wage growth should of course be measured using a proper CPI; the current CPI-W almost certainly overstates the true rate of inflation). To keep lifetime benefits constant you would need to lower initial benefits, which would have the added advantage of encouraging people to retire later. Moreover, having COLAs pegged to wages would help insulate Social Security's finances against changing economic conditions over the long term, reducing uncertainty for policymakers and helping ensure that long-term reforms "stick." As part of broader reforms to maintain solvency you would reduce benefits for high earners, so the end result might not be too different from Graham's idea.

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Tuesday, December 14, 2010

New paper: Should the Retirement Age Be Increased?

"Social Security Reform: Should the Retirement Age Be Increased?", by Benjamin A. Templin, Thomas Jefferson School of Law. December 5, 2010

Thomas Jefferson School of Law Research Paper No. 1720402

In 2010, increasing the retirement age became a focal point of Social Security reform proposals. In a controversial move, President Obama's bipartisan National Commission on Fiscal Responsibility and Reform recommended increasing the full retirement age from 67 to 69 and the age at which benefits could first be claimed from 62 to 64. Both ages would be indexed to increases in longevity so further increases would be possible.

This paper is a comprehensive analysis of the issues surrounding the retirement age provisions in the Social Security Act. The paper considers the four statutory age-related factors affecting benefits - the full retirement age (FRA), the early eligibility age (EEA), the retirement earnings test and the delayed retirement credit. The principal arguments - both for and against an increase - are analyzed to the degree to which each achieves the goals of the Social Security Act. The paper reviews the literature on relevant issues including longevity rates, poverty rates, capacity to work among the elderly, labor force participation among older workers, deficit reduction, and retirement income.

The paper concludes that while most American workers have the capacity to absorb the impact of an increase in the full retirement age, the principal benefit of a deficit reduction could be achieved through alternative reforms, such an increase in the cap on taxable income, a change in COLA calculations and diversification of the Trust Fund.

The paper does, however, endorse an increase in the early eligibility age from 62 to 64. While this reform would not seriously improve the long-term deficit, it would likely keep workers in the labor force longer and increase general tax revenues. Keeping workers in the labor force is a principal goal of the Social Security system; yet contains many disincentives to delay retirement. Behavioral economics helps inform the importance of this measure given that people sacrifice long term economic goals for short-term gains. Raising the early eligibility age by two years will make it necessary for most workers to stay in the labor force longer; thereby increasing their potential benefits and increasing their eventual retirement income.

In order to soften the impact on workers engaged in psychically demanding labor, this paper agrees with the National Commission on Fiscal Responsibility and Reform recommendation to establish a hardship exception to an increase in the EEA for workers who don't qualify for disability but lack the physical capacity to work past 62.

Finally, the paper recommends a series of additional reforms to provide incentives to stay in the labor force. These include eliminating the retirement earnings test, increasing the delayed retirement credit and reducing payroll taxes for older

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Monday, December 13, 2010

Kuttner on the Coming Social Security Cave-In

Over at the Huffington Post, Robert Kuttner writes that the Obama administration is on the verge of giving in to Republican demands to gut Social Security:

If you think the Democratic base is mad at Obama now for making a craven deal with Republicans that continues tax breaks for the richest Americans and adds new ones for their heirs through a big cut in the estate tax, just wait a few weeks until Obama caves on Social Security.

How will this occur? The deficit commission appointed by the President has called for an increase in the retirement age, as well as other cuts in benefits over time. And the deal that Obama made with the Republicans just gave deficit hawks new ammunition by increasing the projected deficit by nearly $900 billion over a decade. Social Security will be in the cross-hairs.

Read it all to get the full flavor.

If by gut you mean agree to any sort of benefit reductions or increases in the retirement age, my guess is that the Obama administration – which should and does want a deal on Social Security – might agree.

But current proposals seem to fall well short of that: the deficit commission's plans wouldn't include personal accounts, which by itself can be considered a victory for the left; would increase payroll taxes on high earners, another thing the right won't be happy about; would focus benefit cuts on high earners; and would provide exemptions for low earners from the retirement age increase. In the context of the overall federal budget shortfall, which can't realistically be resolved on the revenue side, this isn't a terrible deal for the left. But I wouldn't expect the squawking to stop anytime soon.

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Sunday, December 12, 2010

Video: Talkiing retirement age on Fox

This is a few weeks old but I just was sent the video today.

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Friday, December 10, 2010

Social Security Doesn’t Contribute to the Deficit? That Was Then…

President Obama and congressional Republicans have agreed on a tax deal that includes a one-year reduction of the 12.4 percent Social Security payroll tax by 2 percentage points. This would increase take-home pay for a typical $40,000 per year worker by around $800, with maximum savings for an earner at the $106,800 tax cap of $2,136.

The intent of the move is to spur consumption by putting more money in workers' pockets, thereby boosting the economy. I'm skeptical of how well this will work—a lot of that money is going to be saved, used to pay credit card bills, etc., but that's not the major issue here.

The question is how should the payroll tax holiday make us think about Social Security? Interestingly, there seems to be some consensus from the left and right on this issue. Chuck Blahous, former policy aide in the Bush administration, writes at e21 that the payroll tax cut implies "a double-dose of new government debt, via a proposed accounting maneuver to disguise the effects of the agreement's payroll tax cut provision." Likewise, Nancy Altman, Co-director of Social Security Works, writes at the Huffington Post that "the innocent-sounding payroll tax holiday … will lead inexorably to killing Social Security." I more or less agree with both of them, although the horse pretty much left the barn on Social Security's accounting, oh, around 25 years ago, when Social Security surpluses started being used to subsidize the rest of the budget.

However, one thing that the payroll tax holiday does clarify is the Left's claim that Social Security is "self-financing" and "doesn't contribute a dime to the deficit." That was their argument for keeping Social Security off the fiscal commission's chopping block: if the program doesn't contribute to the federal deficit, then there's no justification for reducing Social Security as part of a deficit reduction package.

Well, that was then. Today, if we're funding a $120 billion payroll tax cut using general tax revenues—borrowed general tax revenues, remember—then Social Security is no longer self-financing and, yes, it does contribute to the deficit.

Of course, one could argue that Social Security has been adding to the deficit ever since the stimulus bill, which included President Obama's "Making Work Pay" tax credit. This tax credit was explicitly a refund of part of the Social Security payroll tax, financed with other tax revenues. The $116 billion 10-year cost of the payroll tax cut is effectively added to the deficit and the debt, although it remains to be seen if the credit will survive.

A talking point is a terrible thing to waste, which makes me suspect the Left will continue to claim that Social Security doesn't add a dime to the deficit. But if the payroll tax holiday is passed, its untruth should be clear to all.

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Thursday, December 9, 2010

Agenda for December 13-14, 2010 Technical Panel Meeting

2011 Technical Panel on Assumptions and Methods

Meeting Agenda

December 13-14, 2010

The meetings will be held in the offices of the Social Security Advisory Board:

400 Virginia Avenue SW, Suite 625, Washington, DC 20024

Monday, December 13, 2010

10:45-12:15 Short range assumptions and methods

Presenters: Office of the Chief Actuary

Disability and retirement over the short-range

Reconciling short and long-range methods and assumptions: beneficiary and benefit projections

12:15-1:00 Lunch

1:00-2:00 "Mortality at Older Ages: Why Has the US Fallen Behind Our Peers?"

Presenter: Dr. Samuel Preston, University of Pennsylvania

2:00-2:45 Mortality assumptions and methods

Presenter: by John Bongaarts, Panel member

2:45-3:00 Break

3:00-4:00 Discussion of mortality projections

4:00-5:00 Panel wrap-up

Tuesday, December 14, 2010

10:00-11:30 Long-range Economic assumptions and methods

    Presentation by Andrew Samwick, Panel member

11:30-12:30 Short range economic assumptions and methods

Presenters: Office of the Chief Actuary



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Social Security shuts down “restart” option

USA Today reports that the Social Security Administration has issued a regulation that effectively limits the option to "restart" Social Security benefits, which has increasingly been taken advantage of by financially-savvy retirees. The restart option allowed retirees to withdraw their application for benefits, repay the benefits they had received, the restart at a higher benefit level.

This strategy had two main advantages:

  • First, the repayment of benefits included no interest, making those benefits effectively an interest-free loan. For instance, a person who had claimed benefits $15,000 in annual benefits from age 62 through 70 could make around $15,000 on the deal, assuming a 3 percent interest rate.
  • Second, individuals who worried about dying before claiming benefits could claim at 62, then restart at later ages. This would give seniors the best of both worlds.

The regulation limits restarts to once in a lifetime and the restart must take place within 12 months of initial benefit claiming. Given these restrictions the strategy probably doesn't make much financial sense anymore, given the general hassle of visiting an SS office and running through the paperwork.

But it could allow someone who claimed at an early age then immediately decided to defer retirement another shot at doing so. There wouldn't be a direct financial benefit, but by delaying retirement the individual would assure themselves an higher benefit later in life and increased survivors' benefits for their spouse.

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Video of Chuck Blahous Social Security book event

On Monday the Heritage Foundation held an event based on the release of Chuck Blahous's excellence new book, Social Security: The Unfinished Work, available from fine booksellers everywhere (here's a link to Amazon).

You can watch the video of the event online here or over at Heritage's website.
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Wednesday, December 8, 2010

Raising the retirement age: pro and con

The Heritage Foundation's David John and the Center on Economic and Policy Research's Mark Weisbrot give the pros and cons of raising Social Security's retirement age at the Atlanta Journal Constitution. Click here to read.

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Tuesday, December 7, 2010

Jason Fichtner on Artificially Sweetened COLAs

The Mercatus Institute's Jason Fichtner – the former number 2 at Social Security – has a new policy brief on the social security COLA. Here's the background:

For the second year in a row, Social Security recipients will not receive a cost-of-living adjustment (COLA) increase to their monthly benefits. Social Security benefits only rise when prices go up; in years with low price inflation, they remain steady. And although low price inflation benefits all consumers, Congress has proposed to give every Social Security beneficiary a $250 check, which could cost taxpayers $15 billion.

While it might sound reasonable or fair to give seniors a boost during tough economic times, giving in to such demands would be misguided and undermine the very reason for tying cost-of-living adjustments to the Consumer Price Index (CPI) in the first place—to prevent yearly interest-group lobbying for higher benefit increases and, as the name implies, only provide an adjustment when there's an actual CPI-measured increase in the cost of living. Providing a COLA or one-time payment beyond what is warranted by an increase in the CPI would actually increase "real" benefits, artificially sweetening the COLA.

Check it out here.

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Wednesday, December 1, 2010

C-SPAN Video of AEI Event on the 112th Congress and the Economy

Here's a link to the panel I was on; sadly it's not embeddable. Also check out the first panel on how the health bill is being implemented; very interesting stuff that I hadn't know much about before.

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Allan Sloan’s Social Security Claims Are Turkey

Over at AEI's Enterprise Blog

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