Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
February 28, 1986
Reconsidering Social Security
Many consider Social Security "off limits" in
discussions offederal budget reform. This view
- embodied formally in the Gramm-Rudman
Amendment - limits considerably the options
opento those who would balance the federal
budget. In 1985, spending on the Old Age, Sur-
vivor's and Disability Income Program (OASDI),
along with Medicare, represented about 27 per-
centof all federal spending. To eliminate the
$200 billion budget deficit entirely through
spending cuts would require a 29 percent
across-the-board cut in other spending programs
if Social Security and Medicare were untouched.
If current levels of defense spending also were
preserved, remaining domestic programs would
have to be cut by almost 45 percent.
Social Security programs limit the practicality of
resolving the budget imbalance through
increases in taxes as well, since the large size of
the Social Security tax levies already are a grow-
ing burden on wage income. Not only have
Social Security tax rates risen sharply over time
(the current combined employee and employer
tax is about 14 percent), but the level of earnings
subject to tax also has increased significantly.
The maximum Social Security tax has risen 100-
fold since 1939 and 16-fold just since 1968.
Although efforts to balance the federal budget
clearly would be made easier if current spending
on Social Security programs could be consid-
ered in budget reform, previous attempts to cut
current Social Security benefits have floundered
in Congress. Now that the depth of cuts required
in other programs is more apparent, budget ana-
lysts are once again scrutinizing Social Security
spending, particularly in light ofthe question-
able Constitutional status of Gramm-Rudman. In
this Weekly Letter, we review the case for sub-
jecting the Social Security program to the same
budgetary scrutiny as other income transfer pro-
grams.
Social Security as an entitlement
A major argument against cutting current Social
Security benefits is essentially an ethical one
since receiving Social Security retirement bene-
fits is conditioned, at least partly, on the par-
ticipation of workers in the system in their pre-
retirement years. Indeed, some workers believe
their retirement benefits approximate the current
economic value oftheir accumulated contribu-
tions to the retirement system.
In fact, the relationship between retirement ben-
efits and previous payment of Social Security
taxes is exceedingly weak. The retirement bene-
fits structure is very complex, involving a pro-
gressive benefit structure, dependency benefits
and allowances for survivors and the disabled.
As a result, a large portion of Social Security
benefits are paid to individuals on bases other
than their contributions.
Moreover, the benefits paid to individuals with
identical pre-retirement contribution histories
can be radically different. For example, a house-
hold consisting of a single, 55-year old male
can, under current law, expect to receive at
retirement upon age 65 less than halfthe retire-
ment benefits of a similar household with a non-
working wife, despite identical Social Security
contribution histories.
More importantly, Social Security benefit levels,
even in the aggregate, bear no economic rela-
tionship to prior contribution levels. The system
is funded on a pay-as-you go basis whereby cur-
rent benefits are paid out of current tax revenues
with the Social Security "trust funds" serving
only to buffer transient discrepancies between
current outlays and current Social Security reve-
nues. As a result, Social Security benefits cannot
be viewed as an annuity flowing from accumu-
lated prior contributions. Indeed, the current
population of retirees is receiving benefits three
to four times greater in value than the fair
invested value of its contributions. Such features
make the Social Security retirement program pri-
marily an income transfer program and itcould
be argued, therefore, that Social Security expen-
ditures should be subject to the same annual
budget scrutiny as other income transfer pro-
grams such as Aid to Families with Dependent
Children (ADFC).
Altered expectations
An argument against including Social Security
spending in the annual budget process is that
retirees have conditioned their retirement on the
expectation of certain benefits. Altering thoseFRBSF
benefits presumably would unfairly disrupt their
economic lifestyles at a time when they can do
little to adjust. Such an argument is based in part
on the presumption that today's generous benefit
levels were anticipated fully by the retired dur-
ing their working years and, thereby, induced
irreversible changes in working and saving pat-
terns.
On the contrary, Social Security benefit levels
rose most sharply during the 1970s as a result of
(presumably unanticipated) Congressional
actions and the interaction of Social Security
benefits formulae with inflationary shocks that
occurred at that time. (For example, benefits
were doubly boosted in the 1970s because both
the wage base and benefit levels were indexed
to inflation.) This contributed to an increase in
the incomes of the elderly of over 45 percent, in
real terms, in contrast to a decrease of 7 percent
in real wages of workers between 1970 and
1984.
There also appears to be more room than often
thought for adjusting post-retirement lifestyles to
changes in Social Security benefits. Since the
advent of Social Security, many more individ-
uals over 65 do not work at all or work only
part-time. According to the Economic Report of
the President, whereas only about 14 percent of
persons 65 years or older work today, over 2/ 3 of
persons in the over-65 age group worked prior
to the advent of Social Security. Although any
change in Social Security benefits that might
force additional elderly persons to work is
undesirable in and of itself, this disadvantage
must be weighed against the alternative of an
increasing burden on the working generations.
(According to a recent household survey, leisure
time ofyoung, working households has fallen
nearly 30 percent in just ten years.)
Retirement.incomes
Proposals to cutcurrent Social Security spending
raised the spectre of impoverishing a segment of
our populationthat seemingly already is poor
and in ill health. In fact, Social Security benefits
at the present time represent only about 29 per-
centof the income ofthe elderly when income
is imputed from all sources. The clustering of
retirement ages around the ages of62 and 65
(the ages ofqualification forpartial or total
Social Security benefits) suggests that most
retirement is notstimulated by health considera-
tions but rather by the Social Security system
itself.
There is evidence that the economic status of the
elderly is no longer low relative to other age
groups. According to data from the Department
of Commerce and the Department of Health and
Human Services, the median per capita income
of individuals 65 and over in 1983 was actually
greater than that ofthose between 25 and 65
years of age by about 10 percent. And whereas
the poverty rate ofthe general population has
risen since 1966, the poverty rate ofthe elderly
has fallen 60 percent in the same period. It is
now only about half the rate ofworking house-
holds when the value of medical services and
other non-retirement benefits are included in
income measures.
The current retired generation also has benefit-
ted significantly from the rapid appreciation in
the value of real assets - such as housing-
that occurred in the 1970s. According to Federal
Reserve data, about 70 percent of all retired
households in 1983 owned a home with an
average net equity of $70,000. In addition, 86
percent of retired households held financial
assets with an average value of over $50,000.
Demographic changes
When debating the impact of reductions in
Social Security income on the retired, it also is
important to consider the burden of current
Social Security spending levels on the current
working population. Because the Social Security
system is funded on a pay-as-you-go basis, the
income redistribution caused by any given bene-
fit policy depends critically upon the overall
demographics oftaxpaying and recipient popu-
lations and on the rate of growth ofthe econ-
omy.
Over the past decades, there have been
increases in life expectancy, and, more recently,
sharp downturns in the birthrate. As aresult,
whereas only 1 person in 18 was over 65 at the
time that Social Security was passed, by 2030
the figure will be 1 in 5. When coupled with
secular declines in the rate of economic growth,
it is not possible to improve or even maintain
the relative economic status ofthe retired gener-
ation without a dramatic acceleration in the size
ofthe burden on the youngest workers.
In response to a looming Social Security deficit,
amendments were made to the Social Security
Act in 1983. Although current benefit levels
were left largely untouched by the amendments,
future beneficiarieswiII be affected by a phased-Loss of Social Security Wealth
from 1983 Amendments*
(Households earning $25,000)
Thousands of
1983 dollars
16
Type of Household
* FromPellechio and Goodfellow.
in increase in retirement age, taxation of Social
Security benefits, and other provisions that have
the effect of reducing future benefit levels. In
addition, the scheduled increases in Social
Security tax rates were put into place imme-
diately.
Pellechio and Goodfellow have modeled the
effects of the 1983 amendments on the net ben-
efits from Social Security that can be expected
by various types of working households. They
found that the amendments represented a net
loss (relative to the prior provisions) of net Social
Security benefits to virtually all income classes,
age groups and household types, but particularly
to the youngest households. For a married cou-
ple of median income headed by a 25-year old,
for example, the amendments were tantamount
- in terms of wealth - to a one~time $10,000
to $13,000 tax (see chart). In contrast, a similarly
situated 55 year old couple faced losses Vz to lJ3
that of the young couple. Overall, for many
young households, the Social Security retirement
program can be expected to return less in bene-
fits than they will payout in taxes over their
working lifetime - the opposite ofthe circum-
stances enjoyed by the current generation of
retirees.
Consequences for the economy
Some economists argue that the very existence
of a pay-as-you-go retirement system retards
economic growth. Economist Martin Feldstein
argues that this occurs because Social Security
depresses private saving. The prospect of Social
Security benefits therefore increases lifetime
consumption. At the same time, the Social
Security tax diverts funds away from productive
investment. Recent work by Boskin and others
supports the contention that Social Security
depresses saving and investment and, thereby,
presumably retards economic growth.
A second effect on the economy may flow from
the way in which Social Security has been
altered in recent years. As mentioned earlier,
imbalances in the Social Security budget have
been resolved largely by implementing immedi-
ate increases in taxes while scheduling any
reductions in benefits far into the future. As
Burkhauser and Warlick have argued, the
postponement and ambiguity of benefit cuts may
cause current workers to overestimate their
future Social Security incomes. This, coupled
with the immediate increase in Social Security
taxes may cause them to avoid making the off-
setting increases in private saving that would be
expected to result from reforms such as those
embodied in the 1983 amendments.
Can benefits becut?
Any proposal to cut Social Security spending
raises basic issues dealing with income distribu-
tion and economic growth. What constitutes a
"fair" or equitable distribution of incomein our
society is not possible to specify objectively. It is
clear, however, that the once relatively low eco-
nomic status of the elderly is not as compelling
an argument today against cuts in Social
Security benefits. It also seems clear that the
growing burden on young workers may have
serious implications for the economic well-being
of all members ofthe society, both working and
retired, if it results in reduced economic growth
and an excessive tax on the younger generation.
It also must be recognized that many retired
households do not enjoythe "average" eco-
nomic and health conditions these statistics
imply. Any reform of Social Security spending,
therefore, must recognize the program forwhat
it is - an income transfer program that should
employ, at least partly, means and needs tests.
Randall J. Pozdena, Senior Economist
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthemanagementofthe Federal Reserve Bank of San
Francisco, orofthe Board ofGovernorsofthe Federal Reserve System. .. . .
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reserve pubhca~,ons
can beobtained from the Public Information Department, Federal Reserve BankofSan Francisco, P.O. Box 7702, San FranCISCo
94120. Phone (415) 974-2246.uo~6U!ljsom ljo~n U060JO OpOll0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
large Commercial Banks
Amount
Outstanding
2/5/86
Change
from
1/29/86
Change from 2/6/85
Dollar Percent?
Loans, Leases and Investments1 2 201,382 720 12,822 6.7
Loans and Leases1 6 182,146 801 11,633 6.8
Commercial and Industrial 52,574 507 211 0.4
Real estate 66,083 64 3,886 6.2
Loans to Individuals 38,671 - 84 6,149 18.9
Leases 5,627 - 73 337 6.3
U.S. Treasury and Agency Securities2 10,921 117 - 160 - 1.4
Other Securities2 8,315 - 198 1,347 19.3
Total Deposits 201,193 3,999 7,170 3.6
Demand Deposits 48,129 2,708 3,113 6.9
Demand Deposits Adjusted3 32,061 495 3,102 10.7
OtherTransaction Balances4 15,227 769 1,995 15.0
Total Non-Transaction Balances6 137,837 522 2,064 1.5
Money MarketDeposit
Accounts-Total 45,705 86 2,272 5.2
Time Deposits in Amounts of
$100,000 or more 38,401 354 - 780 - 1.9
Other Liabilities for Borrowed MoneyS 25,012 - 804 6,182 32.8
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
1/27/86
15
64
- 48
Period ended
1/13/86
107
3
104
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes u.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percentchange

Reconsidering Social Security

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Reconsidering Social Security

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Research Papers in Economics