October 22, 2010
Social Security Policy Options
July 1, 2010
Social Security is the federal government's largest single program, and as the U.S. population grows older in the coming decades, its cost is projected to increase more rapidly than its revenues. As a result, under current law, resources dedicated to the programs will become insufficient to pay full benefits in 2039, the Congressional Budget Office (CBO) projects. Long-run sustainability for the program could be attained through various combinations of raising taxes and cutting benefits; such changes would also affect the Social Security taxes paid and the benefits received by various groups of people. This CBO study examines a variety of approaches to changing Social Security, updating an earlier work, Menu of Social Security Options, which CBO published in May 2005. In keeping with CBO's mandate to provide objective, impartial analysis, the current study makes no recommendations.
Social Security, the federal government's largest single program, provides benefits to retired workers (through Old-Age and Survivors Insurance, OASI), to people with disabilities (through Disability Insurance, DI) and to their families as well as to some survivors of deceased workers. Those benefits are financed primarily by payroll taxes collected on people's earnings. In 2010, for the first time since the enactment of the Social Security Amendments of 1983, Social Security's annual outlays will exceed its annual tax revenues, the Congressional Budget Office (CBO) projects. If the economy continues to recover from the recent recession, those tax revenues will again exceed outlays, but only for a few years. CBO anticipates that starting in 2016, if current laws remain in place, the program's annual spending will regularly exceed its tax revenues.
Social Security's dedicated revenue stream sets it apart from most other federal programs in that the dedicated revenues are credited to trust funds that are used to finance the program's activities. Interest on the balances of those funds also is credited to the funds (which often are treated collectively as the OASDI trust funds). CBO estimates that, unless changes are made to the system, the trust funds combined will be exhausted in 2039. At that point, the resources available to the Social Security program will be insufficient to pay full benefits as they are currently structured.
This CBO study first provides an overview of Social Security and discusses some criteria for evaluating proposals to change the system. It then presents a variety of options for changing the Social Security system and analyzes the financial and distributional effects of those options- that is, how they would affect Social Security's finances and how they would alter the benefits paid to people in various earnings categories and people born in various decades.
The Outlook for Social Security's Finances
As the population of the United States continues to grow older, the number of Social Security beneficiaries will continue to rise, and the program's outlays will increase faster than its revenues. Long-term projections are unavoidably uncertain but, under a broad range of assumptions, benefits that are scheduled under current law will consistently exceed revenues.
CBO projects that beginning in 2039 the Social Security Administration will not be able to pay those scheduled benefits, however. If revenues were not increased, benefits would need to be cut by about 20 percent in 2040 to equalize outlays and revenues. Those proportionately lower payments, which would be made to all Social Security recipients once the trust funds were exhausted, are known as payable benefits.
A commonly used summary measure of the system's long-term financial conditions is the 75-year actuarial balance- a figure that measures the long-term difference between the resources dedicated to Social Security and the program's costs under current law. The actuarial balance is the value of Social Security's revenues over the 75-year period, discounted to their value in current dollars, plus the current balance in the OASDI trust funds, minus the present value of future Social Security outlays, minus the value of a year's worth of benefits as a reserve at the end of the period. CBO estimates the 75-year actuarial balance to be -0.6 percent of gross domestic product (GDP); that is, under current law, the resources dedicated to financing the program over the next 75 years fall short of the benefits that will be owed to beneficiaries by about 0.6 percent of GDP. That figure is the amount by which the Social Security payroll tax would have to be raised or scheduled benefits reduced for the system's revenues to be sufficient to cover scheduled benefits. In other words, to bring the program into actuarial balance over the 75 years, payroll taxes would have to be increased immediately by 0.6 percent of GDP and kept at that higher rate, or scheduled benefits would have to be reduced by an equivalent amount, or some combination of those changes and others would have to be implemented.
The actuarial balance averages the smaller deficits that would occur near the beginning of the projection period and the larger ones that would occur near the end. In 2084, scheduled outlays would exceed revenues by 1.4 percent of GDP.
In this study, CBO analyzes 30 options that are among those that have been considered by various analysts and policymakers as possible components of proposals to provide long-term financial stability for Social Security. The options follow the convention of not reducing initial benefits for people who are currently older than 55, and all would directly affect outlays for benefits or federal revenues dedicated to Social Security.
The options fall into five categories:
- Increases in the Social Security payroll tax,
- Reductions in people's initial benefits,
- Increases in benefits for law earners,
- Increases in the full retirement age, and
- Reductions in the cost-of-living adjustments that are applied to continuing benefits.
Each option is analyzed in isolation, although most proposals to make substantial changes to Social Security combine several provisions. Many options would interact with one another, so combining them might cause changes to the overall finances of the system that are larger or smaller than would be produced by a simple sum of the effects of several discrete options.
This list of options is far from exhaustive. It does not include changes that would draw on general government revenues, create individual accounts, or change the trust funds' investments. Other than an increase in the Social Security payroll tax, changes to federal tax policy are not considered. The options do not include any that apply only to people who receive DI benefits, although some of the options would affect OASI and DI beneficiaries alike.
Effects of the Options
This study analyzes the overall effect of each option on the finances of the Social Security system. Some options, such as those that would apply the payroll tax rate to all earnings or those that would index initial benefits to prices, would more than eliminate Social Security's actuarial deficit; others would have far smaller financial effects (see Summary Figure 1).
This study also analyzes the options' effects on taxes that would be paid and benefits that would be received by various groups of program participants. For that distributional analysis, participants are grouped by the amount of their lifetime household earnings and by their birth cohort (that is, by the decade in which they were born). Those distributional effects of the options are measured relative to the outcomes that would result both from scheduled benefits and from payable benefits under current law.
Some options, such as an across-the-board increase in the payroll tax rate or a flat reduction in benefits, would affect all participants proportionately, but some options would have disparate effects on people in different earnings groups with higher lifetime earnings by placing an additional tax on earnings above a threshold or by increasing the progressivity of the Social Security benefit formula.
Many options with similar financial effects in the aggregate would affect older and younger generations differently. In particular, the timing of the changes would affect their impact on different generations (as well as the magnitude of the change necessary to bring the system into balance). Some options, such as one that would reduce benefits by a flat 15 percent, would take effect in a single year and would affect all future beneficiaries the same way. Others would be phased in and, initially, would have only small effects. For example, a policy that gradually reduced benefits would have a much larger effect on people whose benefits began in 2040 than it would on those whose benefits began in 2020. Raising tax rates would increase the amounts paid by younger people but make little difference in the sum of taxes paid over a lifetime by people who already have left or are about to leave the workforce.
The Long-Term Budget Outlook
June 30, 2010
This Congressional Budget Office (CBO) report examines the pressures on the federal budget by presenting the agency's projections of federal spending and revenues over the coming decades. Under current laws and policies, an aging population and rapidly rising health care costs will sharply increase federal spending for health care programs and Social Security. Unless revenues increase at a similar pace, such spending will cause federal debt to grow to unsustainable levels. If policymakers are to put the nation on a sustainable budgetary path, they will need to let revenues increase substantially as a percentage of gross domestic product, decrease spending significantly from projected levels, or adopt some combination of those two approaches.
Recently, the federal government has been recording the largest budget deficits, as a share of the economy, since the end of World War II. As a result of those deficits, the amount of federal debt held by the public has surged. At the end of 2008, that debt equaled 40 percent of the nation's annual economic output (as measured by gross domestic product, or GDP), a little above the 40-year average of 36 percent. Since then, large budget deficits have caused debt held by the public to shoot upward; the Congressional Budget Office (CBO) projects that federal debt will reach 62 percent of GDP by the end of this year--the highest percentage since shortly after World War II. The sharp rise in debt stems partly from lower tax revenues and higher federal spending related to the recent severe recession and turmoil in financial markets. However, the growing debt also reflects an imbalance between spending and revenues that predated those economic developments.
As the economy recovers and the policies adopted to counteract the recession and the financial turmoil phase out, budget deficits will probably decline markedly in the next few years. But over the long term, the budget outlook is daunting. The retirement of the baby-boom generation portends a significant and sustained increase in the share of the population receiving benefits from Social Security, Medicare, and Medicaid. Moreover, per capita spending for health care is likely to continue rising faster than spending per person on other goods and services for many years (although the magnitude of that gap is very uncertain). Without significant changes in government policy, those factors will boost federal outlays sharply relative to GDP in coming decades under any plausible assumptions about future trends in the economy, demographics, and health care costs.
The Outlook for Major Health Care Programs and Social Security
CBO projects that if current laws do not change, federal spending on major mandatory health care programs will grow from roughly 5 percent of GDP today to about 10 percent in 2035 and will continue to increase there-after. Those projections include all of the effects of the recently enacted health care legislation, which is expected to increase federal spending in the next 10 years and for most of the following decade. By 2030, however, that legislation will slightly reduce federal spending for health care if all of its provisions are fully implemented, CBO projects. That reduction in the level of spending in 2030 yields lower projections of health care spending in the longer term--even though, owing to the great uncertainties involved in projecting such spending many decades in the future, enactment of the legislation did not cause CBO to change its estimates of longer-term growth rates for spending on the government's health care programs.
Under current law, spending on Social Security is also projected to rise over time as a share of GDP, albeit much less dramatically. CBO projects that Social Security spending will increase from less than 5 percent of GDP today to about 6 percent in 2030 and then stabilize at roughly that level.
All told, CBO projects, the aging of the population and the rising cost of health care will cause spending on the major mandatory health care programs and Social Security to grow from roughly 10 percent of GDP today to about 16 percent of GDP 25 years from now if current laws are not changed. (By comparison, spending on all of the federal government's programs and activities, excluding interest payments on debt, has averaged 18.5 percent of GDP over the past 40 years.) To put U.S. fiscal policy on a sustainable path, lawmakers would have to substantially reduce the growth in outlays for those programs relative to the amounts that CBO is projecting--or else match that growth with equivalent declines in other federal spending, corresponding increases in federal revenues, or some combination of the two.
Alternative Long-Term Scenarios
In this report, CBO presents the long-term budget picture under two scenarios that embody different assumptions about future policies governing federal revenues and spending. Budget projections grow increasingly uncertain as they extend farther into the future, so this report focuses largely on the next 25 years. However, because considerable interest exists in the longer-term outlook, figures showing projections through 2080 and associated data are available in Appendix A of the report, and associated data are available on CBO's Web site.
The first long-term budget scenario used in this analysis, the extended-baseline scenario, adheres closely to current law. It incorporates CBO's current estimate of the impact of the recently enacted health care legislation on revenues and mandatory spending. (That estimate is unchanged from the one that CBO and the staff of the Joint Committee on Taxation published in March, when the legislation was being considered.) Under this scenario, the expiration of most of the tax cuts enacted in 2001 and 2003, the growing reach of the alternative minimum tax, and the way in which the tax system interacts with economic growth would result in steadily higher average tax rates. Those rising rates, combined with the tax provisions of the recent health care legislation, would push total revenues to 23 percent of GDP by 2035--much higher than has typically been seen in recent decades--and to larger percentages thereafter. At the same time, government spending on everything other than the major mandatory health care programs, Social Security, and interest on federal debt--activities such as national defense and a wide variety of domestic programs--would decline to the lowest percentage of GDP since before World War II.
That significant increase in revenues and decrease in the relative importance of other spending would offset much--though not all--of the rise in spending on health care programs and Social Security. As a result, debt would increase from its already high levels relative to GDP, as would the required interest payments on that debt. Federal debt held by the public would grow from an estimated 62 percent of GDP this year to about 80 percent by 2035. Interest payments, which absorb federal resources that could otherwise be used to pay for government services, currently amount to more than 1 percent of GDP; under this scenario, they would rise to 4 percent of GDP (or one-sixth of federal revenues) by 2035.
The budget outlook is much bleaker under the alternative fiscal scenario, which incorporates several changes to current law that are widely expected to occur or that would modify some provisions of law that might be difficult to sustain for a long period. In this scenario, CBO assumed that Medicare's payment rates for physicians would gradually increase (which would not happen under current law) and that several policies enacted in the recent health care legislation that would restrain growth in health care spending would not continue in effect after 2020. In addition, under the alternative scenario, spending on activities other than the major mandatory health care programs, Social Security, and interest would fall below the average level of the past 40 years relative to GDP, though not as low as under the extended-baseline scenario. More important, CBO assumed for this scenario that most of the provisions of the 2001 and 2003 tax cuts would be extended, that the reach of the alternative minimum tax would be kept close to its historical extent, and that over the longer run, tax law would evolve further so that revenues would remain at about 19 percent of GDP, near their historical average.
Under that combination of policy assumptions, federal debt would grow much more rapidly than under the extended-baseline scenario. With significantly lower revenues and higher outlays, debt would reach 87 percent of GDP by 2020, CBO projects. After that, the growing imbalance between revenues and noninterest spending, combined with spiraling interest payments, would swiftly push debt to unsustainable levels. Debt as a share of GDP would exceed its historical peak of 109 percent by 2025 and would reach 185 percent in 2035.
Neither of those scenarios represents a prediction by CBO of what policies will be in effect during the next several decades. The policies adopted in coming years will surely differ from those assumed for the scenarios. (And even if the assumed policies were adopted, their economic and budgetary consequences would certainly differ from those projected in this report.) Nevertheless, these projections, encompassing two very different sets of policy assumptions, provide a clear indication of the serious nature of the fiscal challenge facing the nation.
The Impact of Growing Deficits and Debt
In fact, CBO's projections understate the severity of the long-term budget problem because they do not incorporate the significant negative effects that accumulating substantial amounts of additional federal debt would have on the economy:
- Large budget deficits would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment--which in turn would lower income growth in the United States.
- Growing debt would also reduce lawmakers' ability to respond to economic downturns and other challenges.
- Over time, higher debt would increase the probability of a fiscal crisis in which investors would lose confidence in the government's ability to manage its budget, and the government would be forced to pay much more to borrow money.
Keeping deficits and debt from growing to unsustainable levels would require raising revenues as a percentage of GDP significantly above past levels, reducing outlays sharply relative to CBO's projections, or some combination of those approaches. Making such changes while economic activity and employment remain well below their potential levels would probably slow the economic recovery. However, the sooner that long-term changes to spending and revenues are agreed on, and the sooner they are carried out once the economic weakness ends, the smaller will be the damage to the economy from growing federal debt. Earlier action would require more sacrifices by earlier generations to benefit future generations, but it would also permit smaller or more gradual changes and would give people more time to adjust to them.