Heritage Foundation Leadership for America

The Social Security system, according to its own actuaries, faces a financial crisis of immense proportions. The Office of the Chief Actuary of the Social Security Administration (SSA) is projecting that within 15 years, the system will begin taking in less money than it needs to pay the benefits promised to participants. Moreover, within 30 years, it will have only enough money to pay less than 75 cents of every dollar of benefits it promises. By 2075, using its intermediate assumptions, Social Security will be running an annual deficit of $562 billion (in 1999 inflation-adjusted dollars). ²

Despite these dire predictions, supporters of the current Social Security system blithely assert that the problem can be solved by faster economic growth. Without much evidence, they claim that current economic projections are entirely too pessimistic and that the financial shortfall will disappear if the numbers are made more optimistic.

Robert Reich, former Secretary of Labor in the Clinton Administration, for example, has called the SSA economic projections "wildly pessimistic." ³ Economist James K. Galbraith claims that if higher growth rates were substituted for the SSA's projected rates, "future deficits disappear without any cuts in benefits or increases in taxes." ⁴ These assertions were bolstered by the Department of Commerce's October 1999 adjustment in its economic growth figures, which shows that the U.S. economy grew at a faster rate from 1959 through 1998 than previously estimated. ⁵

Regrettably, claims that Social Security can be saved by faster economic growth are wrong. If anything, the projections underlying the Social Security Administration's forecasts are likely to be overly optimistic. ⁶ And even if the SSA massively underestimates the future rate of economic growth, higher growth will have little impact on the system's solvency. By some measures, faster growth could even add to Social Security's problems.

Consistent with the SSA's own approach, this analysis attempts to capture the impact of economic growth caused by many factors (such as new technology, improvements in skills and training, deregulation, and capital accumulation) to the extent that this economic growth is reflected in greater worker productivity and higher wages. An increase in other sources of income, such as dividends or rent, does not increase Social Security payroll tax revenues (or benefits).

An increase in average wages has two effects on the balance between Social Security expenditures and revenues. First, an increase in the average earnings of workers and the self-employed increases the payroll tax base and the amount of payroll tax revenue that is available to pay benefits. This improves the solvency of the Social Security system.

However, there is also a second effect. According to current law, the Social Security benefit to which a retiree is entitled is calculated as a proportion of the value of the "Average Wage Index" on the year of retirement. ¹¹ Each year, the Average Wage Index is calculated by the Social Security Administration using the average value of wage, salary, and self-employment income for all workers in the economy. If, in a certain year, the Average Wage Index increases (due to the faster growth of wages in the real economy), the Social Security Administration must pay higher benefits to workers who are retiring in that year.

While this effect is initially small in the first year, the impact becomes greater over the long term as successive cohorts of workers retire, each of whom must be paid higher benefits as the average amount of wages rises because of this increase in the Average Wage Index.

In short, an increase in the average wage earned by workers not only increases the revenues that the Social Security Administration has available to pay benefits, but also increases the benefit obligations that the Social Security trust fund must meet. Over the long term, the positive revenue impact of wage growth comes close to being cancelled out by the increase in benefit obligations that it also generates.

The Projected Effect of Faster Economic Growth.
The Social Security Administration's "best guess" of future economic and demographic conditions is represented by the "Intermediate Assumptions" scenario that SSA publishes each year in the Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. These projections include estimates of future mortality, fertility, inflation, economic growth, and interest rates that are used to forecast the expected revenues and expenditures of the Social Security system over the next 75 years.

The Social Security Administration also makes projections based on a pessimistic "High Cost Assumptions" scenario and an optimistic "Low Cost Assumptions" scenario. These two sets of forecasts represent, respectively, fiscal outcomes where all of the underlying demographic and economic conditions are much less favorable and a scenario in which conditions will be much more favorable than the Social Security Administration projects. ¹²

Charts 2 through 6 show the future fiscal condition of the Social Security system under a scenario in which wages grow at the rate projected by the Social Security Administration in its "Low Cost Assumptions" (or extremely optimistic) scenario, but where all other economic and demographic variables (fertility, life expectancy, inflation, and interest rates) occur exactly as projected in its "Intermediate Cost" (or "best guess") scenario. In short, the projections hold constant all of the SSA's demographic and economic projections except for average wages, which the author of this analysis assumes will grow at the rate projected in the SSA's most optimistic scenario. ¹³

The projections shown in Charts 2 through 6 assume that average wages grow at an annual rate of 1.4 percent after inflation over the next 75 years, rather than the 0.9 percent rate projected in the SSA's "Intermediate Cost" scenario. This 1.4 percent rate of wage growth was selected because it is the rate used by the Social Security Administration in its "Low Cost" or optimistic set of projections. In other words, the scenario reported in these charts assumes that over the next 75 years, wages grow at a rate that is 56 percent faster than the rate projected by the Social Security Administration in its "best guess" about future economic conditions.

To give an idea of the magnitude of this difference in growth rates, consider that if wages grow at the 1.4 percent rate projected in Social Security's most optimistic scenario, by 2075 the average wage per worker in the United States would be $83,374 (in terms of 1999 dollars), rather than the $57,438 predicted under the SSA's "Intermediate Cost" set of projections.

The degree to which the projection of 1.4 percent annual real growth in wages is extremely optimistic becomes clear when one considers the historical rates of growth of wages. According to the Social Security Administration's 1999 annual trustees' report, "the average annual rate of change in average real earnings for the total U.S. economy was an increase of 0.9 percent for the 40 years 1958-97." ¹⁴ The report also states that the average annual real growth in wages during the decades 1968-1977, 1978-1987, and 1988-1997, respectively, was 0.4 percent, 0.0 percent, and 0.8 percent.

In other words, under the Social Security Administration's "best guess" scenario, wages will grow at least 12.5 percent faster than they actually have in any decade since the 1960s. The optimistic scenario used in this analysis assumes a 1.4 percent annual real growth rate in wages that lies more than 56 percent above the growth rate of U.S. wages in the entire period since the mid-1950s. ¹⁵

As can be seen from both Chart 2 and Chart 3, the faster growth in wages pushes back the date of insolvency by a mere two years, from 2014 to 2016. By 2035, the annual deficit is equal to 3.85 percent of taxable payroll under the scenario of rapid economic growth, only 1.19 percentage points below the deficit of 5.04 percent of taxable payroll that occurs under the Social Security Administration's baseline assumptions. By 2075, Social Security's annual shortfall as a percent of payroll is equal to 5.12 percent under the assumption of faster wage growth, compared with 6.54 percent under the SSA's intermediate projections.

Chart 2 shows the annual expenditures and revenues of the Social Security system as a percent of taxable payroll under two sets of assumptions: the Social Security Administration's "Intermediate Cost" (or "best guess") assumptions and a scenario in which wages grow at an annual rate that is 56 percent faster than under the SSA's "Intermediate Cost" assumptions. Chart 3 reports Social Security's annual deficit or surplus as a percent of taxable payroll in each of these two scenarios. Expressing Social Security's revenues and expenditures as a percent of taxable payroll enables us to examine the surplus or deficit relative to the tax base that is potentially available to fund the system's needs.

The implications of the projections shown in Chart 4 can be expressed in terms of the increase in payroll taxes needed to balance the Social Security system under each set of assumptions.By 2040, even under the scenario in which wages grow at a rate that is 56 percent faster than is currently projected, the Social Security OASDI tax rate would have to be raised by 30 percent (or 3.76 percentage points) over the current rate of 12.4 percent to pay promised benefits. By 2075, OASDI payroll tax rates would need to be increased by 5.12 percentage points above the current level of 12.4 percent to 17.52 percent in order to generate sufficient revenues to pay the benefits promised under current law.

Social Security's financial position also can be measured in terms of inflation-adjusted dollars. While the system's deficit or surplus as a percent of taxable payroll is a good measure of the balance of the system relative to the potential tax base, expressing the balance in terms of inflation-adjusted dollars gives a very good sense of the absolute financial burden of any imbalance.

Chart 4 shows the effect on Social Security revenues and expenditures (in terms of 1999 inflation-adjusted dollars) of a 56 percent increase in the growth rate in real wages above the rate projected in the SSA's "Intermediate Assumptions" scenario. As Chart 4 shows, the increase in economic growth causes an increase in both Social Security benefits and taxes over the next 75 years.

As can be seen in Chart 5, an increase in the rate of wage growth has little impact on Social Security's financial health, measured in 1999 inflation-adjusted dollars. If the economic growth rate is raised by 56 percent, the Social Security system's insolvency date--when revenues can no longer cover benefits--is pushed back by a mere two years (from 2014 under the "Intermediate Assumptions" scenario to 2016).

In fact, increases in economic growth lead to increases in Social Security deficits during the years after 2055. Under the scenario of a 56 percent jump in the growth rate of wages, by 2075 Social Security's annual deficit is $629.9 billion (in 1999 inflation-adjusted dollars), an amount that is $67.8 billion higher than the $562.1 billion deficit existing under the SSA's "best guess" assumptions. This hike in the deficit occurs because faster economic growth eventually results in larger dollar increases in benefits than in revenues.

CONCLUSION

According to projections made by the Social Security Administration's own Office of the Chief Actuary, even a massive 56 percent increase in the rate of economic growth above projected levels will do little to solve Social Security's financial crisis. If the average annual growth rate of wages over the next 75 years is increased from 0.9 percent to 1.4 percent, by 2035 the Social Security system will still be able to pay out only 77 cents for every dollar of promised benefits. In that year, benefits must be cut by 23 percent, or payroll taxes increased by 30 percent from the levels promised in current law, if the system is to remain in balance.

In fact, by some measures, the projections from the Office of the Chief Actuary suggest that faster economic growth actually may hurt rather than help the system's long-term financial health. According to the Social Security Administration's projections, if wages grow at an annual real rate of 1.4 percent, by 2075 the OASDI program will be running annual deficits of about $630 billion (in inflation-adjusted 1999 dollars). By comparison, the program's annual operating deficit will be "only" $562.1 billion by 2075 if wages grow at only 0.9 percent per annum.

The long-term financial crisis facing Social Security is very real and cannot simply be wished away by assuming future rates of economic growth that are higher than any figure that is justified by the evidence. Even if wages grow for the next 75 years at a rate 56 percent above the actual growth rate achieved in the period since World War II, Social Security will continue to face dire financial problems. Under the current pay-as-you-go structure, these problems can be solved only by drastic cuts in benefits or by massive hikes in payroll taxes, which would hurt current and future generations and drive down their rates of return from the program.

The real solution to both the solvency crisis and the rate of return crisis confronting Social Security is to create a system that allows workers to fund their retirement by investing their own payroll taxes rather than relying on the payroll taxes paid by younger generations.

Gareth G. Davis is a former Policy Analyst in the Center for Data Analysis at The Heritage Foundation.