The Hidden Dividend of Social Security Reform

T he federal government faces an enormous fiscal challenge. Deficits and debt are both far higher than they should be, and early in the 2030s — when both Social Security and Medicare are projected to become insolvent — the budget faces a day of reckoning. Taxes must increase, or spending must be cut.

But a new analysis of Social Security reform options from the University of Pennsylvania’s gold-standard Penn Wharton Budget Model shows there are two ways to address the debt: the hard way and the easy way. Economic growth is a dimension that Washington’s usual scorekeepers largely miss. But it opens doors for entitlement reform, both economically and politically.

Social Security faces a financing shortfall exceeding $30 trillion. The traditional question is how to divide the burden between higher taxes and lower benefits. Those arguments are well-worn, but as senior voters gain power, both parties now promise to “protect” Social Security benefits.

But the Penn Wharton analysis shows that balancing Social Security’s books isn’t necessarily the same as reducing the federal government’s looming fiscal gap. How we choose to fix Social Security could have dramatically different effects on the deficit and debt.

The most important measure of the government’s debt burden is the ratio of debt to gross domestic product, or debt divided by GDP. This measures the dollar value of the debt against the size of the economy that must service that debt.

Most analyses of Social Security reform plans focus on the numerator of the debt/GDP equation while ignoring the denominator. That is, they look at how much of Social Security’s funding gap a set of reforms addresses, without thinking about how those same reforms affect the economy.

Penn Wharton addresses that shortcoming. Its budget model evaluated seven reform packages, each calibrated to fill Social Security’s 75-year funding gap. The most revealing comparison is between two packages that achieve the same result for Social Security but take opposite routes to get there.

The first reform package relies entirely on taxes. It immediately raises the combined payroll tax rate from 12.4 percent to 13.73 percent, with further increases to 15.63 percent by 2100, and sharply increases the taxable earnings ceiling from $191,400 in 2027 under current law to $332,100. The package also taxes earnings above that ceiling at half the total payroll tax rate, without providing additional benefits.

The second package relies entirely on benefit reductions. It gradually and progressively lowers initial retirement benefits, limits the benefits on which cost-of-living adjustments (COLAs) are paid, and raises the full retirement age from 67 to 70.

The tax-increase and benefit-reduction packages have nearly identical effects on Social Security’s long-term funding gap: it is erased. Yet their effects on federal indebtedness are very different. By 2060, the tax-increase package reduces federal debt relative to GDP by 14.3 percentage points, compared to the Congressional Budget Office’s budget baseline in which Congress borrows to pay scheduled Social Security benefits. The benefit-reduction package lowers the debt-to-GDP ratio by 29.2 percentage points, more than twice as much, despite having an identical effect on Social Security’s finances.

Why does one solvency fix accomplish so much more than the other? What it comes down to is how people would react to different Social Security reforms.

When Social Security benefits are reduced, people tend to work and save more on their own to make up the difference. For any given person, these effects may be small. But compounded over millions of people and many years, the economy grows faster. The Penn Wharton model projects that, under the benefit-cuts package, GDP would be 12.1 percent above the baseline by 2060, thereby increasing the denominator of the debt/GDP equation.

On top of that, when people respond to lower future benefits by earning and saving more, the Treasury collects additional income and investment taxes. That reduces debt even outside of Social Security. By comparison, Penn Wharton projects that GDP under the tax increase package is just 0.4 percent higher than it would be if Congress simply borrowed to fund Social Security.

Now, this isn’t a free lunch. People expecting smaller Social Security checks must save more during their working lives, meaning they consume less today. That’s why Social Security benefit cuts are unpopular. But there may be a way to sell a Social Security reform package based on benefit reductions.

Federal debt is currently about 100 percent of GDP, and the Congressional Budget Office projects it will approach 175 percent by 2056. In reality, a fiscal crisis is likely well before then. Congress must address the rising debt, one way or another.

The tax-increase Social Security reform package offsets less than one-fifth of the projected increase in debt. The benefit-focused package offsets nearly two-fifths. The benefit-reduction Social Security reform package reduces the debt burden, so other costly programs such as Medicare don’t have to cut as much.

In other words, though cutting benefits to save Social Security is unpopular, the dramatic economic gains from a benefit-reduction reform package make it far easier to save Medicare. That’s a better sell to voters than raising taxes doubly to salvage both entitlements.

Social Security isn’t just another federal program. It’s the largest federal program, spending $1.7 trillion annually, and rising. The 12.4 percent Social Security payroll tax is the largest tax most workers pay. And Social Security benefits are the largest source of income for most retirees. Social Security is big enough to matter for the U.S. economy as a whole, and changes to the program can have far-reaching economic effects. For policymakers to ignore Social Security’s economic impact is to miss half the story.