Last week was not a good one for Social Security as a campaign issue. On Tuesday, Senator Kerry's campaign speech in Wilkes-Barre (and related materials) suggested a profound disregard for the issue. President Bush said very little there on Friday about the need for reform and his principles for accomplishing it. In the briefest possible statement, here is why Social Security should be a campaign issue.
At present, the Social Security actuaries project an unfunded obligation of $10.4 trillion in the Old-Age, Survivors, and Disability Insurance (OASDI) program. This number comes directly from the 2004 Trustees Report released in March. (See Section IV.B.5 and Tables IV.B.7 and IV.B.8 in particular.) This is the present value of the projected payments less the present value of projected revenues for the system over the infinite horizon. It is the most comprehensive way to measure the hole in the system's finances.
Note that this is the unfunded part of the obligations--it is over and above all of the payroll taxes (12.4 percent of taxable payroll) and income taxes on benefits that go to support the program under current law. If this gap were to be closed through payroll taxes, it would require them to be raised by 3.5 percentage points, immediately and permanently, with the additional surpluses over the next few decades saved (in Treasury bonds) to finance annual deficits that are projected to grow to about 6 percentage points of payroll over the next 75 years.
This $10.4 trillion unfunded obligation is sometimes referred to as implicit debt, to distinguish it from the federal government's explicit debt issued in the form of Treasury bills, notes, and bonds held by the public. At present, implicit debt from Social Security and Medicare is several times larger than the government's explicit debt. Is having so much implicit debt a problem? I think so, and the reason is that, just like explicit debt, we accrue interest on implicit debt.
As an example, suppose that I made a promise to pay you $100 (in today's dollars) in 20 years. At a real interest rate of 3 percent per year (the long-term rate assumed in the Trustees Report), that obligation has a present value of 100/(1.03^20), or $55.37. I have implicit debt of $55.37 today. What happens if I don't do anything to reduce that obligation this year? Next year, with only 19 years left, the obligation will have a present value of 100/(1.03^19), or $57.03. As you would expect, the present value of the implicit debt grows at the interest rate each year, just like the value of explicit debt would if we issued more debt to cover the interest payments due each year.
So if we have an implicit debt of $10.4 trillion, and the real interest rate is 3 percent, then next year, the implicit debt will grow by 0.03*10.4 trillion = $312 billion, up to $10.7 trillion, if the assumptions underlying the projection stay the same. Why does this matter? Primarily, it matters because both the President and Senator Kerry have repeatedly stated (see the two speeches in Pennsylvania linked above) that they will not cut benefits for those at or near retirement age. (The Senator's statement may be even more encompassing, including benefits at any time in the future. I cannot tell for sure from his public statements.) This, in turn, means that each year that elapses without reform causes the burden of financing the unfunded obligations to be shifted away from one more birth cohort that crosses the threshold of being "at or near retirement." The more we wait, the larger the burden on future generations, and the higher that 3.5 percentage point surtax would have to climb.
If I were running the show, both Social Security and Medicare (which has even larger unfunded obligations) would be reformed so that under current law and reasonable economic and demographic assumptions, they are projected to have zero unfunded obligations. This means changing current law to reduce future benefits, raise future taxes, or both. It means revisiting the issue periodically to ensure that unfunded obligations never stray too far from zero due to changes in projection assumptions or the program's experience.
In some upcoming posts, I'll outline the way I would do it, as well as offer some critiques of what the candidates and their parties have (and have not) said about the issue.