What To Do About Social Security

In our two previous posts, we showed that Social Security is a type of Ponzi scheme and that the system's current trajectory is clearly unsustainable. In this article, we will now turn our attention to possible solutions.

In this discussion, we will endeavor to focus on general principles rather than minute details. I recognize that no one cares, and no one should care, what precise level I think payroll tax rates should be or what the retirement age should be or anything else that specific. (Conveniently, I also have no interest in doing the research and math necessary to define details that would work.) Instead, we'll be interested to explain the features that would make up a good plan, and those features that we should want to avoid.

We should also note for any libertarian-types that may read this, that we're taking for granted the fact that some form of taxation will exist. There are interesting and compelling arguments that can be made against taxation on a purely philosophical level, but we're nowhere near the point where those arguments have a chance politically. Thus, it is still useful and necessary to discuss the relative merits of possible alternatives. We are not trying to define a perfect system; now and always, we are just trying to define a system that sucks less.

With those disclaimers out, let's begin by noting the key elements of the present system (and we'll focus on the old-age benefits). The exact eligibility rules are stupidly complicated, but this gives you the general idea:

• Individuals over the retirement age (which ranges from 65 to 67 depending on when you were born) are generally eligible to claim Social Security benefits.
• The amount of benefits one actually gets varies based on a few different factors, but the average monthly benefit in November 2015 for a retired worker was $1,340.
• These benefits are indexed to a metric that measures inflation, so that the benefits theoretically rise at the same rate as overall prices. (In economist-speak, we would say that the real (inflation-adjusted) wages are designed to remain constant over time.)
• The benefits are financed by payroll taxes collected from wages. The relevant payroll tax rate for Social Security is 12.4% in total (6.2% directly out of your paycheck which you see, and a matching 6.2% that is paid by your employer). 
• Wages over and above $118,500 (in 2015 and 2016) are exempt from taxation. The idea is that people that make more than that probably won't need Social Security and so shouldn't be required to pay a tax on all of their wages.

Now that we have the general outline, let's begin by discussing some of the bad solutions.

Immediate Abolition of Social Security

No one likes Ponzi schemes or payroll taxes, so the simplest solution to the Social Security shortfall might be to just end it as soon as possible. Under such a system, we could either let the Social Security Administration use its current $2.8T reserves to pay down benefits for a while until it runs out. Or we could cut off benefits immediately and let those reserves be used to combat the rest of the government's deficit. Either way, the ultimate outcome is the same. Many of the 43 million people that depend on Social Security retirement benefits will be abruptly and unexpectedly cut off in short order.

Now it's difficult to know exactly how many of these people truly need the benefits and who just collects because it's available. But it seems safe to assume that a significant number of seniors are entirely dependent on this income. Cutting them off would be devastating to them and likely destabilizing to our country general. Indeed, it's tough to imagine the precise consequences of millions of people losing a key income source virtually overnight. But it would not be good. Moreover, it would obviously be politically impossible. Any politician that managed to pass such a scheme would be quickly voted out by those 43 million in the next election, and the policy would be undone anyway.

Just as important, the current beneficiaries didn't do anything to deserve that fate. To be eligible, they paid money into the system for multiple years and that was paid out to older generations. It may not be fair to force the Millennials and Generation Xers to subsidize the Baby Boomers, but then it wasn't fair that the Baby Boomers had to subsidize the previous generations either. This is the problem of the system's design; someone was always going to be left holding the bag. But even if we set aside the practical consideration of what would happen if millions lost their income source, it does not seem just to force one particular generation to suffer all the consequences of a failed policy.

Privatize the System

As a general rule, the competitive free market system is capable of providing goods and services at a higher quality and lower cost than the government. You don't need to believe this is universally true to acknowledge that it is generally true. No one thinks the Post Office would do a better job than Apple or Google at making smart phones, and people are unlikely to choose the state-subsidized Amtrak over a bus or plane, even on purely economic grounds. Indeed, Amtrak is really a wonderful case because the government has somehow managed to make moving people along the ground with minimal friction, consistently more expensive and dangerous than flying those same people through the air. How this could possibly be so is difficult to fathom.

But I digress. The point is that we accept the general idea the free market tends to produce more efficient outcomes than the government. Thus, when people propose that a current function of government be privatized, this often sounds like a good idea. And it may be. But all too often, privatization schemes really just amount to the government choosing to benefit particular private interests at the expense of everyone else. So-called privatizing of Social Security is one example of this.

When people refer to privatization, they are most likely referring to a setup similar to 401(k) plans. Instead of paying to the Social Security slush fund, workers would start contributing to an account that is specifically for them. This solves the wealth transfer / Ponzi scheme aspect of the present system, which is a good thing. But the problem is that then the government would inevitably prescribe rules for how these funds could be invested, just as they have for 401(k) plans. So, if you're lucky, you'd get to choose between a small handful of mutual funds invested in equities or bonds. And these funds would invariably be managed by the big investment firms. This would artificially cause more money to flow into the stock and bond markets, driving prices higher than they would otherwise be. Additionally, it's a gift to the Wall Street firms who get to take a cut out of the money you have invested in their mutual funds, and which you can't avoid. So while owning your money is an improvement, restraining your freedom to use that money and giving a handout to Wall Street should be opposed.

Some people recognize the problem of giving more handouts to the Wall Street firms and have proposed an alternative privatization solution. Economist Lawrence Kotlikoff, who has written extensively on Social Security, has proposed one such plan. Under his solution, individuals would be required to pay 8% of their wages to a dedicated account. Then this account would be automatically invested in a diversified market portfolio determined by the government, thereby cutting out Wall Street. The problem is that now you have no choice in how your money is invested at all; you're just counting on the government's computer algorithm to do a good job. But, as if acknowledging this flaw, the plan has a built-in solution for this as well: the government just guarantees a minimum return. That is, if the investments didn't produce enough profits, the government will step in to increase it.

In this system, we still have more money artificially being forced into the stock and bonds markets, distorting prices. And now the government is guaranteeing returns. So at the end of the day, even though the system is theoretically privatized, all taxpayers are once again on the hook to transfer wealth to others. The system would work fine if prices were generally rising. But if the economy tanks, the system would be in just as much trouble as the current Social Security system is now. Thus, it's hard to see how this is a good solution.

Just Increase the Payroll Tax

In yesterday's post, we noted that the projected shortfalls in Social Security could be remedied if an immediate 31% payroll tax hike (from 12.4% in total to about 16.3%) was imposed on working Americans. On the surface, this doesn't seem incredibly bad. But remember, this doesn't resolve the underlying problem with Social Security. It's still an inter-generational wealth transfer and politicians will still have powerful incentives to let the system become insolvent again.

Perhaps a more important objection, however, is that the payroll tax is a really awful device. You see, a common understanding in economics is that if you tax something, you'll get less of it. Tax cigarettes, and people will smoke less. Tax alcohol and less alcohol will be consumed. Tax the payroll, and you get fewer jobs. This is intuitive, because the payroll tax directly increases how much an employer has to spend to get the same amount of labor. For instance, if a would-be employee expects their take-home pay to be $938 a week, the employer has to pay $1,062 / week just for the salary and Social Security taxes. This example uses a gross pay on the paycheck of $1,000. The employer would pay 6.2% or $62 directly to the Social Security Administration, and the employee would see 6.2% or $62 come out of their gross paycheck. And that's just for Social Security, before income taxes, or Medicare taxes. If the payroll tax didn't exist, the employer might pay their employee the full $1,062 or they might keep the savings and be that much closer to affording another worker. Either way, it's easy to see how the payroll tax increases the cost of hiring and paying workers.

Another problem with the Social Security payroll tax is that it's not progressive at all. If a homeless guy gets a job and starts making $500 a month, he would pay the same rate as I do on my salary as a financial analyst. Some may agree with this setup, but I find it difficult to say that people at that level of desperation should be required to support the government. When it comes to income taxes, the same homeless guy wouldn't be required to pay anything. But the payroll tax is the ultimate blunt instrument, and no one is allowed to escape its effects.

The combination of these issues, the evils of payroll taxes in general and the particular evils of our current payroll tax, makes it difficult to advocate for simply increasing the rate. If the payroll tax is already bad and the Social Security system is broken, it naturally follows that we shouldn't proceed by doubling down on both.

Solutions to Support

Having discussed the flaws of several popular solutions, we can proceed to define the characteristics and features of a reform plan worthy of support.

Here are some of the key guidelines for an optimal solution:

• Gradual - the solution should be implemented slowly over time to avoid causing abrupt hardships
• Shared burden - No individual group is to blame for the current problem, and no existing group has disproportionately benefited. Thus, the cost of the solution should be borne by all parties.
• Voluntary investing - the government should not force individuals to save or invest in a particular way. Individuals should be allowed to make financial decisions for themselves.
• No corporate handouts - Individual private firms should not benefit directly based on the policy that is adopted.
• Avoid Ponzi schemes - Ponzi schemes, especially political ones, are inherently unsustainable. In the long-term, such structures should be phased out to put the government (and the individuals) on a more sound financial footing
• Simple - The Social Security system is notoriously complex and therefore wasteful.
• Tax incentives matter - The current payroll tax directly discourages hiring. Most other forms of taxation are far more benign and should be preferred.

Based on those priorities, we believe the ideal solutions will contain some combination of the following features, which were inspired in large part by the proposal offered by DownsizeDC, a think tank that is oddly good on almost every issue. Anyway, here are some possible features:

Social Security Opt-out
Steps need to be taken to reduce the future liabilities of the Social Security system. However, it's unlikely that they can be reduced enough for the system to meet its obligations without collecting taxes from the people in the workforce today. However, working Americans should be given the option to opt-out of receiving Social Security benefits in the future in exchange for having a lower payroll tax rate now. Given the choice between a tax cut today and promised payments from the US government many years in the future, few people would be foolish enough to choose the second option.

This is the most important feature of the plan because it creates a mechanism to gradually phase out the Social Security retirement system in a voluntary way. It also presents a way to reduce the harms done by the payroll tax in the short-term.

Means-tested benefits
Social Security is not intended to be a government-backed investment product. It was implemented during the Great Depression to protect those citizens that were perceived as particularly vulnerable. In keeping with this spirit, and given that cuts must be made somewhere, the ideal solution should consider reducing or eliminating benefits to wealthier individuals that can support themselves without Social Security income.*

Of course, some may argue that this would make Social Security a "bad deal" for rich people that paid taxes for many years and now receive limited benefits, if any. But this is the nature of a Ponzi scheme; each subsequent participant tends to get a worse outcome than the one that preceded them. And to call Social Security "a deal" is somewhat misleading in the first place. No individual chose to be a part of Social Security, and there was no bargaining involved. It must be reiterated that Social Security is not a government-sponsored annuity product that anyone volunteered for; it is a wealth transfer program created by law in which everyone is required to participate. That some people benefit at the expense of others is inherent in the system's design. It's a "bad deal" for some precisely because it was never a deal to begin with. The purpose of reforming the system is to limit these harmful effects as much as possible.

Increasing the retirement age
When the Social Security system was implemented, the US life expectancy was considerably shorter than it is today. This is part of the reason it's in financial straits. Thus, a solution to reduce the future liabilities of the system is to phase in further increases to the retirement age before benefits start. This increase should be phased in gradually on a go-forward basis to limit the harm done to recent retirees and others on the brink of retirement, who have made long-term plans based on the current rules.

Cut Federal spending
Wasteful government spending in other areas can be reduced to further shore-up the system and possibly enhance the degree of the opt-out provision. While cutting spending is always difficult, presenting cuts as necessary to protect Social Security should give proposals a fighting chance.

Alternative taxation forms
As discussed above, most other forms of taxation would be preferable to the negative effects of payroll taxes. Eliminating special deductions and/or loopholes in the income tax code, imposing property taxes, or creating national sales tax would all likely be better alternatives to the payroll tax, even if they were revenue neutral. This isn't essential for reforming the system, but since Social Security relies on payroll taxes, it's worth considering.

Don't Replace Social Security
As we have seen, it is important to avoid replacing Social Security with a "privatized" solution that seeks to achieve the same purpose. Americans should not be coerced into saving for the future or investing in a particular way. By phasing out the Social Security retirement system and replacing it with nothing, individuals will be given greater control over their money, Wall Street interests won't reap any special benefits, and we will eliminate the need for any kind of federal bureaucracy to track or enforce savings. Replacing it with nothing is the prudent solution.

Ultimately, there are no easy solutions to the Social Security problem, but some solutions are clearly superior to others. Regardless of what part of the political spectrum you come from, no one wants to see handouts to investment banks or more false promises from the government. And the next time this issue comes up, hopefully this discussion will help all of us distinguish serious proposals from politics as usual.

*At first blush, it may seem that the same reasoning deployed to justify means-testing could be used to justify disproportionate taxation on the rich. We won't get into the details of income taxation in this article, but for now, it is important to point out that reducing government benefits is fundamentally different from confiscating more wealth through taxes. The net effect on the individual looks similar , but the underlying logic varies significantly. Assuming no fraud or theft was committed, income taxes take money from an individual that they have earned by providing value to other people, either employers or customers. Thus, if we increase the tax rate on higher-income individuals, we are simultaneously punishing them for providing value to others and reducing their incentive to do so.

By contrast, entitlement benefits from the government have not been earned. It's true that Social Security recipients paid into the system previously, but this fact alone tells us very little. We pay taxes for all kinds of things that we never directly benefit from, and for many things that actually harm us (for example, our foreign policy). That is the nature of all taxation, and it is why voluntary exchanges in the marketplace are preferable wherever possible. Ultimately, the purpose of the Social Security system and tax was to provide for vulnerable members of society. And just as it would be a scandal if Warren Buffett was on food stamps, it is reasonable to consider reducing benefits to retirees that are financially secure.