Business & Economics

Answering Common Questions About Social Security: Part 1

How it works, how it’s financed and why it faces a financing shortfall

Image Credit: C.J. Burton/Getty Images

Social Security is the largest federal program, affecting Americans’ individual economic lives more than any other. The prominence of Social Security naturally gives rise to many questions from Americans who are trying to plan their economic futures. The questions and answers that follow are among those most commonly asked about Social Security’s current operations and status. This article is part one of a two-part series. The second part can be found here.

What is the Social Security payroll tax rate?

The combined Social Security tax rate is 12.4%. Although nominally half (6.2 points) is paid by the worker and the other half (6.2 points) by the worker’s employer, economists generally agree that both halves of the tax—that is, all 12.4 points—are deducted from the worker’s compensation and effectively borne by the worker.

At what age can Americans claim Social Security old-age benefits?

Workers’ Social Security old-age benefits can be claimed as early as age 62, although annual benefits are reduced for claims prior to Full Retirement Age (FRA), to reflect the fact that the claimant will receive benefits for more years. The FRA is increasing gradually, and it will be 67 for those born in 1960 or later. Social Security allows individuals age 62 and older to choose their age of claim based on what best fits their individual circumstances, including their health, employment status, expected longevity, economic position, available savings, other retirement income sources and other personal considerations. Individuals who are able to delay their claims can receive higher annual benefits and thereby reduce their risk of outliving their retirement savings.

Is Social Security an entitlement?

Yes. Although it has become common in social media memes to declare that Social Security is not an entitlement, it is actually the largest and most prototypical federal entitlement program. An entitlement program is one in which participants are entitled to benefits as long as they meet certain statutory criteria, without federal lawmakers needing to enact new appropriations legislation each year. There is a widespread myth that Social Security is not an entitlement program because workers have paid into it with their payroll taxes. This is incorrect. To the contrary, it is precisely workers’ entitlement to benefits established by their payroll tax contributions that makes Social Security an entitlement program.

Is Social Security fully self-financing?

Social Security is mostly but not entirely self-financing. The vast majority of program revenues come from worker payroll tax contributions, as well as from the income taxation of Social Security benefits. A smaller revenue component comes from subsidies from the federal government’s General Fund (mostly issued during 2011–2012) and from interest earnings on those subsidies. Importantly, although Social Security is designed to be self-financing, this does not mean that current benefit schedules reflect the amounts workers have paid into the system. Scheduled benefits actually substantially exceed worker payroll tax contributions, which means that unless taxes are raised, benefit growth will need to be moderated if the program is to avoid insolvency while retaining its current financing structure.

How big is the Social Security financing shortfall?

The Social Security imbalance is usually measured by the program’s trustees as a percentage of workers’ taxable earnings. In the 2020 trustees report, the imbalance was estimated at 3.21% of workers’ taxable earnings, on average, over the next 75 years. Insolvency could be prevented for the next 75 years by increasing the payroll rate by 3.14 points, from 12.40% to 15.54%, or alternatively by reducing future benefits by 23% across the board.

Why does the Social Security financial shortfall exist?

Simplifying, the shortfall arises from the interaction of three factors. One is that Social Security is not a funded system in which workers build savings to finance their own future benefits, but rather a pay-as-you-go system in which retirees’ benefits are paid from the tax contributions of current workers. A second factor is that the ratio of beneficiaries to taxpaying workers is rising because Americans are living longer, and this growth in the number of beneficiaries is being accelerated by the retirements of the historically large baby-boom generation. A third factor involves automatic benefit increases that were enacted in the 1970s, which are raising program costs higher than Social Security payroll tax contributions can finance.

Haven’t workers paid fully for their own benefits?

No, not in the aggregate. The Social Security shortfall arises because benefit schedules exceed the amount that can be financed from payroll taxes contributed by workers.

How are Social Security benefits indexed to grow automatically? Does benefit growth keep pace with changes in the cost of living?

Social Security benefits are indexed to grow in two important ways. One form of indexing determines the growth of an individual’s Social Security benefit from year to year. Once a person begins to receive Social Security benefits, they are increased each year through a cost-of-living adjustment, reflecting national price inflation as measured by the Consumer Price Index (CPI-W).

The other form of indexing causes the benefits of each succeeding birth cohort of beneficiaries to be larger than the benefits of those born one year earlier. Social Security’s benefit formula is adjusted upward from one birth year to the next with growth in the national Average Wage Index. Because wages over time grow substantially faster than price inflation, this indexing is a major engine of Social Security cost growth. Along with population aging and pay-as-you-go financing, the wage indexing of initial benefit levels is one of the main reasons Social Security finances are out of balance.

Does Social Security contribute to the federal budget deficit?

Yes. Although Social Security is designed to be self-financing on average over time, it is permitted to run cash surpluses in some years and deficits in other years. In years when the program operates cash deficits of payroll taxes relative to benefit obligations, it increases federal budget deficits, as it has done since 2010. Social Security contributes to the deficit in other ways as well. Although it is mostly funded by worker payroll taxes, federal lawmakers have occasionally contributed general revenues to Social Security’s trust funds. These General Fund subsidies add directly to federal budget deficits and debt.

Is Social Security progressive? Are parts of Social Security regressive?

Social Security is progressive on average, meaning that it provides more generous returns to individuals who have smaller earnings than to individuals with greater earnings. That said, income redistribution within Social Security is inconsistently progressive, and there are pockets of regressive income redistribution (i.e., taking money from those with less and giving it to those with more) that interfere with its overall progressivity. For example, some Social Security benefits (such as the nonworking spouse benefit) disproportionately benefit higher-income families.

Social Security’s progressive benefit formula is also fairly crude in that it operates on individuals’ average lifetime earnings rather than their annual earnings. As such, it steers higher returns as much to individuals who work fewer years over their lifetimes as it does to individuals who work consistently but are paid less. Consequently, Social Security provides more generous returns for sporadic, high-income workers, in a manner that a more precisely targeted system would deliver only to low-income households.

Does the Consumer Price Index overstate or understate price inflation faced by seniors?

Economists generally agree that the Consumer Price Index (CPI-W) overstates actual price inflation. The “chained CPI” (C-CPI-U) is a more accurate measure of price inflation because it accounts for changes in consumers’ purchasing patterns. Some have argued that an experimental measure known as CPI-E (which is usually larger than CPI-W) better reflects price inflation faced by seniors. However, the CPI-E is also inaccurate because it too is not a chained index, and thus it does not fully account for purchase substitutions.

Seniors face certain rising costs late in life for reasons other than price inflation—for example, the emergence of new health services and technologies, and the fact that seniors have more health conditions requiring care. As an analogy, consider that the owner of an older car might have more expensive repair bills than the owner of a newer car. This is predominantly because the older car needs more repairs, not because of price inflation. Similarly, seniors face higher health costs for reasons unrelated to the CPI. How to help seniors finance rising health costs is a substantial health policy challenge, but it does not bear directly on calculating the CPI.

Can faster economic growth eliminate Social Security’s financial shortfall?

Almost certainly no. Even if growth in workers’ taxable earnings were more than 50% faster than currently projected, less than two-fifths of Social Security’s long-range shortfall would be eliminated. Lawmakers must legislate financing reforms for Social Security’s finances to be protected; the problem will not take care of itself.

Will Social Security be there when today’s young workers retire?

Almost certainly yes, though there will likely be substantial changes. Social Security is currently projected to be insolvent in 2035. If trust fund depletion occurs under its current financing system, benefits will not disappear but will be reduced to the amount that can be financed by incoming payroll taxes—an estimated reduction of more than 20%. To avoid this sudden cut, lawmakers must increase taxes, slow benefit growth or both in amounts that are together sufficient to close the shortfall.

The longer these actions are postponed, the more drastic they must be and the more difficult they will be to enact. If federal lawmakers prove unable or unwilling to avert Social Security insolvency, the program will likely need to be bailed out with general government revenues, ending its historical design as a program in which workers’ benefits have been earned by their contributions.

Can Social Security’s shortfall be fixed with minor adjustments?

Social Security has passed the point where modest adjustments can correct program finances. Had the shortfall been corrected when it was first identified more than 30 years ago, it could have been fixed with very subtle, gradual changes to benefit schedules, tax schedules or both. That is no longer the case. For example, to correct the shortfall now with changes to Social Security’s payroll tax rate, lawmakers would need to immediately increase the tax rate from 12.4% to 15.54%. To correct the shortfall with benefit reductions affecting everyone retiring next year and afterward would require cuts averaging 23% beginning next year. Few Americans would consider these changes to be minor.

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