August 14, 2001
Comments Presented to the President's Commission to Strengthen Social Security
Submitted by Dean Baker,
Center for Economic and Policy Research
August 14, 2001
I appreciate the willingness of the Social Security
Commission to consider a wide range of views on the problems facing the program.
This represents a very positive development. If its final report and
recommendations are to be viewed seriously, it is essential that it take these
views into consideration.
I will make three main points in my comments:
1) The commission has overstepped its bounds in questioning
the value of the assets held by the trust fund. When Congress passed the
legislation that led to the accumulation of bonds by the trust fund, it was
assigning these assets to Social Security (there is no other plausible
interpretation of this build-up). The budget issues associated with paying the
interest and principle on these bonds were not the charge of this commission.
2) If the system actually faces a shortfall after the trust
fund is depleted in 2038, it is easy to design measures that preserve the
existing system while increasing its fairness. For example, if the cap on
taxable wages was raised enough to cover the same percentage of wages as the
Greenspan Commission considered appropriate in 1983, it would eliminate nearly
30 percent of the projected seventy five year shortfall in the program. If the
cap was removed completely, the increase in revenue would be almost enough to
make the program fully solvent for its seventy five year planning period.
3) The commission appears to be operating under the
assumption that the stock market will provide substantially higher returns than
the government bonds currently held by the trust fund. There are two reasons for
believing that this is not true:
a) the Social Security trustees
project that real corporate profits will grow at approximately half their
historic rate over the program's seventy-five year planning period, and
b) the current price to earnings
ratio of the stock market is nearly twice its historic average, which has
depressed dividend yields to close to half their historic average.
The only stock projections which have actually been derived
from the trustees' profit projections show that real stock returns will
less than 4.0 percent over the seventy five year planning period (see
Dean Baker's 2nd Letter to Martin Feldstein on Stock Market Projections
and Social Security).
The difference between this projected return and the return projected
government bonds will not even enough to cover the administrative cost
individual accounts. If the commission expects a proposal for investing
the stock market to be treated seriously, it must derive its
projections for the
components of stock returns (capital gains and dividend yields) in the
rigorous manner as all the projections that appear in the trustees
Each of these issues will be addressed in turn.
The Trust Fund is an
Asset for Social Security
The Commission was asked to evaluate the future of the SS
program, it was not asked to design budgets for the federal government for the
next thirty or forty years. The commission has gone to great lengths to
emphasize that the bonds held by the Social Security trust fund, like all
government bonds, are a liability of the federal government. This claim is true,
but it has no obvious relevance to the Social Security program. Under current
law, these bonds are assets of the Social Security program.
The 1983 Social Security commission, which was chaired by
Alan Greenspan, proposed a schedule of taxes and benefits which was projected to
lead to the accumulation of a large surplus in the Social Security trust fund.
This plan was approved by an overwhelming majority in both houses of Congress,
which presumably intended this surplus to be an asset for the program in future
years (it is difficult to imagine what else it could have intended). As a
result, the Social Security trust fund has accumulated over $1 trillion in
government bonds in the last 18 years. It is currently adding more than $170
billion a year to the trust fund, as its current revenue far exceeds benefits.
If there were any doubts about the intention of Congress to
keep the finances of the Social Security program separate from the overall
budget, these should have been eliminated when Congress voted to remove the
Social Security program from the overall budget in 1990.1
As a result of this separation, the current surplus of the Social Security
program will not add to the surplus of the federal government, nor will the
deficit projected in future years add to the government's deficit. Under
current law, when the Social Security trust fund begins to rely on the interest
and principle from its bonds to pay benefits, it has exactly the same effect on
the federal budget as when any other holder of federal bonds chooses to sell its
bonds. At that point, the federal government can either borrow this money from
another source, leaving its total debt unchanged, or it can choose to run a
surplus on its budget, and pay off the debt held by the trust fund as it comes
The treatment of the bonds held by the trust fund as real
assets is more than just a semantic issue. These bonds were accumulated as a
result of deliberately setting the regressive payroll tax at a level that was
higher than necessary to pay current benefits. This could be justified, if this
money would eventually be used to support Social Security's progressive
benefit structure. However, this implies repaying the bonds held by the trust
fund with money raised through general revenue. The vast majority of general
revenue is obtained through progressive individual or corporate income taxes.
If the government defaults on the bonds held by the trust
fund, an option that the commission apparently viewed as acceptable in its
interim report, it would lead to an enormous transfer from the bottom 80 percent
of the population (the families who pay most of the Social Security tax) to the
top 5 percent of the population (the families who pay most of the income tax).
In a recent study, I calculated that such a default would transfer over $370
billion to the richest 5 percent of families, if it took place immediately, with
$270 billion going to the richest 1 percent.2
If the default did not take place until 2016, since the fund will continue to
accumulate assets in the meantime, the transfer to the richest 5 percent will be
over $1 trillion, in 2001 dollars. Given the size of the redistribution that
would result from a default on the trust fund's bonds, the public would be
right to view this as more than a semantic question.
and Alternative Scenarios
As is widely known, the Social Security trustees currently
project that the trust fund will be depleted in 2038, at which point the program
will only be able to pay approximately 72 percent of scheduled benefits.
However, it is less widely recognized that this projection rests on assumptions
that are considerably more pessimistic than those used by other government
agencies, or than recent experience indicates is plausible.
In the former category, it is worth noting the trustees
assumption that annual productivity growth will average 1.5 percent annually is
more than a full percentage point below the 2.7 percent annual rate of
productivity growth assumed by the Congressional Budget Office (CBO) in its most
recent set of projections (2001).3
The growth rate assumed by the trustees implies that productivity growth will
effectively remain at the low rates seen over the years 1973-1995 for the
indefinite future. While not all economists accept that the productivity upturn
of the late nineties will be sustained, there is little reason to expect that
over the next seventy five years productivity growth will be as low as the
country has ever seen.
On this topic, it also worth making a comparison to
projections concerning other nations. The 1994 World Bank volume, Averting
the Old-Age Crisis, (which was produced under the direction of commission
member Estelle James), included a table of projections which assumed that other
industrialized nations would sustain a 2.0 percent average annual rate of real
wage growth over the next forty years (World Bank 1994, p 159). Keeping with the
trustees projections, this table assumed that real wage growth over this period
in the United States would average just 1.0 percent. This difference in growth
paths implies that, in 2040, real wages in France, Germany, and other western
European nations will be close to 50 percent higher than in the United States.
This view seems implausible on its face. Furthermore, if it were true, it
suggests that the nation faces far greater concerns than the possibility of
shortfall in its Social Security program in thirty eight years.
The more plausible scenario is that a reasonable projection
of real wage growth for the United States would be close to the path the World
Bank projected for other industrialized nations, and to the historic average for
the United States. If the projection for the average rate of real wage growth
was raised by 0.5 percentage points, it would eliminate approximately half of
the shortfall projected over the next fifty years, and push the date of the
projected depletion of the trust fund past 2045.
The trustees assumptions on immigration also appear to be
very much out of line with the evidence. The trustees assume that immigration
will average just 900,000 annually. This is a projection which is supposed to
apply to a period when the United States will be experiencing a serious labor
shortage due to the retirement of the baby boomer cohort. By contrast, according
to data from the 2000 census, over the last ten years net immigration averaged
1,330,000 per year.4
It is reasonable to expect that we will see at least as much immigration during
the decades when the trustees project that the country will be experiencing a
severe labor shortage, as we saw in the last decade. Large inflows of
immigrants, depending on their exact timing, can significantly reduce the
shortfall currently projected for the program.
However, even if the trustees projections are assumed to be
accurate, the picture is not nearly as dire as polls indicate the public
believes. While many workers, and especially young workers, believe that Social
Security will not be there for them, the projections from the trustees show a
very different picture. The program could pay all scheduled benefits for the
next thirty seven years, with no changes whatsoever. Even after the trust fund
is projected to be depleted, it would still pay retirees a larger real benefit
than workers receive today. In fact, the projections show that a worker who is
near twenty today and earns the average wage, and expects to retire around 2045,
can expect a benefit of $1,320 per month (in today's dollars), or 25.5 percent
more than what an average retiree would receive currently.5
This would be the case, if nothing is ever done to change the program, and the
trustees projections prove entirely accurate.
It is also worth pointing out that the real source of the
projected problems in the Social Security program is simply the fact that
workers are expected to live longer in the future than they did in the past.
Longer life spans are the expected result of growing affluence and improving
medical technology. If future generations of workers choose to take a portion of
their increased longevity in the form of longer retirements, then it will cost
more money. There is no way around this arithmetic, but it does not present any
obvious crisis. We have dealt with this problem in the past -- thankfully
life-spans have been increasing since the program was created. Past generations
have chosen -- through their representatives in Congress -- to meet the costs of
a longer retirement primarily through increasing the contribution or tax rate
for Social Security during their working years. President Bush apparently does
not consider this an option at present, but given the program's financial
strength, there is no reason to be considering Social Security tax increases for
the foreseeable future.
As far as the more long-term future, no one knows how
future generations will view their options. There is certainly no evidence to
suggest that future generations of workers will be more hostile to increasing
the tax rate for Social Security than were previous generations. It is also
important to recognize that an increase in the payroll tax rate is not the only
or the best way to increase revenue for the program. The tax is currently
capped, so that it does not apply to wage income above $80,400. If this cap were
removed, it would raise an amount equal to a payroll tax increase of 1.50
percentage points, nearly eliminating the seventy five year projected short-fall
in the program.6
Removing the cap, combined with an increase in the payroll tax of 0.3 percentage
points on both employee and employer, phased in over the years 2011-2020 (if
still needed), would be sufficient to keep the program solvent over its seventy
five year planning horizon.
It is important to recognize that the increase in wage
inequality over the last two decades has contributed to Social Security's
financial problems, since a larger portion of wage income is now going to high
end wage earners, who are over the cap. The Greenspan Commission set the cap at
a level which covered 90 percent of wage income. Presently, just over 85 percent
of wage income is subject to the cap. If the cap were raised enough to again
cover 90 percent of wage income -- the level that the Greenspan Commission
considered appropriate -- it would eliminate 0.54 percentage points of the
projected shortfall, or nearly 30 percent. In other words, much of the work of
this commission could be accomplished simply by restoring the share of wages
subject to Social Security taxes to the level set by the Greenspan Commission in
There is one final point worth noting on the questions of
generational equity that have often arisen in the context of the Social Security
debate. All current projections show that future generations of workers will
both live longer and enjoy higher living standards than the current generation
of workers. The only question raised in this debate is how much better the
living standards of future generations will be, on average.
The main determinant of the well-being of future
generations will be the rate of growth of the real wage. The Social Security
trustees have projected that real wage growth will average 1.0 percent a year.
This means that the average real wage for workers in the year 2040 will be
nearly 50 percent higher than it is at present. However, many people, most
notably Senator Moynihan, the commission's co-chair, have argued that the
consumer price index (CPI) overstates the true rate of inflation by
approximately 1.0 percentage point a year. There are two important implications
to this claim, regardless of whether or not it is true.
First, an overstated CPI implies that past and future rates
of real wage growth are much higher than is shown by the official CPI. If
Senator Moynihan's assessment of the CPI is correct, and the Social Security
trustees projections prove exactly right, then the average real wage of workers
in 2040 will be nearly 120 percent higher than it is for workers today. This
would have an enormous impact on any assessment of generational equity, since
clearly out children and grand children will be enjoying far higher standards of
living than we do at present, regardless of what is done with Social Security.
The second important implication of Senator Moynihan's view
is that the real rates of return on Social Security would be approximately 1.0
percentage point higher than the numbers conventionally used. The CPI is the
yardstick by which payroll taxes and benefits are converted into a common
measure. If Senator Moynihan is correct in his assessment of the CPI, then all
calculations of rates of return must be adjusted to take into account the
overstatement, including those done by this commission in its interim report.
I have argued extensively that there is little evidence to
support the view that the CPI substantially overstates the true rate of
However, if the commission draws the opposite conclusion on this issue, then it
must be consistent and accept all the implications of its position. To do
otherwise would invite public ridicule.
The final point that I would urge the commission to take
seriously, is the need to derive projections of stock returns, based on the
components (dividends and capital gains), from the other projections in the
Social Security trustees report, if stock ownership is part of its final plan.
The trustees produce very detailed projections for all the economic and
demographic variables that are relevant to the financial health of Social
Security. For example, table V.A1 includes decade by decade projections of life
expectancy and birth rates. Table V.B1 includes decade by decade projections of
wage growth, inflation, labor force growth, interest rates, and other relevant
variables. The trustees report also includes careful explanations of how these
numbers are derived and the sensitivity of the calculations to varying each
It would be possible to construct similar projections for
capital gains and dividend yields as I have already done (see Dean
Baker's 2nd Letter to Martin Feldstein on Stock Market Projections and
M.I.T. economist Peter Diamond has also written on this topic,
great detail how projections of stock returns can be derived from the
growth projections which are implicit in the Social Security trustees
This issue is important both as a question of consistency,
and because the existing projections do not support the assumptions on stock
returns put forward by advocates of investing Social Security money in the stock
market. In terms of consistency, it makes no sense to have detailed projections
for all the relevant demographic and economic variables, without making similar
projections for stock returns. If all the other projections prove completely
accurate, but the assumptions on stock returns turn out to be too optimistic,
then the program will find itself with severe financial problems. If it is
important that the projections for other economic or demographic variables be
subject to rigorous scrutiny, then it must be important that the projections for
stock returns are subject to the same sort of scrutiny.
The second reason why it is essential that the commission
derive projections of stock returns from the other variables is that the
existing projections contradict claims by proponents of stock returns as to what
yields can be anticipated. My own work showed that real returns will average
close to 3.6 percent annually, far below the 7.0 percent conventionally assumed
by advocates of investing Social Security money in the stock market. Professor
Diamond's work showed that 7.0 percent returns would be possible, but only after
the market declined by close to 50 percent from its current levels.
The reasons why it will be impossible to get historic rates
of returns given current price to earnings ratios are simple. First, the price
to earnings ratios are presently close to double their historic average. Even
with recent declines, the average price to earnings ratio for the market as a
whole remains over 25 to 1. This compares to a historic average of approximately
14.5 to 1. As the price to earnings ratio has risen, the dividend yield
(including share buybacks) has fallen proportionately. Historically the dividend
yield has been close to 4.0 percent of the share price. It presently hovers near
2.0 percent (including share buybacks). This is an inevitable result of the
higher than normal price to earnings ratio. Firms cannot pay out more money in
dividends just because their share price is high. They generally pay out between
50 to 60 percent of after-tax profits as dividends or share buybacks. With the
current price to earnings ratio, this implies a dividend yield of just over 2.0
The other reason why projections of stock returns derived
from the Social Security trustees projections are lower than past returns is
that the trustees project that profit growth will be considerably lower in the
future than in the past. Over the last fifty years, real profit growth has
averaged more than 3.0 percent annually, measured against the consumer price
index. Real profit growth is projected to average just over 1.5 percent annually
(also measured against the consumer price index) over the next seventy five
years. Assuming that the price to earnings ratio stays approximately the same in
the future (no one considers it plausible that it would rise indefinitely) the
average real growth rate of stock prices must be approximately equal to the 1.5
percent annual projected growth rate of corporate profits.
Adding the 2.0 percent dividend yield to the 1.5 percent
real growth in share prices gives a 3.5 percent real return. This is
approximately half of the 7.0 percent real return assumed by proponents of
investing Social Security money in the stock market. The difference between the
3.5 percent projected return on stocks and the 3.0 percent real return projected
for government bonds is not likely to be large enough to even cover the
administrative costs of individual accounts.
If there is anything missing from this analysis, it should
be quite simple for the economists working with the commission to explain the
flaw. It would take a competent economist no more than an hour to derive
projections of stock returns from the Social Security trustees profit
projections. Before, hundreds of billions of workers' Social Security money is
placed at risk in the stock market, it seems reasonable to expect that the
commission would produce an analysis that would at least show how it is possible
to have the returns from the stock market which it is assuming.
In conclusion, I would urge the commission to produce a
final document that is internally consistent and meets the same standards that
the Social Security Administration applies to its work. This means first and
foremost, that the report's assumptions about stock returns -- and other issues
-- must be consistent with other assumptions that appear in the trustees report,
and are accepted by the commission. A report that is not internally consistent
cannot be taken seriously by Congress or the public.
1The removal of Social
Security's finances from the overall budget was part of the Budget
Enforcement Act of 1990, which was included in P.L. 101-508.
2 "Defaulting on the
Social Security Trust Fund Bonds: Winners and Losers," by Dean Baker,
Center for Economic and Policy Research, 2001.
Economic and Budget Outlook: Fiscal Years 2002-2011. The importance of
this difference for the Social Security projections is reduced somewhat by
the fact that CBO assumes a considerably larger gap between the rate of
inflation as measured by the GDP deflator and the rate of inflation as
measured by the consumer price index. However, even after adjusting for this
effect, the CBO projection would still add more than 0.5 percentage points
to the rate of real wage growth projected by the trustees.
4 Table QT-02, "Profile
of Selected Social Characteristics, 2000 Census.
5 This number is derived
from projected benefits that appear in the updated version of table III.B.5
in the Social Security trustees report. The projected benefit is multiplied
by the percentage of benefits that are projected to be covered by tax
6 This figure is derived
from the estimate in the Report of the
1994-1996 Advisory Council on Social Security (p 238), that raising the
cap enough to cover 90 percent of wage income would reduce the projected
shortfall by 0.5 percentage points of payroll. Since this rise in the tax
would raise the share of wage income covered from approximately 85 percent
to 90 percent, it is assumed that raising the share to 100 percent would
reduce the projected shortfall by three times as much.
7 Baker, D. 1997, Getting
Prices Right: The Debate Over the Consumer Price Index, Armonk, NY: M.E.
8 Diamond, P. 1999,
"What Stock Market Returns to Expect For the Future?" Boston, MA:
Issue Brief from the Center for Retirement Research at Boston College.