Tax Foundation: State-level statistics on effect of lifting payroll tax ceiling

The Tax Foundation provides state-by-state data on the number of individuals who would be affected by proposals to eliminate the payroll tax ceiling, with or without a "donut hole" as proposed by Sen. Obama. One thing that becomes apparent is that very few workers would be affected with the $200k or $250k donut hole exemptions, which is one reason why they address less than half the 75-year shortfall while eliminating the cap for all workers above the current ceiling of $102,000 would come close to fixing it.

Also worth noting is that the Tax Foundation's data is based on an annual cross section; while very few people earn over the taxable maximum in any given year, over their working lifetimes around one-in-five has at least some earnings above the cap. Read more!

A Social Security pander from Obama

I know that much of my published work seems to be picking on Barack Obama (see here and here…). This isn't really intentional – the vast majority of what I'm working on has nothing to do with the candidates or the election. Nevertheless, things continue to pop up…

The latest Social Security-related proposal from Sen. Obama is to exempt any senior earning less than $50,000 from income taxes. His campaign claims this would save 7 million retirees an average of $1,400 per year.

Why is an exemption from income taxes a Social Security proposal? Because most income tax revenues from lower income seniors are from income taxes levied on their Social Security benefits, and under law those income tax revenues go back to Social Security to help keep the system solvent for the future. In other words, this income tax cut for seniors would be paid for largely out of Social Security money.

How much would it affect Social Security? This is very ballpark, but $1,400 times 7 million equals $9.8 billion per year in lost income tax revenues per year. Let's assume that all of that would otherwise flow to Social Security. The total payroll tax base in 2008 is estimated by the Trustees at $5.567 trillion, so a reduction of $9.8 billion is equal to around 0.18% of payroll. Assuming this ratio remains constant in coming years, the income tax reduction for seniors would increase Social Security's 75-year shortfall of 1.7% of payroll by around 10%.

To me, that seems a bit much for what's pretty clearly an election-year pander to a voting group – older voters – that Obama has a distinct weakness with. According to Gallup, McCain leads Obama among older voters by 51% to 35%, which almost matches Obama's 57%-37% lead among individuals aged 18-29 and would certainly more than match Obama's advantage among young voters due to older folks far greater likelihood of voting. (According to the Census Bureau, individuals age 65 and over are twice as likely to vote as individuals age 18-24.)

I don't take particularly seriously any candidate's claim to be a "different kind of politician" – our problems with partisanship are basically a function of our political structures and the fact that neither party is currently dominant. But still, Senator Obama has placed a lot of emphasis on practicing "a new kind of politics" and this Social Security pander looks distinctly old school to me.

Granted, Senator Obama has proposed a tax change that would more than cover the cost of the tax cut for seniors. Obama would eliminate the current "cap" on the 12.4 percent payroll tax, though with a "donut hole" exemption for workers earning between $102,000 and $250,000 per year. Phased in over 10 years, my estimate is that this would fix around 36% of the 75-year shortfall, though at the cost of raising the top marginal tax rate on earned income from around 37.9% – 35% income taxes and 2.9% Medicare taxes – to over 50%.

Whatever the merits of the Obama proposal, after netting out the tax cut for seniors Obama's plan would fix only around one-quarter of the long-term shortfall. To his credit, Obama has taken the Social Security problem seriously, at least in rhetoric. As the campaign has progressed, though, his policy seems less and less serious on the issue.

Read more!

IBD: Obama And McCain Divided On Reform For Social Security

Jed Graham writes in Investor's Business Daily on how Senator's Obama and McCain stack up on Social Security reform. I'm briefly quote, and will expand on the point at the bottom.

The Social Security fixes touted by John McCain and Barack Obama couldn't be any further apart — unless Obama was offering a true fix.

McCain would close looming Social Security shortfalls by curbing benefit promises. Obama would leave benefits untouched and rely just on tax hikes — though not nearly enough to erase the funding gap.

But their plans do share one common feature: Both would likely be dead on arrival in Congress, say Social Security reform advocates.

"They're both very politically attractive options if you're running in a primary," said Andrew Biggs, resident scholar at the conservative American Enterprise Institute. "I don't see either as being politically feasible."

Still, their plans give a sense of the priorities each would bring as president to any serious talks with Congress. McCain would push for Social Security reform that depends much more on spending restraint than new taxes. He is prepared to ask for broad sacrifice.

"My children and their children will not receive the benefits we will enjoy," he said in a 2006 speech on entitlements. "That is an inescapable fact, and any politician who tells you otherwise, Democrat or Republican, is lying."

Half A Plan

Obama doesn't want to ask anyone who isn't rich to sacrifice. He'll push for a big tax hike on higher earners and eschews benefit cuts.

"The best way forward is to adjust the cap on the payroll tax so that people like me pay a little bit more and people in need are protected," Obama said recently. "That way we can extend the promise of Social Security without shifting the burden on to seniors."

The 12.4% Social Security tax phases out at $102,000, but Obama would slap the tax on high earners.

He says he would create a "donut hole," shielding some wages above $102,000 from the tax so as not to "ensnare middle class Americans."

Only the tiny fraction of workers earning perhaps over $200,000 would be hit. While workers only pay half the 12.4% tax, employers would most likely pass on their share by reducing worker salaries.

This hike would come on top of Obama's bid to reverse the Bush tax cuts for higher earners to pay for expanding health care coverage. Thus the top marginal rate on wages could near 55% vs. 37.9% now, including Medicare taxes.

By reserving such a big tax hike for Social Security, Obama would limit the options for dealing with far more daunting fiscal challenges posed by Medicare and Medicaid.

"It's important for people not to look at Social Security in isolation," said Robert Bixby, executive director of the fiscal watchdog Concord Coalition.

"It's easier to do cost control for Social Security than it is for Medicare," he said. "If you use the revenue option for Social Security, that means it might not be available for other things."

But Bixby suspects that any politically viable Social Security fix will include benefit cuts and tax hikes.

Closing entitlement deficits by relying "exclusively or perhaps even primarily on increased revenues . . . could significantly impair economic growth," the Congressional Budget Office has said.

An IBD analysis shows that a 12.4% tax on wages over $200,000 would only delay Social Security's cash-flow deficits by four years to 2021. Over 75 years, the plan would erase just half of the $6.5 trillion unfunded liability at present value.

That includes $2.2 trillion of government IOUs in the trust fund. As Social Security's trustees noted last year, "Treasury must still come up with this amount in future cash" to make good on those IOUs.

McCain has yet to spell out how he'd alter benefits, such as lifting the retirement age. But the changes would be big. By 2041, Social Security could only pay 78% of scheduled benefits without tax hikes.

McCain has long backed the idea of letting workers invest some of their Social Security taxes to try to offset some of the benefit cuts.

President Bush pushed personal accounts in 2005, but made little headway on Capitol Hill.

Obama has attacked the idea as a way to "gamble away people's retirement on the stock market."

In a possible hint at compromise, McCain said he favors "some form of personal retirement accounts."

McCain might accept accounts financed via a dollop of income on top of the payroll tax, Bixby says.

"Then you get into the question of whether it's a tax increase," he said. "I don't think it is. The money wouldn't be going to the government."

Some context on my thoughts: In a Republican primary, it's almost impossible to talk about any form of increased revenues for Social Security, while in a Democratic primary it's almost impossible to talk about any reductions in benefits. This is not to say that either candidate favors a path other than the one they've outlined, but merely what is appealing to either party's base is not necessarily something that can pass in Congress and be signed by the President. Ultimately, Social Security reform will be a package of different provisions. While interest groups on either side pressure candidates to rule out provisions they don't favor, Congress and a President McCain/Obama will in the end have to say yes or no to a package. Should a president oppose an otherwise perfect bill because it contained a penny of tax increases/benefit cuts? If not, then it probably makes sense for them to keep their options open and focus on how to build a process where both sides can get together to hash things out. Read more!

Response to questions on Angry Bear

Over at Angry Bear, Bruce Webb posts a number of questions on Social Security financing and reform put together by Arne. These raise a number of important and interesting issues which deserve treatment at some length, so rather than post in the comments I thought I'd do a fresh post here.

 

1. What should we do if the SSA intermediate forecast is right? When and how would we change?
   

   The intermediate forecast is the Social Security trustees and actuaries "best guess" of the program's finances going out into the future. CBO also puts out a forecast based on its own best guess, which is slightly more optimistic than SSA's but qualitatively similar.
   

   If we assume the intermediate forecast is correct, what should we do? Actually, the easier question to answer is 'when should we do it?', the answer to that being that we should start immediately. Why? Because any solution will be both economically more efficient and generationally fairer if we spread it across as many cohorts as possible. The deadweight losses associated with tax increases are more than proportional to the tax rate, so it's better to have a small tax increase over a long time than a large tax increase focused on a smaller number of cohorts. Likewise, it is easier to adjust to small benefit reductions than to large ones, so starting today means everyone make adjust a bit.
   

   How should we fix Social Security? This demands a long answer, but to make it short I would: a) focus on reducing promised benefits rather than increasing taxes. Why? Principally because we're going to need all the taxes we have, plus some, to fix Medicare; it's relatively easy for people to make up for reduced Social Security benefits by saving more, while it's tougher on the health care side. b) I would introduce some measure of prefunding; this is designed to smooth cost burdens over generations, such that today's generation pays more so future ones can pay a bit less. I'm fine on this being a 'carve-out' financed from the existing payroll tax so long as the associated transition costs are 'paid for', meaning not borrowed. Otherwise, an add-on funded with new contributions is preferable. c) I'd change the tax/benefit structures to simplify the program to make it more understandable; equalize treatment between different household types (why should single earner couples get a better deal than dual-earners?); and encourage delayed retirement (say, by increasing the early retirement age, reducing the payroll tax at older ages to encourage work, and increasing the normal retirement age). This is a rough sketch, but more or less lays things out.
   

2. Which is really more important, productivity or demographics?
   

   Demographics are almost certainly more important than productivity (a view I believe most experts on either side would share). Because retirement benefits are indexed to wages, higher productivity/wages translates to higher benefits. Because benefits for current retirees are indexed to inflation, not wages, increased wage growth will reduce costs relative to the wage base for a while. But once the higher wages start to filter through to new benefits, costs stop declining.
   

   Fertility and mortality (i.e., life expectancies) play a more direct and longer-lasting role. Increased life expectancies have only a small positive effect through taxes (a few working age people live longer and pay in more) but a large negative effect through benefit costs (if people live longer, we must pay them for a greater number of years). Fertility has a large effect by increasing the ratio of workers to retirees, which directly reduces costs. The effects of fertility may be exaggerated in the 75-year financing measure, since it counts all the taxes these new workers pay but not all the benefits that will be owed to them, but it's still a major factor.
   

   Anyone interested in the relative importance of the different variables should check out the sensitivity analysis in the Trustees Report, which shows the effects of different values for each.
   

3. Given that the TF lasts at least 20 more years, is moving (some of) it from US Treasuries to equities a good idea? How does that change with LC instead of IC?
   

   While I tend to favor private investment (through personal accounts) for purposes of pre-funding – i.e., putting aside more money today to reduce costs in the future – I don't believe switching from bonds to stocks is of major importance. Any investment has a combination of risk and return, and at market equilibrium the total 'value' provided by each investment is around the same. That is, the safety of bonds compensates for their lower returns, while the high returns on stocks compensate for their higher risk. There's reason to believe that stock returns still tend to be higher than is necessary to compensate for their level of risk, meaning there's something of a 'free lunch' to holding them. For that reason, some stock holdings may make sense, especially for low earners who can't save on their own. But overall I've shifted toward CBO's view of things, in which stocks aren't treated as 'free money' for the system, versus the SSA actuaries' view which tends to focus on returns more than risk.
   

4. Is solvency relevant?
   

   If the program becomes insolvent, by law it can no longer pay full scheduled benefits. That will be a pretty important consideration for people at the time. More broadly, we should be thinking in terms of the efficacy of the program and the relative costs and benefits allotted to different generations. Those aren't solvency related, but are nevertheless quite important.
   

5. Are the stochastic projections (Appendix E) meaningful?
   

   The stochastic projections, which attempt to quantify the uncertainty regarding future financing projections, are far superior to the Low Cost/Intermediate Cost/High Cost scenarios the actuaries have traditionally used. CBO uses only a stochastic simulation to portray uncertainty. Why are the Low/High Cost scenarios flawed? Each demographic and economic variable (wage growth, fertility, etc.) is assigned a high and low cost value, in addition to the intermediate value that we generally focus on. The Low or High Cost scenarios combine the low and high cost values for each variable to show how things turn out if everything goes right or everything goes wrong. What's wrong with this? First, there is no probability assigned to the low and high values for each variable – they're just 'low' and 'high'. What's that supposed to mean? Is there a 10% chance of being low or high? 5%? 1%? We don't knows. Second, the Low Cost and High Cost scenarios assume that every variable takes its low or high cost value, regardless of whether it's likely that they would occur together. That is, there's no accounting for the covariation between the different variables.
   

   How does the stochastic analysis work? Each variable has an average value derived from the Trustees intermediate projections. However, it's also allowed to randomly vary from year to based on how that variable varied in the past. For instance, let's assume that real wage growth has an average value going forward of 1.1% per year (this is the intermediate projection, but also the average over the past 40 years). Based on historical date, real wage growth has a standard deviation of 2.1 percentage points. Using a random number generator, the actuaries create thousands of outcomes for real wage growth in each year going forward. They do a similar exercise for each of the other variables. They then feed each random scenario into the actuarial model to calculate the actuarial balance. Each individual random scenario has no real meaning, but together they give a much better view of the level of uncertainty regarding future Social Security financing. The stochastic model isn't perfect, and work is continuing to improve it. But now that the stochastic analysis is available, I personally believe that relying on the Low and High Cost scenarios is all but indefensible – they're simply inferior to the stochastic analysis.
   

6. What do the 1984 and 1985 reports show us about intent?
   

   This question is a little hard to understand, since the Trustees Reports in general don't discuss Congressional intent. If the question is, did Congress in the 1983 reforms intend to cause a big trust fund buildup over the next four decades, which would then be drawn down over the following four decades or so, the general view is 'no.' Neither the Greenspan Commission nor Congress were very well aware that the system would be running large surpluses through the early 21^st century, largely because the SSA actuaries didn't provide them with this information. The Commission's concern was maintaining short-term solvency through the 1980s, since benefits were at risk of not being paid, and then reaching 75-year solvency. They would submit potential reforms to the actuaries, who would then tell them whether they system was solvent or not. As I understand it, the Commission was not provided with the year by-year data we take for granted today. There's a good report from the Congressional Research Service on this episode – very instructive.
   

7. Why did the TF ratio outperform expectations in the late 90's? Can it do so again?
   

   The main reason the Trust Fund ratio (and system financing in general) outperformed expectations in the late 1990s was that the Trustees and actuaries underestimated the strength of the economy at that time. The Trustees are reluctant to jump on board with new trends in economic or demographic thinking, at least in terms of applying them to their long-term projections. This caused their Reports in the late 1990s to look pessimistic. However, most economists have now backed off the most optimistic views of the "new economy" and extremely high future productivity. Had the Trustees bought into that view their Reports in the 1990s would have looked more accurate, but they'd be forced to back off significantly today. Can the system outperform expectations again? Sure, and it almost surely will. But it will almost surely underperform expectations as well. For instance, recent Reports might not have anticipated the current economic slowdown and so the system might underperform for a year of two. But the ups and downs of the business cycle aren't very meaningful with regard to their longer term projections.

Read more!

GAO: Long-term still unsustainable

The Government Accountability Office released an update to their long-term fiscal outlook. GAO illustrates taxes and spending under two baselines:

The first is “Baseline Extended,” which follows the CBO’s January baseline estimates for the first 10 years and then simply holds revenue and spending other than large entitlement programs constant as a share of gross domestic product (GDP). The second is the “Alternative simulation” based on historical trends and recent policy preferences. Under these alternative assumptions, discretionary spending grows with the economy rather than inflation during the first 10 years, Medicare physician payments are not reduced as in current law, and revenues are brought down to their historical level.

The following table summarizes the fiscal gap under the two baselines.

So we have a choice between a 17% increase in federal taxes or reduction in spending under the optimistic baseline, or a 36% increase in taxes or reduction in spending in the other. As with other analyses, most of this is driven by cost growth in health care, with smaller contributions from Social Security and other programs. Sobering stuff. Read more!

Obama discusses Social Security reform

Here's Barack Obama in Gresham, Oregon discussing Social Security reform, both his own ideas and criticism of Sen. McCain:



Obama says that a first priority is to stop spending the Social Security surplus, which implies balancing the non-Social Security "on-budget."

Second, he opposes any changes such as increasing the normal retirement age or reducing annual cost of living increases, because he believes his own plan -- eliminating the payroll tax ceiling, with a "donut hole" between the current ceiling of $102,000 and around $250,000 -- will be sufficient.

Obama proposes eliminating income taxes on Social Security benefits for individuals earning less than $50,000 in retirement. Obama says this will benefit around 7 million people, at an average of $1,400 per person. As this income tax revenue currently flows to Social Security, this will reduce the program's solvency. (While I don't know the source of his numbers, taking him at his word this would cost around $9.8 billion annually -- a lot of money, though relatively small on Social Security's scale.)

Obama also discusses his plan to automatically enroll individuals in workplace defined contribution pension plans. This is a very good idea, with bipartisan support. (See this proposal from the Retirement Security Project at the Brookings Institution.)

Update: A friend emails: "I guess Obama is unconcerned about generational equity. He wants to reduce taxes on people already getting the best deal (current retirees) and increase them on the generations already getting the worst deal (current workers)."

Me: Hard to deny that's the net result Sen. Obama's policies. To a large degree, Social Security is all about spreading cost burdens over time; making Social Security an even better deal for current retirees will require larger tax increases or benefit reductions on future participants. It's not clear why that's justified on either a policy or a moral basis, though electorally it's got an obvious appeal. Read more!

New paper: Social Security Cost-of-Living Adjustments and the Consumer Price Index

Clark Burdick and Lynne Fisher of SSA have an interesting paper in the latest issue of the Social Security Bulletin, which includes a lot of information I'd not previously known on the CPI and the CPI for the elderly (CPI-E), which some have proposed using to calculate Social Security Cost of Living Adjustments. Here's the summary of "Social Security Cost-of-Living Adjustments and the Consumer Price Index."

OASDI benefits are indexed for inflation to protect beneficiaries from the loss of purchasing power implied by inflation. In the absence of such indexing, the purchasing power of Social Security benefits would be eroded as rising prices raise the cost of living. By statute, cost-of-living adjustments (COLAs) for Social Security benefits are calculated using the Bureau of Labor Statistics (BLS) Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI‑W). Some argue that this index does not accurately reflect the inflation experienced by the elderly population and should be changed to an elderly-specific price index such as the Experimental Consumer Price Index for Americans 62 Years of Age and Older, often referred to as the Consumer Price Index for the Elderly (CPI‑E).

Others argue that the measure of inflation underlying the COLA is technically biased, causing it to overestimate changes in the cost of living. This argument implies that current COLAs tend to increase, rather than merely maintain, the purchasing power of benefits over time. Potential bias in the CPI as a cost-of-living index arises from a number of sources, including incomplete accounting for the ability of consumers to substitute goods or change purchasing outlets in response to relative price changes. The BLS has constructed a new index called the Chained Consumer Price Index for All Urban Consumers (C‑CPI‑U) that better accounts for those consumer adjustments.

Price indexes are not true cost-of-living indexes, but approximations of cost-of-living indexes (COLI). The Bureau of Labor Statistics (2006a) explains the difference between the two:

As it pertains to the CPI, the COLI for the current month is based on the answer to the following question: "What is the cost, at this month's market prices, of achieving the standard of living actually attained in the base period?" This cost is a hypothetical expenditure—the lowest expenditure level necessary at this month's prices to achieve the base-period's living standard. . . . Unfortunately, because the cost of achieving a living standard cannot be observed directly, in operational terms, a COLI can only be approximated. Although the CPI cannot be said to equal a cost-of-living index, the concept of the COLI provides the CPI's measurement objective and the standard by which we define any bias in the CPI.

While all versions of the CPI only approximate the actual changes in the cost of living, the CPI‑E has several additional technical limitations. First, the CPI‑E may better account for the goods and services typically purchased by the elderly, but the expenditure weights for the elderly are the only difference between the CPI‑E and CPI‑W. These weights are based on a much smaller sample than the other two indices, making it less precise. Second, the CPI‑E does not account for differences in retail outlets frequented by the aged population or the prices they pay. Finally, the purchasing population measured in the CPI‑E is not necessarily identical to the Social Security beneficiary population, where more than one-fifth of OASDI beneficiaries are under age 62. Likewise, over one-fifth of persons aged 62 or older are not beneficiaries, but they are included in the CPI‑E population.

Finally, changes in the index used to calculate COLAs directly affect the amount of benefits paid, and as a result, projected solvency of the Social Security program. A switch to the CPI‑E for the December 2006 COLA (received in January 2007) would have resulted in an average monthly benefit $0.90 higher than that received. If the December 2006 COLA had been adjusted by the Chained CPI-U instead, the average monthly benefit would have been $4.70 less than with current indexing. Any changes to the COLA that would cause faster growth in individual benefits would make the projected date of insolvency sooner, while slower growth would delay insolvency. Hobijn and Lagakos (2003) estimated that switching to the CPI-E for COLAs would move projected insolvency sooner by 3–5 years. A projection by SSA's Office of the Chief Actuary estimated that annual COLAs based on the Chained C‑CPI‑U beginning in 2006 would delay the date of OASDI insolvency by 4 years.

My take-away from this is that there isn't currently a perfect option for measuring price changes for the elderly. The CPI-W suffers from overstatement; the CPI-U is a better measure overall but not well-geared toward the elderly; and the CPI-E would need further development before it could be well utilized. For reform purposes, a well developed chained-CPI-E might be a good compromise: it would track the spending patterns of the elderly better than any current measure, and would likely reduce COLAs somewhat but not so much as using the current chained CPI. However, developing a new measure of inflation would be major undertaking by BLS.

Update: A friend emails that Social Security is not by law required to use the CPI-W. When BLS introduced the CPI-U SSA considered using it, but decided to remain with the CPI-W. What I'm wondering is whether this discretion implies that SSA could shift to the chained CPI without legislation.

Read more!