How to Save Social Security

(This article previously appeared on the American Institute of Economic Research site.)

Since its enactment in 1935, Social Security has become an important feature of the retirement landscape for all Americans. But its finances are in need of repair, and we can’t simply ignore the problem.

Since 2010, the taxes paid into the Social Security system have been falling short of the benefits paid out. The Social Security system is consuming the surplus that was accumulated in earlier years and, as estimated by the Social Security Trustees, this surplus is expected to run out in 2034, at which point it will become impossible to pay the benefits at the level currently promised.

The problem is a demographic one.

In 1960, there were about five workers for every Social Security beneficiary. This meant that there was plenty of money coming into the system to support the claimants, even with Social Security tax rates much below today’s level. By 1990, that ratio had fallen to about  3 1/2 workers for every beneficiary — still sustainable. By 2010, there were a bit under three workers for every beneficiary, and the program started running a deficit. The problem is worsening, and by 2030 we are expected to have only about two workers per beneficiary.

Because Social Security is an important part of the financial life of nearly everyone in the United States, reforming it is a complex and often emotional topic. At the end of the day, there are only two ways to fix the problem: increase revenues or reduce the outlays in some fashion.

Any reform will adversely affect some groups while helping others. Nevertheless, some reform is needed in the next few years, or Social Security will start imposing a significant burden on the federal budget. There are many reform proposals out there, and it would be impossible to discuss them all in detail here. (We discuss some of the major proposals in the American Institute of Economic Research’s Research Brief, Reforming Social Security.)

Every option for reform has opposition, but it still should be possible to create a package of reforms that would fix the finances of Social Security. The advantage of the package approach is that the burden of adjustment is spread among all societal groups, so no one is seen as clearly benefiting at the expense of others.

One example of a possible package of reforms:

Raise the cap on taxable earnings (this closes about 30 percent of the program’s financial gap) Social Security’s payroll tax is currently capped at earnings of $118,500 a year; a figure indexed to the national average wage index. In the 1950s and 1960s, when the cap was much lower, less than 80 percent of all wages were taxed by Social Security. Over time the cap was raised, and by 1983, about 90 percent of covered wages were taxable. Since then, it has fallen to around 83 percent. Some have called for raising the cap to a level that would again cover 90 percent of earnings; currently, this would be about $275,000.

Gradually raise Social Security’s Full Retirement Age (this closes about 25 percent of the gap) This has already been done once, from age 65 to 66, and another increase, to 67, is on the way. People argue that the Full Retirement Age should be raised because the average life expectancy of Americans is rising. In effect, people are receiving more lifetime benefits by virtue of living longer than previous beneficiaries. One proposal calls for gradually raising the retirement age from 67 in 2023 to 70 in 2069 and gradually raising the early retirement age from 62 to 65, while eliminating Social Security’s delayed retirement credits.

Change the way Social Security benefits are indexed for the annual cost-of-living adjustment (which closes 10 percent of the gap) Policy makers and economists have argued that the current indexing formula does not accurately reflect changes in the cost of living. Some, including President Obama, have proposed using a different index —the chained CPI (Consumer Price Index), which accounts for people purchasing lower-cost alternatives in response to rising prices. Using the chained CPI would reduce cost-of-living adjustments.

Raise payroll taxes to cover the rest (the increase would be about 1 percent, split between employer and employee) By contrast, an increase of 2.7 percent, split between employer and employee, would cover the 75-year financing shortfall for Social Security.

With this assortment of changes, all major groups in society face some costs.

Those who are working and far from retirement age would face decades of higher payroll taxes, and the taxes would be much higher for high earners, because the taxable cap is raised.

Those who are close to retirement would not pay the higher payroll taxes for much longer, but they would have to accept a higher retirement age. And current Social Security beneficiaries would see lower cost-of-living adjustments in the future.

Sooner or later, lawmakers are going to need to confront this difficult question, and every year of delay makes it a more difficult choice. When the burden of reform is spread among all major stakeholders, the chances of such a reform being adopted increase.

And if the reform is composed of several changes, each change can be made less drastic, making it possible for people affected by it to adjust more easily.