Politics & Policy

The FICA Flaw

Social Security is structurally damaged and in need of immediate repair.

When I was a teenager, I landed my first real job. That’s the kind of job that promises a paycheck at the end of a hard week’s work. I had great plans for my earnings. But when the day of anticipation finally arrived, the total dollar amount printed on my paycheck was less than what I expected. Now, I knew that there might be some federal and state income taxes withheld, but who — or what — was this FICA?

My father said that FICA stood for the Federal Insurance Contributions Act, which funds Social Security and Medicare. He explained that Social Security was the government’s way of promising older Americans an income when they retired. But, as he also explained, Social Security is a “pay-as-you-go” program: The taxes paid by today’s workers provide benefits for today’s retirees, with nothing saved for the future.

I didn’t think it would work then, and now as an adult (not to mention an economist) I understand that it cannot work. A program that doesn’t save, but instead simply transfers money from workers to retirees is sensitive to the number of workers paying in and the number of retirees collecting. It’s common sense.

When Social Security was signed into law in 1935, life expectancy at birth in the United States was 61 years, and those who reached age 65 were expected to live another 12 years. Today, life expectancy at birth is more than 76 years, and those reaching age 65 will likely live an additional 17 to 18 years. More people are living to retirement age and retirees are surviving for many more years than in the past.

Moreover, birth rates during the Baby Boom of the 1950s were almost 65% higher than those today, swelling the number of workers paying into the program. As family sizes continue to shrink, so too does the workforce that supports Social Security.

The inevitable result is that fewer workers will be available to support a growing number of retirees. The ratio of workers to retirees, which is the principal measure of a pay-as-you-go system’s financial viability, dropped from 41.9 to 1 in 1945, to 5.1 to 1 in 1960 and to 3.2 to 1 in 1975. Within 30 years, there will be just two workers for every beneficiary, creating an ever-increasing burden on American workers.

For Social Security recipients, the result of these demographic changes is declining rates of return. The return from a pay-as-you-go program like Social Security is merely labor force growth plus wage growth, which together form the growth rate of the tax base supporting the program. From 1960 to 2000, Social Security’s pay-as-you-go return averaged around 2.9% after inflation (though early retirees received much higher returns, because they did not pay in for their full careers).

From 2000 to 2075, Social Security’s pay-as-you-go return will average just 1.4%, less than half what can be received from a guaranteed government bond. Such returns are increasingly unattractive. Younger generations want and deserve better.

If Social Security is to remain strong, it must reestablish itself on a base of real savings and investment, which provide returns substantially above those of the pay-as-you-go program. This “transition” is not free, of course: We must save more now if we want to reap the benefits of a funded system down the road. But the longer real reform is delayed, the costlier the fix is likely to be.

Personal-account plans, such as the three put forward by the President’s Commission to Strengthen Social Security, can provide higher long-run benefits at lower long-run costs than the current program is capable of paying. In addition, these personal account proposals allow workers to own, control, and pass on at least a portion of their Social Security savings, and provide greater protections against poverty.

In his State of the Union address, President Bush said: “We will not deny, we will not ignore, we will not pass along our problems to other Congresses, other presidents, and other generations. . . . As we continue to work together to keep Social Security sound and reliable, we must offer younger workers a chance to invest in retirement accounts that they will control and they will own.”

The 108th Congress has a wonderful opportunity to allow workers to redirect some of their payroll taxes into individually owned, privately invested retirement accounts that promise greater economic security to all Americans. More tax increases and benefit cuts cannot possibly save a system that is flawed in its very structure and facing demographic trends that are strongly working against it. There is no time like the present to save Social Security for the future.

— Thomas F. Siems is a senior economist at the Federal Reserve Bank of Dallas and on the advisory board of the Cato Institute’s Project on Social Security Choice.


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