Fixing Social Security and Medicare

States and localities have a stake in the new bipartisan commission on fiscal responsibility.
June 17, 2010 AT 3:00 AM
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

President Obama's new bipartisan commission on fiscal responsibility cannot be allowed to fail. At the very least, it must produce a workable and lasting solution to the chronic funding problems of Social Security and Medicare. If nothing is done, these two entitlement programs will soon run short of money and face benefit cutbacks and emergency tax increases. Once Congress fixes these two programs, the U.S. government's remaining fiscal problems will have fewer moving parts.

Solutions to both programs' financial deficits will affect all Americans, including states and localities as employers. Everybody knows that Social Security is underfunded, and many realize that Medicare has a similar problem -- although few understand that Medicare is the bigger monster. Nobody expects the repair job to be easy.

Here's the four-step cure for our nation's ailing retirement-security system:

1. "Longevi-tize" retirement ages. The first national retirement system under German Chancellor Otto von Bismarck set 70 as the retirement age in 1889. German males' life expectancy then was 72 so their initial benefit period averaged two years. Germany later reduced the threshold to age 65 in 1916. That set the global pattern later adopted by America's Social Security system in 1935. U.S. life expectancy at birth back then was less than 65 because of childhood mortality. Males making it to 65 then could expect to live another 12 years. In the past 50 years, Americans' unisex life expectancy at age 65 has increased by four years and now averages 18 years. Although Social Security's full-benefits age was raised in 1983 from 65 to 67 for those born after 1960, Medicare's eligibility age remains unchanged at age 65.

To restore fiscal balance to both Social Security and Medicare, the normal retirement age for full benefits must be adjusted to reflect increased life expectancies. This prolongs the payroll tax contributions into both systems and reduces the lifetime benefits payouts, which shrinks the actuarial deficiencies. First, the Medicare eligibility age must be aligned with Social Security: today's 60-year-olds become eligible at 66. Second, the normal retirement age for both programs must be increased for those born after 1960.

By increasing the retirement age by one month for each birth year following 1960, much of the actuarial imbalance will be solved. Americans born in 1984 would receive full benefits at age 69; those born in 2008 would vest fully at age 71. (Remember that under today's underfunded system, our youngest Americans will be lucky to receive 50 to 60 cents on the promised retirement dollar at age 67.)

In order to stem their ever-rising pension costs, many state and local pension funds will eventually follow suit and match these age requirements.

2. Cap COLAs. Elderly retirees with lower incomes depend heavily on cost-of-living allowances to sustain the purchasing value of their budgets. Those with ample financial resources can independently withstand the impact of inflation. By capping the COLAs under Social Security at a fixed-dollar level, the vulnerable elderly can remain protected while the trustees balance the books actuarially. A $400 annual cap on COLAs should apply to all retirees, which still allows a 3 percent annual increase for the median retiree. Parallel phase-outs of Medicare subsidy increases for retirees above median income would be equally appropriate.

3. Feed the Kitty. Nobody wants to pay more taxes, but the measures outlined above will not solve the entire problem. So let's get realistic about the taxes that will be needed. The last trustees report showed the two systems underfunded actuarially by about 6 percent of payroll for the next 75 years. And although the benefits reforms outlined above will help a lot, higher taxes or new taxes are inevitable.

If we simply raise the payroll tax to pay the bills, the self-employment tax rate will exceed 20 percent plus those individuals' income taxes, which many would consider confiscatory. Increasing the payroll tax will only amplify and multiply the calls for state and local governments to participate universally in Social Security. (Ten states and their employees now sidestep these payroll taxes.) Thus, it may be wiser to find another dedicated tax source for these two programs, such as a value-added tax (VAT), which is ultimately a broad-based tax on consumption of both goods and services.

The VAT is disliked by some conservatives because it's a new tax that could be raised in later years, and by some liberals who think it's regressive. But it may be a superior alternative to higher payroll taxes (which are also regressive), and favors savings over consumption. Most importantly, a VAT would collect revenues from the retirees who unwittingly caused this financial problem by failing to demand fiscal reforms from Congress during their working lives. Otherwise, younger workers will increasingly pay the intergenerational cost of their parents' implicit desire to have their cake and eat it too.

For those who oppose the VAT on grounds of regressivity, there is a simple solution: Devote all revenues from the federal estate tax to Social Security and Medicare trust funds, as part of the deal. Estate taxes apply only to the wealthiest Americans. Although they generate relatively modest total revenues, they capture a commensurate share of the wealth that escapes a consumption-based tax.

In a future column, I'll explain how a national VAT could work, and might be extended to state governments as part of a broader national fiscal reform to achieve long-term sustainability and stabilization during future economic shocks. For those who hate the idea of a new tax that could feed yet more government spending, I have a suggestion below.

4. Fly with an actuarial "autopilot." No bipartisan agreement can ever be achieved unless Congress stops writing blank checks that virtually ensure future under-funding. A permanent solution must include a failsafe autopilot for both Social Security and Medicare. Otherwise, conservatives will naturally fear that increased taxes will only lead to more increased taxes. The autopilot would require automatic benefits adjustments in the future if ongoing revenues are insufficient actuarially.

The actuarial autopilot would trigger the following actions if future revenues earmarked for these programs are projected actuarially to fall short of their costs:

  • Social Security cost-of-living adjustments would be suspended that year;
  • Retirement ages would increase permanently by one more month for each year the programs are actuarially deficient;
  • Medicare subsidy levels would be frozen that year; and
  • Future payment levels would then be trimmed actuarially for those who have not yet retired.

By making these incremental budget-balancing actions automatic, the fiscal problems of these two vital programs cannot snowball by neglect, as they have in the past. Congress will then be accountable for curing financial shortfalls, instead of passing them along to the next session.

Opportunities to Negotiate

To achieve a bipartisan majority in both houses of Congress, the Obama administration will need to cut deals on both sides of the aisles. Here are some bargaining chips that could help win the necessary majorities:

For Republicans:

  • Allow younger Americans to invest some of their contributions in a personal retirement account. If they gain ground in the November mid-term elections, it's hard to imagine why Republicans will ever accept a major tax increase for these entitlement programs without a modest provision along these lines. In a future column, I'll explain how this "voluntary carve out" option could work, without undermining the system.
  • As a condition for earmarking the estate tax for Social Security and Medicare, raise the exemption from $1 million next year to $5 million, reduce the tax rate to 33 percent from 55 percent for estates under $10 million, and inflation-index the tax brackets.
  • Lockbox the VAT. Allow no federal uses of VAT revenues other than Social Security and Medicare -- just like the payroll tax has been earmarked exclusively for the entire 75-year history of these two programs.
  • Phase-in a seven-year schedule for the required tax increases. Raising taxes too quickly would jeopardize the fragile economic recovery. Any scheduled tax increases should be deferred if the economy falters. The actuarial autopilot would then kick in.

For Democrats:

  • Keep the early retirement age at 62 with actuarial reductions for both Social Security and Medicare. The current system allows workers to receive reduced annual benefits under Social Security at age 62. There is no reason that Medicare benefits could not follow the same pattern. Early retirees born in 1960 would face a reduction of 30 percent, for example. This partially offsets the higher Medicare full-retirement ages needed to align that program with Social Security and improve the actuarial balance.
  • Make catastrophic Medicare benefits available at cost for all Americans over age 57. This modest "public option" would expand the safety net without a fiscal drain, and would not threaten the health insurance industry. Coverage for claims exceeding an average worker's annual salary ($33,000) might be the right level for such a self-funded program.
  • Increase the new (health-care law's) Medicare tax on unearned income from 3.8 percent to "five-point-something" percent, in exchange for a capped 12-year increase of capital gains and dividend income taxes from today's 15 percent rate to 20 percent (and 25 percent thereafter) and a 60 percent majority voting requirement in both houses to raise any of these three tax limits before 2025. Wealthy capital markets investors would squawk but accept the deal, to eliminate tax risk in their investments.

Nobody expects these changes to come without a stormy debate, but they are all logical, necessary and inevitable. Adoption of these measures soon after the November elections would send a powerful signal to all investors who buy U.S. government bonds. America can set the example and provide political precedent for recalcitrant European leaders who need to take similar actions. Getting our fiscal houses in order will set the stage for long-term global economic growth that would reap dividends far beyond the personal sacrifices that most Americans would face to get us there. Once again, we would be world leaders, and both parties can claim victory by putting their differences aside in the national interest.