January 13, 2005
By Rea S. Hederman, Jr., William W. Beach and Andrew Grossman
proposes to solve the problem of Social Security's unfunded
liabilities by enacting a reform plan that includes personal
retirement accounts (PRAs). Proponents of PRAs argue that this sort
of reform would increase national savings, bolster employment, and
improve economic growth, all while closing Social Security's
funding gap. Opponents, such as Representative Charles Rangel
(D-NY), argue that "There is no crisis" in Social Security's
funding that demands wholesale reform and that Social Security's
shortfall is only a "challenge" that can be addressed by making
small changes to the current program.
One such change
that has been proposed would be to raise payroll taxes enough to
render Social Security solvent. Opponents of real reform are right
that raising payroll taxes could close a portion of Social
Security's funding gap, but they are wrong in saying that doing so
would require only a small change. Raising payroll taxes would make
Social Security a worse deal for millions of working Americans,
harm the economy, and cost thousands of jobs, and still would not
fix Social Security.
faces an unfunded liability of $27 trillion in 2003 dollars over
the next 75 years. This number represents the amount that the
system, despite having promised the money to America's workers,
will be unable to pay. Short of major reforms, raising taxes or
cutting benefits are the only ways to close this funding gap.
Right now, workers
pay a 6.2 percent tax on their wages up to $90,000 to fund Social
Security. Employers pay an additional 6.2 percent tax. This
division in the payroll tax is artificial, however, as employers
regard their part of the payroll tax as an expense of hiring, just
like wages and other benefits: In other words, it is money that the
employer is willing to spend on his workers. Though workers see
only a 6.2 percent deduction on their pay stubs for Social
Security, they really pay the whole 12.4 percent tax in terms of
Trustees estimate in their most recent annual report that
increasing the payroll tax by 1.89 percentage points, to 14.29
percent in total, would be sufficient to make Social Security's Old
Age, Survivors, and Disability programs solvent. This is the sort of "small change" that opponents
of reform paint as a reasonable solution to Social Security's
The average worker
might disagree. If payroll taxes were increased by 1.89 percentage
points, a worker earning $35,000 would forego an additional $662 in
pay every year. Raising payroll taxes by 1.89 percentage points
would cost this worker, on average:
In other words,
this "small change" in the payroll tax would have a major impact on
most workers' household budgets.
Using the Global
Insight U.S. Macroeconomic Model, economists at The Heritage
Foundation's Center for Data Analysis simulated a 1.89 percentage
point increase in the payroll tax.
It should be no
surprise that a tax increase of this magnitude would increase the
cost of labor in the economy and thereby have an impact on jobs.
The CDA study found that a 1.89 percentage point increase in the
payroll tax would reduce potential employment by 277,000 jobs per
year, on average, over the next 10 years relative to the
spillover effects on economic growth as well. Increasing the
payroll tax would reduce U.S. gross domestic product (GDP), a broad
measure of economic activity, by $34.6 billion per year, on
average, over the next 10 years.
the payroll tax would have a major impact on U.S. households. On
average, every American would have $302 less in disposable income
per year for each of the next 10 years, amounting to over $1,200
per year for a family of four. Personal savings would also decline
in the aggregate by $46.9 billion per year, on average, over the
next 10 years. Ironically, this decline in savings would make worse
the very problem that Social Security is intended to fix-workers
retiring with insufficient savings.
But the problem is
even more fundamental: Social Security's very structure is such
that even all this sacrifice would not be enough to save it.
Currently, the system is in a cash-flow surplus, which means that
it takes in every year more money in taxes than it pays out. But
these extra funds don't really accumulate. Instead, the government
spends them and issues the Social Security Trust Fund special
bonds, which are really just IOUs to pay back the money at a later
Social Security's Trustees, the system is set to have a negative
cash flow beginning in 2018. To pay out promised benefits, it will
have to cash in the government's IOUs, and the money to pay them
will have to come from somewhere-either higher general revenue
taxes (e.g., income taxes), lower government spending, or,
ironically, more government debt. Because of the way the Trust Fund
operates, raising payroll taxes would only delay the date when
Social Security's cash flow goes negative. Future tax increases or
benefit cuts would still be on the table.
Opponents of real
Social Security reform are right, but also deeply misleading, when
they say that the current system can be saved by making only small
changes: The changes may indeed be small, but the numbers involved
are enormous. Raising the payroll tax enough to fully fund Social
Security would put a damper on savings, jobs, and economic growth
to the great detriment of working Americans. And raising taxes
enough to take Social Security's cash-flow problem off the table
would require even more sacrifice.
Opponents of the
President's plan to reform Social Security with personal retirement
accounts should come clean when they say that the current system
can be fixed: Their medicine may be just as bad as the disease
Hederman, Jr., is Manager of Operations and a Senior Policy Analyst
in, and William W. Beach is John M. Olin Fellow in Economics and
Director of, the Center for Data Analysis at The Heritage
Foundation. Andrew Grossman is Senior Writer at The Heritage
 The Trustees base this estimate on a 75-year time
 Data taken from U.S.
Department of Labor, Bureau of Labor Statistics, Consumer
 These estimates are
preliminary and subject to change. CDA used the Global Insight,
Inc., U.S. Macroeconomic Model to conduct this analysis. The
methodologies, assumptions, conclusions, and opinions in this
report are entirely the work of Heritage Foundation analysts. They
have not been endorsed by and do not necessarily reflect the views
of the owners of the model.
Small fixes turn out not to be so small.
Rea S. Hederman, Jr.
Director, Center for Data Analysis and Lazof Family Fellow
Read More >>
William W. Beach
Director, Center for Data Analysis and Lazof Family Fellow
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