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BACKGROUND

paper

Financing Social Security:
Issues for the
Short and Long Term

July 19 77

Congress of the United States
Congressional Budget Office
Washington, D.C.

FINANCING SOCIAL SECURITY:
ISSUES FOR THE SHORT AND LONG TERM

THE CONGRESS OF THE UNITED STATES
CONGRESSIONAL BUDGET OFFICE

For sale by the Superintendent of Documents, U .S. Government Printing Office
Washington, D .C . 20402

PREFACE
This year the Congress faces the difficult problems arising
from the weakened financial status of the social security system.
Because the program is so large — making up one-fifth of the federal
budget and touching the lives of most American households — changes
in the financing structure of social security can have important
effects on other parts of the budget as well as on individuals and
the U. S. economy in general. Many options are available for closing
the projected near-term and long-term deficits in the old-age,
survivors and disability insurance program.
Financing Social
Security discusses some of the major alternatives.
Because the report was prepared before the announcement of the
Carter Administration's proposal for refinancing the social security
system, the Administration's approach is not considered in detail in
the text. An analysis of the proposal, however, has been added as an
appendix to the report.
The study was prepared by June O'Neill of the Congressional
Budget Office's Budget Analysis Division.
The author wishes to
acknowledge a number of persons, both at CBO and in other
organizations, for their contributions and valuable comments on the
report.
In particular, thanks go to Robert M. Ball, Lucia Becerra,
Jack Besansky, Steven Chadima, Ronald F. Hoffman, James W. Kelly,
Mickey Levy, George Merrill, Benjamin Okner, Patricia Pacey, and
James Rotherham.
The author is grateful to the Social Security
Administration for the data and helpful criticism they furnished.
The manuscript was edited by Johanna Zacharias and prepared for
publication under her supervision. Gwen Coleman typed the several
drafts with, the help of Marsha Mottesheard, Paula Spitzig, and Anne
Benjamin.
In keeping with CBO's mandate to provide objective
analysis, this report offers no recommendations.

Alice Rivlin
Director
July 1977

iii

TABLE OF CONTENTS
Page
P r e f a c e .....................................................

ii i

S u m m a r y .....................................................

Chapter I. I n t r o d u c t i o n ........................... .. . .
Short-Run Financing Issues .............................
Long-Run Financing Issues ...............................
Fundamental Choices ......................................
Plan of the R e p o r t ......................................

1
3
4
4
7

Chapter II. How the System W o r k s .........................
T a x e s ....................................................
B e n e f i t s ................................................
The Financing Picture to 1985:
Issues and Alternatives .....................
The Recent Decline in the Trust Fund B a l a n c e s ..........
The Next D e c a d e ..........................................
Options for the Short R u n ................................
Funding from OASDI Taxes ...............................
Funding from General Revenues ...........................
Shift the HI Tax to O A S D I ................................

9
9
12

Chapter III.

The Long-Range Financing
Picture — to 2050 ...........................
Reviewing the Assumptions ...............................
The Problem of Over i n d e xi ng.............................
Options for Revising the Benefit Structure . . ........
Long-Term Costs Under the Ford Administration
and Hsiao Alternatives ...............................
The Cost of W a i t i n g ......................................
Other O p t i o n s ............................................
The Role of Social Security and
Long-Run Considerations ...............................

17
17
19
22
24
28
29

Chapter IV.

Appendix A.

31
34
38
43
49
51
51
53

Note on Indexing.............................

Appendix B. Note on President Carter's Proposals
for Financing the OASDI Programs .......................

LIST OF TABLES
Page
1.
2.
3.
4.
5.
6.
7.
8.

9.
10.

11.
11.
12.

13.
B-l.
B-2.
B-3.

Beneficiaries and Cash Benefits in the Old-Age,
Survivors, and Disability Insurance
Programs (OASDI) ....................................
Estimated OASDHI Taxes and Federal Income Taxes
Paid as a Percent of Family I n c o m e .................
Monthly Benefits and Replacement Rates for
Workers in Various Circumstances ...................
Social Security Replacement Rate for a 65-Year-Old
Male Retiree Earning the Median W a g e ...............
Assets of the Old-Age, Survivors Insurance (OASI)
and Disability Insurance (DI) Programs ............
Alternative Economic Assumptions .....................
Status of Social Security Benefit Programs
Under Alternative Economic Assumptions ............
Projected Expenditures of the Old-Age, Survivors and
Disability Insurance System as Percent of Taxable
Payroll Under Current Law and Different Long Range
A s s u m p t i o n s ........................................
Projections of the U.S. Population of Retirement
Age as a Percent of the Working Age Population
Under Alternative Fertility Assumptions ..........
Replacement Rates and Implied OASDI Tax Rates
in the Year 2045 Under Current Law and
Alternative Assumptions About Future Wage
and Price I n c r e a s e s ...............................
(Part One). Projected Constant Dollars Benefits
(Excluding Spouse Benefit) for New Retirees
Under the Ford and Hsiao Pr op o s a l s .................
(Part Two).............................................
Projected OASDI Expenditures as a Percentage of
Taxable Earnings Under the Current Coupled System
and the Ford Administration and Hsiao Proposed
Alternatives ........................................
Projected OASDI Expenditures as a Percent of
Taxable Payroll Under the Ford and Hsiao
Proposals Introduced at Different Times ..........
Projections of the Short-Term OASDI Deficit
Defined Three Different Ways .......................
Projections of the Carter Proposal
for Increasing OASDI Revenues .....................
The Carter Proposal for Funding the
25-Year Deficit in OASDI ...........................

vi i

2
10
14
16
18
20
21

32
36

41
46
47

50
52
67
68
75

SUMMARY

During the past few years, several government reports have
presented an increasingly pessimistic picture of the financial
outlook for the social security system.
They cite current funding
deficits and project dwindling trust funds over the next five years.
They also suggest that, during the first half of the next century,
sharp increases in payroll taxes will be needed to support projected
benefit payments.
Not surprisingly, these gloomy prognoses have
aroused considerable public concern.
Of course, there is no danger that the system will not continue
to make payments to present and future retirees, for unlike a private
insurance program, social security benefits are supported by tax
receipts.
These receipts can always be raised.
The real problems
involve the mechanics of taxation and decisions about the structure
of benefits in the long term.
Social Security benefits are funded largely by current payroll
taxes.
The trust funds that handle the financing of the cash
benefits -- for Old Age and Survivors Insurance (OASI) and Disability
Insurance (DI) — function mainly as accounts into which earmarked
taxes are deposited and from which benefits are paid. The reserves
held in trust serve primarily to cushion temporary excesses of
outlays over revenues.
One consequence of a pay-as-you-go system such as social
security is that the financial status of the system is extremely
vulnerable to unforseen changes in the population or in the economy.
A decline in the growth of wages or employment will reduce payroll
tax receipts; an increase in the number of people drawing benefits
(whether because they retire earlier or because they live longer)
will increase outlays. Since forecasting is an uncertain business,
the planning of future tax rates can never be done with any sure
knowledge of the size of the tax base or the beneficiary population.
The immediate problem now being faced was precipitated to a
large extent by the recession, which reduced payroll tax receipts
below expected levels.
The possibility of a serious long-range
problem (after the year 2010) has been raised as a result of
reevaluating projections of the future size of the retired

93-486

- 7 7 - 2

population relative to the working population, and from reevaluating
the way a certain provision in current law (the so-called "coupled
system") can affect future benefits.
If no changes were made in
current law, these factors would cause total benefits to rise much
faster than total taxable wages to pay for them.
Because the
schedules of benefits and taxes are statutory, changes in benefit and
revenue policies must be enacted by the Congress.
In the 95th
Congress, issues related to both short- and long-run problems are
likely to arise.

FINANCING ISSUES FOR THE SHORT TERM
Over the past five years, social security outlays have been
growing at a faster rate than revenues. As a result, the balances in
the combined OASDI trust funds have fallen from an amount equal to
one year's outlays in 1970 to less than half of a year's outlays at
the start of 1977.
The economic slowdown of the past few years clearly
contributed to the decline. Payroll tax receipts have grown slowly
because of the slow growth in real wage rates and because of the high
unemployment since 1974. Outlays increased rapidly as a result of a
20 percent across-the-board increase in benefits and because
benefits have been tied (since 1975, automatically) to increases in
the consumer price index. In addition, the number of beneficiaries
grew somewhat more than expected, as workers, faced with poor job
opportunities and rising social security benefits, retired earlier
than they might have had the economy been stronger.
The number of
disability insurance beneficiaries has risen faster than can be
explained by economic factors alone, which has resulted in a more
rapid increase in outlays and a more precipitous decline in the DI
trust fund.
Although wages and employment will rise more rapidly with
economic recovery, it does not appear likely that these increases
could compensate for the erosion that has already occurred.
Projections made by the Congressional Budget Office indicate that
the balances in the combined OASDI trust funds will be depleted by
1982 or 1983, depending on what it is assumed will happen to economic
growth. Considered separately, the DI fund is likely to be exhausted
by 1979; the OASI fund between 1983 and 1985.

Because of the immediate vulnerability of the DI trust fund,
one temporary measure would be to shift a small portion of the OASI
tax to the DI fund. Doing so would require legislation. This shift
would not, of course, solve the problem of the less immediate but
still pressing issue of the declining balances in the combined OASDI
funds.
In principle, the short-run financing problems can be
alleviated either by raising revenues, reducing benefits, or some
combination of both.
Major changes in the benefit structure are
likely to be more difficult to agree on and to implement quickly,
however, so the primary emphasis in the short run is likely to focus
on the provision of additional revenues.
Several alternatives are
available.
General Revenues Versus Payroll Tax Funding —

Fundamental Choices

Perhaps the most important decision to be made with respect to
the short-run financing problem is:
o

Whether to rely exclusively on the payroll tax, which has
until now been the sole means of funding social security, or

Whether to use general revenue funding.

The choice
security.

involves

basic

questions

about

the

role

social

Those observers who view social security primarily as a
compulsory lifetime savings program regard the payroll tax as a
mandatory contribution to an earned retirement benefit; they
therefore view the payroll tax as the appropriate funding mechanism
for the program.
Although the link between benefits and
contributions is weak, many people feel that public support for the
program depends on the link, and indeed many would strengthen it.
Another argument for retaining the payroll tax as the sole source of
financing social security is that it is believed to encourage fiscal
discipline,
since legislated increases
in benefits must be
accompanied by increases in the payroll tax.
Another way of viewing social security is simply as a tax and
transfer system, which redistributes income from one group to
another. Those observers who stress the income-transfer elements of
the program would like to see the source of funding shifted, at least

partially, to general revenues, which are basically derived from the
income tax. The federal income tax can be better scaled to ability
to pay since it can take account of dependents and other special
circumstances of the taxpayer.
Moreover, a shift to the federal
income tax is preferred by some as a way of increasing the overall
progressivity of the federal tax system.
The use of general revenue funding could challenge the present
character of the social security program.
It may be difficult to
justify the use of general revenues to pay benefits that are related
to past earnings. Moreover, it could also be difficult to justify
the use of general revenues to pay those benefits that conform to the
so-called "social adequacy" criteria of social security.
No means
test is used in determining eligibility for the latter category of
benefits and many higher-income persons receive them.
One objection to raising social security taxes in 1978 is that
doing so could restrict economic growth at a time when unemployment
may still be high.
(The same objection would apply to the use of
general revenue funding if it were obtained through an income tax
increase rather than an increase in the deficit.)
Any restrictive
effect of a payroll tax increase could, however, be counterbalanced
by a reduction in the federal income tax. If an income tax reduction
were scaled to benefit low-income families with earnings, the
tendency for the tradeoff to result in reduced progressivity of the
overall tax system would also be mitigated.
Alternative Ways to Increase Payroll Tax Revenues
There are two ways to increase revenues through the payroll
tax. One is a hike in the tax rate. The other is an increase in the
taxable earnings base -- i.e., the maximum amount of earnings subject
to the tax. And, of course, both alternatives could be combined.
The major considerations in choosing between a payroll tax
rate increase and an increase in the tax base are:
o

An
increase
in the
tax
base would
increase the
progressivity of the social security tax. Only families in
the top 40 percent of the income distribution would have an
earner subject to the increase. An increase in the tax rate
would be paid by families at all levels of income, although
it would be concentrated among the upper 60 percent of
families, who pay most of the social security tax.

Because relatively few workers earn more than the taxable
maximum, it requires a substantial increase in the ceiling
to obtain the same amount of revenue that could be derived
from a small tax rate increase. To raise as much in taxes,
for example, as an increase in the OASDI tax rate from 9.9
percent to 10.9 percent (0.8 percentage point in 1978, and
another 0.2 percentage point in 1981) would require a 63
percent increase in the taxable maximum above the increases
scheduled in current law. The taxable maximum would rise to
$28,800 instead of $17,700 in 1978 and would go up to
$42,900 instead of $26,100 by 1983.
This would increase
from 85 percent to 96 percent the proportion of workers
whose total earnings were taxable. Both alternatives would
maintain the trust fund balances at more than 36 percent of
annual outlays through 1983.

An increase in the taxable earnings base provides less and
less financing assistance, on balance, as time goes on.
Since benefits are based on taxable earnings, an increase
in the earnings base results in higher benefits in the
future for high wage earners, thereby adding to the longrun size and costs of the system.

LONG-RUN FINANCING ISSUES
The long-run financial situation of the social security system
depends critically on future fertility rates, the rate of inflation,
and the rate of growth of real wages (that is, wages adjusted for
inflation).
If the current benefit structure is maintained, and if
fertility rates stabilize at an average of 2.1 children per woman
(this is the rate that would keep population at a stationary level),
and if prices (CPI) and real wages rise by 4 and 2 percent a year
respectively, social security expenditures are projected to increase
to 22 percent of taxable payroll by the year 2030.
If tax receipts
were set to match these, this would imply a tax burden more than
double the current OASDI tax level of 9.9 percent for employees and
employers combined.
If the fertility rates stabilize at 1.7, and if prices (CPI)
and real wages grow at 5 and 1.25 percent a year, respectively,
benefits are estimated to amount to as much as 37 percent of taxable
payroll by the year 2030.

One major factor underlying these sharp increases in the tax
burden is a projected increase in the ratio of retired to working
populations expected to start about 40 years from now. This increase
is the result of the swing that has occurred in the birth rate —
from the prolonged baby boom that began after World War II to the
very low birth rates of the 1970s. While the fertility rate may rise
above its current low of roughly 1.7, it is not expected to rise much
above the 2.1 level over the long term.
The other major factor pushing up tax costs is the result of a
technical flaw in the 1972 social security amendments.
These
amendments sought to index the benefits of retired workers so that
their benefits would not be eroded by inflation. The amendments do
succeed in achieving this worthwhile goal. The particular mechanism
used for achieving this goal, however, also results in an unintended
overadjustment for inflation of the benefits of workers who will
retire in the future. The mechanism adjusts the benefit rate table
for determining benefits in such a way that the ratio of benefits to
past earnings rises with the rate of inflation. Since the pressure
of inflation typically leads to higher earnings for those who are
working, and a higher earnings base leads to higher social security
benefits, the additional adjustment in the benefit table for price
changes is a second adjustment for inflation.
The effect of this overadjustment is cumulative. As a result,
the replacement rate — the ratio of a new retiree's benefit to his
earnings in the year before retirement — may increase dramatically
under conditions of persistent
inflation.
In fact, with
persistently high rates of inflation, some retirees could receive
benefits that exceed their pre-retirement wages; that is, their
replacement rates could exceed 100 percent.
Obviously, as
replacement rates rise, the ratio of benefit payments to taxable
wages grows, and so do the financial pressures on the system.
Options for Revising the Benefit Structure
Because of the potentially serious fiscal consequences of the
present system, which is described as being "overindexed," there has
been considerable interest in adopting a new procedure to adjust the
benefits of existing and future retirees for inflation. One major
issue underlying the choice of a new procedure is: How important
should social security benefits be in providing income in retirement
as the standard of living rises in the future? Should a level of

xiv

benefits intended to serve as the primary or sole source of
retirement income be the goal? Or should benefits be scaled so that
they serve only as a component of retirement income, with transfers
filling in for those with low income and with private savings and
pensions expected to play an increasing role?
How these questions are answered depends partly on how
people's saving and spending behavior are expected to change as
economic growth raises their standard of living to ever higher
levels.
Of course, a high guaranteed social security benefit can
itself affect incentives to save and to work and these are additional
concerns.
Any change in the benefit adjustment mechanism is likely to
influence the amount of benefits and of social security outlays in
the future and so will also affect the amount of taxes paid by future
workers. Thus, another issue to be resolved for the long run is how
to distribute resources between future workers and beneficiaries.
There are many ways to correct the provision in current law
that leads to the overindexing of benefits. Two proposals have been
made, which reflect two quite different answers to the overall
question about the future size and role of social security.
One
approach is represented by the "Social Security Benefit Indexing
Act" (H.R. 14430), proposed by the Ford Administration in 1976. (A
similar proposal has been made by the Carter Administration.
See
Appendix B for a discussion.) Another approach is represented by the
Hsiao proposal (H.R. 12334), named for the director of a panel
established to advise the Congress on social security.
In general terms, the Ford Administration's proposal seeks to
provide a level of benefits to the average new retiree that will
always replace the same proportion of past earnings regardless of how
high the standard of living of the average retiree becomes.
The Hsiao proposal seeks to provide a benefit that always
replaces the same proportion of earnings for workers at the same
standard of living.
The social security benefit structure is
progressive, however, so that the proportion of earnings replaced by
benefits declines at higher earnings levels. The Hsiao proposal does
not attempt to compensate for this aspect of the benefit structure.
Therefore, as the average worker becomes a richer worker, the Hsiao
proposal would give him a higher benefit, but not proportionately as
high as his earnings.

For example, if wages adjusted for inflation rise by 2 percent
a year, the median annual earnings would rise from the 1975 level of
$8,600 to about $37,000 by the year 2049 (in terms of today's
purchasing power). The Ford Administration's proposal, in contrast,
would give the median wage worker retiring in the year 2050 a benefit
of about $16,000, which is about the same proportion of past earnings
as the median earner would get if he retired today.
The Hsiao
proposal would give the worker retiring in 2050 a benefit of $8,600,
which replaces a smaller proportion of past earnings than is the case
for today's median wage worker at retirement.
Because it provides higher benefits than the Hsiao approach,
the Ford Administration's proposal would entail higher future
expenditures.
Under the assumptions of a 4 percent rate of
inflation, a 1.75 percent growth in real wages, and a fertility rate
of 1.9, the Ford Administration's proposal would result in
expenditures equal to 19 percent of taxable payroll by the year 2050.
This compares with 29 percent under the present benefit structure and
11 percent under the Hsiao proposal.
(The current level is 11
percent.) Thus, unless other measures are taken to reduce outlays,
both the Ford Administration's approach and a continuation of
current policy mean that social security will consume a much larger
share of the nation's future resources than would be the case under
the Hsiao approach.
There are, of course, many possible ways to restructure social
security benefits. Some observers would combine the features of the
two proposals.
For example, the average replacement rate could be
allowed to decline at first, with the rise in average earnings, as in
the Hsiao proposal, but after reaching a particular level, it could
be held constant. The Ford Administration's proposal seeks to hold
the average replacement rate constant at the level reached in the
late 1970s. By that time, however, the replacement rate is likely to
exceed 45 percent, which is very high by historical standards: the
replacement rate for the median-wage earner averaged around 30
percent over the 20 years prior to 1972.

xvi

CHAPTER I.

INTRODUCTION

The social security system experienced tremendous growth over
the six years, 1970-1976. The number of beneficiaries increased by
26 percent; total benefit payments (adjusted for inflation) rose by
61 percent. In calendar year 1976, social security benefit payments
accounted for 4.5 percent of the gross national product, or one-fifth
of the entire federal budget.
In that year, the system paid out
about $76 billion in cash benefits to 33 million persons; recipients
included retired and disabled workers and their dependents, and the
survivors of deceased workers (see Table 1).
People who currently receive benefits and those who expect
them in the future count on social security as an important source of
income when they retire.
In 1975, for example, an average of about
39 percent of the personal income of individuals aged 65 years or
older came from social security.
The financing of social security is handled through trust
funds. V
Most wage- and salary-earners and self-employed persons
make mandatory contributions to the separate old-age and survivors
(OASI) and disability insurance (DI) trust funds through earmarked
taxes on their earnings. 2/ Unlike private insurance funds, however,
the social security trust funds need not hold as assets the
accumulated tax contributions of present and future beneficiaries in
order to insure the payment of obligations.
The power of the
government to tax assures that these obligations will be met.

The status of the trust funds is under the charge of the Board of
Trustees, which issues an annual report on the financial
operation of OASDI to the Congress.
The trustees include the
Secretary of the Treasury, Secretary of Labor, and Secretary of
Health, Education, and Welfare.

Another payment is made into the hospital insurance (HI) fund for
medicare hospital benefits.

93-486 0 - 7 7 - 3

TABLE 1.

BENEFICIARIES AND CASH BENEFITS IN THE OLD-AGE, SURVIVORS,
AND DISABILITY INSURANCE PROGRAMS (OASDI): SELECTED
CALENDAR YEARS 1950-1976

1950

1960

1965

1970

1974

1975

1976

3.5

14.8

20.9

26.2

30.9

31.9

33.0

Retired workers,
dependents, and
survivors (OASI)

3.5

14.2

19.1

23.6

26.9

27.6

28.4

Retired workers
only

1.8

8.1

11.1

13.3

16.0

16.5

17.2

Disabled workers and
dependents (DI)

0.7

1.7

2.7

3.9

4.3

4.6

1.0

11.3

18.3

31.9

58.5

66.9

75.6

OASI

1.0

10.7

16.7

28.8

51.6

58.5

65.7

—

0.6

1.6

3.1

6.9

8.4

9.9

Beneficiary or Benefit
Number of beneficiaries a/
(in millions)
Total

Annual cash benefits
(in billions of dollars)

SOURCE:

Social Security Administration,
Education and Welfare.

As of December of each year.

Department

Health,

For the most part, the annual flow of tax payments earmarked
for the trust funds is used to pay for the current flow of benefits.
Thus, social security is essentially funded on a pay-as-you-go
basis.
The role of the trust funds is to provide a reserve to
cushion temporary shortfalls in revenues and also to maintain public
confidence in the stability of the program.
The minimum level of
trust fund balances necessary to provide a temporary cushion is
generally considered to be an amount not more than a single year's*
benefits. Some analysts believe it could be a good deal less.
SHORT-RUN FINANCING ISSUES
Since the financing of benefits depends almost exclusively on
the flow of current tax payments, and since payroll tax rates are not
continuously adjusted, short-run problems can arise if unexpected
economic changes cause payrolls -- and hence tax receipts -- to fall
behind benefit commitments.
Social security revenues have fallen
behind outlays during the past few years primarily as a result of two
factors: the slow growth in the average real wage since 1973, and the
high unemployment of the recession.
Recovery from the recession will undoubtedly stimulate an
increase in payroll tax receipts.
Even under optimistic economic
projections for the next decade, however, revenues are not expected
to rise enough to prevent a continuing decline in the trust fund
balances as a percent of annual outlays.
The steepness of the
expected drop depends on the economic outlook, of course, and differs
for each fund.
According to the Congressional Budget Office's
projections, balances in the OASI trust fund will decline more
gradually, falling to between 13 percent and 19 percent of a year's
outlays by the start of 1982. In the case of the DI trust fund, the
outlook is more pessimistic, since outlays in this program have risen
by an unexpectedly large amount over the past few years.
It is
likely that the DI trust fund will be depleted in the next two years
if no action is taken to increase future revenues.
Among the possible solutions to the short-run problem are tax
increases (in the rate, in the earnings base, or in both), a loan or
grant from general federal revenues, or a shift of a portion of the
hospital insurance (HI) fund to the OASDI funds. Any changes in the
benefit structure that result in reduced outlays would, of course,
also help reduce the deficit.

LONG-RUN FINANCING ISSUES
In the long run, the financing of benefits under a pay-as-yougo system can meet with difficulties if population shifts cause an
increase in the ratio of retired persons to persons of working age.
As persons born during the baby boom after World War II reach
retirement age, a very high ratio of retirees to workers is likely to
occur, particularly if the low birth rates now prevailing should
continue.
Under the tax and benefit provisions in current law,
benefits would exceed revenues by large and growing margins after the
year 2010.
Any solution to this long-run fiscal problem will
obviously entail an increase -- and possibly a substantial one -- in
payroll or income taxes, a slowdown in the rate of benefit increases,
or some combination of these measures.
One factor that exacerbates the long-run situation and that
can be remedied now is a technical flaw in the procedure for
determining benefits; the flaw is often referred to as overindexing.
As a result of this fault, the benefits awarded the newly retiring
workers of the future will reflect an overcompensation for past
inflation.
If present high rates of inflation should continue,
future outlays would escalate as a proportion of expected tax
receipts. Several proposals to correct this feature of current law
have already been put forth. These are discussed in Chapter IV.
FUNDAMENTAL CHOICES
Traditionally, social security has been viewed as a compulsory
savings system that insures that individuals, during their working
years, will provide for their own retirement -- in effect, a selffinancing, lifetime savings program.
In practice, however, the
system does not strictly fit this description. On the contrary, it
has had many elements of an annual transfer program. When taxes paid
by current workers finance the benefits of current retirees,
purchasing power is transferred from one group in the population to
another.
In addition, the benefit structure has been designed in an
attempt to satisfy dual principles. On the one hand, the principle
of what is called "individual equity" is stressed. Strict adherence
to this principle implies that the amount of a person's benefits
would be determined solely by his lifetime contributions. Although,

upon retirement, the individual does receive a benefit that is
related to past earnings, and therefore indirectly to past taxes,
that relationship is rather loose. Individual equity has given way
to a large extent to another principle, often referred to as "social
adequacy."
In
an
effort
to
provide
social
adequacy,
several
redistributive factors have been incorporated into the benefit
structure.
For example, the benefit formula is tilted in favor of
those with lower pre-retirement earnings.
In addition, a retired
worker with a dependent spouse receives additional benefits without
having paid any additional taxes.
The way current and future problems of financing social
security are resolved can have important effects on how the character
of the social security program will evolve.
Two major issues are
involved:
o

Should social security strengthen its role as a compulsory
savings program, relating benefits more strictly to
earnings?
Or should the system move further in the
direction of an income transfer system, pursuing the goal
of social adequacy?

What should the role of social security be as a source of
income for the retired and disabled as real income levels
rise in the future?

With respect to the first issue, the question has been raised
whether the present redistributive aspects of the program are in fact
effective in promoting social adequacy. Because social security is
not a means-tested program, i.e., the level of family income is not
used to determine benefits, some critics have argued that it does not
and cannot efficiently target benefits toward those who are most
needy. Groups receiving favored treatment, such as wives qualifying
for the spouse benefit and retired workers whose earnings in covered
employment were low, may have considerable income from other
sources, including pensions from work in federal or other uncovered
employment.
Thus, it has been suggested that the social adequacy
goal of the program would be better handled directly by a meanstested program such as the Supplemental Security Income (SSI)

program introduced in 1974.
SSI provides a federally guaranteed
minimum income for the elderly who have not been brought to that
level by social security or other programs.
The decision whether to use general revenues for financing
social security rather than relying solely on the payroll tax can
affect the future direction of social security with respect to
whether it moves more toward an income transfer program.
Although
payments to current beneficiaries are not actually paid out of
accumulated and invested lifetime contributions, the concept of the
"earned right" has been very important to the success and acceptance
of social security as an institution. The fact that the program is
financed by an earmarked tax on earnings is believed to be consistent
with the concept of the earned right.
On the other hand, general revenue financing is considered
preferable by those who stress the redistributive elements of social
security. General revenues are to a large extent derived from the
personal income tax, which being graduated is more progressive, and,
taking account of family size and more income sources, is better
related to ability to pay.
There is a question, however, about
whether benefits could long continue to be related to earnings and
whether the program would not eventually evolve into a means-tested
welfare program if substantial general revenue payments were used to
finance the program.
The second major issue is how important social security
benefits should be in providing income in retirement as the standard
of living rises.
Should the benefits be maintained at a level at
which they could serve as the primary or sole source of retirement
income? Or should benefits be scaled so that they serve only as a
component of retirement income, with private savings and pensions,
and transfers to those with low income, expected to grow in
importance?
The choice of a new benefit computation procedure to
correct overindexing can have important effects on the future role of
social security. The arguments favoring a more substantial role for
social security stress the inadequacies of the private pension
system as a source of income.
Arguments favoring a smaller scope
emphasize the negative effects that large benefits could have on
economic growth.
That is, a high guaranteed pension could reduce
savings
and hence capital
accumulation,
and could provide
disincentives to continue working.

PLAN OF THE REPORT
This study focuses primarily on the OASDI short-run financing
picture and on some issues that must be faced when considering the
long-run status of social security. (The problems of finance in the
medicare Hospital Insurance (HI) component are not included.)
Chapter II presents a brief description of how social security works
—
how it is financed and by whom' —
how benefit amounts are
determined and how they are distributed.
Chapter III looks at
projections of social security receipts, outlays and trust fund
balances through 1985 under different economic paths, and discusses
options for raising revenues.
Chapter IV discusses the long-run
forecast (to the year 2050), the overindexing flaw in current law,
and the major options that have been proposed for dealing with this
problem.
A more technical discussion of the indexing of benefits is
contained in Appendix A.
The Carter Administration recently
proposals for financing the OASDI programs.
these proposals.

presented a set of
Appendix B describes

CHAPTER II.

HOW THE SYSTEM WORKS

TAXES
Whenever an individual works in employment covered by the
program, taxes are levied on his earnings up to a maximum dollar
amount.
In 1977, the tax is 9.9 percent of the first $16,500 of
wages, about 88 percent of which is allocated to the Old Age and
Survivors Insurance (OASI) Fund and the remainder to the Disability
Insurance (DI) Fund.
Employer and employee each pay half of this
payroll tax. There is an additional payroll tax of 1.8 percent on
the same portion of earnings (again shared by employer and employee)
for the hospital insurance (HI) program. Self-employed persons pay a
tax of 7 percent of their net earnings to the OASI and DI trust funds
combined, and a tax of 0.9 percent for hospital insurance.
About 9 out of 10 wage- and salary-earners, and self-employed
persons, work in jobs covered by the program and are therefore
subject to mandatory payroll taxes. The principal groups not covered
are civilian employees of the federal government, who are covered
under a federal retirement program, some state and local government
employees, and persons working for charitable organizations.
The social security tax is often said to be regressive, since
the tax takes a constant, ungraduated proportion of a worker's
earnings up to the set maximum. As earnings rise above that point,
the tax becomes a decreasing proportion of the worker's total wages.
The distributional burden of the tax, however, rather than an
individual's covered earnings, is perhaps better measured against
total family income. The covered earnings of any one worker are not
necessarily indicative of his other sources of income or the income
of his family.
Although federal income tax payments are highly progressive -that is, they rise sharply as a percent of income -- the social
security tax also tends to be somewhat progressive for all but those
families in the highest-income quintile.
Table 2 depicts this
pattern for 1976.
At lower levels of income, taxable earnings —
hence social security taxes -- are a small proportion of total
income.
About 40 percent of all families in the lowest-income
quintile rely exclusively on income from sources other than earnings
-- that is, income from cash transfers from the government, private

93 - 4 8 6 0 - 7 7 - 4

TABLE 2. ESTIMATED OASDHI TAXES AND FEDERAL INCOME TAXES PAID AS A
PERCENT OF FAMILY INCOME: FAMILIES IN QUINTILES RANKED BY
1976 INCOME a/

Federal
Income
Taxes

OASDHI
Taxes
(Employee1s
Share)

Combined
Federal
Tax Payments

Quintiles
by Income

Total b/
Family
Income

Lowest

100.0

2.3

2.4

4.7

Second

100.0

4.1

3.5

7.6

Third

100.0

8.1

4.4

12.5

Fourth

100.0

11.3

4.6

15.9

Highest

100.0

17.1

3.6

20.7

All families

100.0

12.1

3.9

16.0

SOURCE:

CBO calculations based on data provided by the Office of Tax
Analysis, U.S. Department of the Treasury.

Unrelated individuals are counted as families.

The estimated 1976 incomes (before taxes) for the quintiles are:
Lowest
Second
Third
Fourth
Highest

--—
---

up to $5,669 including losses
$5,669 to $9,854
$9,854 to $14,679
$14,679 to $21,540
$21,540 and over.

Income includes an estimate of capital gains as well as wages and
salaries, self-employment income, interest, dividends, rent,
social security, government and private pensions, public assis
tance, veterans' benefits, workmen's compensation, unemployment
compensation, alimony, and other miscellaneous sources.

pensions, and income from interest, rent, and so forth. As incomes
rise, earnings become the dominant source of income.
Because
families with higher incomes are likely to have more than one earner
(about 75 percent of families in the top quintile have two or more
earners), the total earnings of many families remain fully taxable
beyond $15,300, the maximum taxable amount for an individual in 1976,
the date for the table. At the highest income levels, total family
earnings eventually exceed the taxable maximum, and income from
property
(capital
gains,
rent,
interest,
dividends)
becomes
relatively more important.
One recent development that helps relieve the burden of the
social security tax for many of those families in the lowest-income
group who do have earnings is the earned-income credit. The credit
was introduced by the Tax Reduction Act of 1976 and was intended, at
least in part, to provide some relief from the payroll tax for lowincome families.
The credit is equal to 10 percent of the first
$4,000 of earned income, and it is then reduced by 10 percent of
adjusted gross income exceeding $4,000.
The credit is, however,
limited to taxpayers with dependent children.
In Table 2, the
earned-income credit is included as an offset to federal income tax
payments.
If the credit were interpreted as an offset to the
payroll tax, then social security taxes would appear more pro
gressive at the lower part of the income distribution.
It should be noted that only the employee's share of social
security taxes is included in Table 2. Although employers pay half
the tax at the time of collection, many analysts believe that, to a
large extent, the employer's share is eventually shifted to the
worker in the form of reductions in wage increases that otherwise
would have occurred. This problem should be considered in comparing
the size of social security taxes and of federal income taxes at each
income level.
Those observers who view social security as a compulsory
savings program evaluate the tax and benefit structure together. To
assess the equity of the system from this perspective would require
measures of the relation between the expected return (i.e., the
present value of an individual's social security benefits) to the
accumulated value of the individual's social security tax payments.
Efforts to make such calculations differ in both methodology and in
results regarding the way the expected return varies by income.
Measurement is complicated because aspects of social security

favoring lower-income workers are offset by others favoring higherincome groups. V
Pronounced differentials do occur between oneearner and two-earner households (one-earner households are favored
because of the benefit for dependent spouses) and between men and
women (women are favored partly because of their greater longevity).
BENEFITS
Workers' eligiblity for benefits is based on three criteria: a
minimum period in covered employment, age, and disability status.
The minimum age of eligibility for retirement benefits is now 62
years. Dependents or survivors of workers may also be eligible for
benefits.
Income from non-earnings sources is not considered in
determining eligibility for benefits. But benefits are subject to
reduction if the beneficiary or retired worker has earnings from
employment and is less than 72 years old.
The size of a retired worker's monthly benefit is determined by
a multi-step process.
First, the worker's covered earnings are
averaged over a specified number of years (currently 20 years for a
large proportion of workers, with the exact number varying by date of

The benefit formula favors earners with lower wages. The shorter
life expectancy of less-educated persons and lower-wage earners,
however, works the other way, reducing the expected value of
lifetime benefits; this factor is somewhat offset by survivors'
benefits. See L.A. Thompson, "Intracohort Redistribution in the
Social Security Retirement Program" (paper delivered at the
American
Statistical
Association,
Boston,
August
1976);
J. O'Neill, "Returns to Social Security" (paper presented at
meetings of the American Economic Association, Atlantic City,
September 1976) and "Issues Concerning Women and Social
Security" (paper given at the proceedings of the Eighth Social
Security Conference, University of Michigan, Ann Arbor, October
1974); A Frieden, D. Leimer, and R. Hoffman, "Internal Rates of
Return to Retired Worker-Only Beneficiaries Under Social
Security, 1976-1970," U.S. Department of Health, Education, and
Welfare, Social Security Administration, Office of Research and
Statistics, Studies in Income Distribution #5, October 1976.

birth and sex). 2/ These average monthly earnings are then applied
to a benefit rate table in order to determine the worker's Primary
Insurance Amount (PIA). The table is described in Chapter IV. The
formula is progressive and provides for a PIA that declines as a
percent of average monthly earnings as they rise.
The actual benefit paid to a social security recipient is
determined as a percent of the PIA; the proportion varies according
to several factors.
Workers retiring at age 65 receive a benefit
equal to 100 percent of their PIA. Those retiring between the ages
of 62 and 65 take a reduction in their PIA. The spouse of a retired
or disabled worker receives a benefit equal to 50 percent of the
wage-earner1s PIA if the benefit is claimed after age 65 (and in such
a case, the benefit rises to 100 percent when the wage-earner dies,
provided he did not also claim the benefit before age 65 years).
When the spouse of a beneficiary reaches retirement age, he or she is
automatically entitled to the spouse benefit. A spouse with covered
earnings of his own receives an amount equal to the spouse benefit or
his own benefit, whichever is higher. 2/
Monthly benefits in 1976 for hypothetical workers in different
circumstances are shown in Table 3.
Benefits are also shown as a
percent of earnings in the year before retirement; these percents are
frequently referred to as replacement rates. 4/
Because of the
progressive element in the benefit computation schedule, replacement
rates are lower for workers with higher earnings. It should be noted

The averaging period is scheduled to increase each year until it
has reached its maximum of 35 years for all new retirees.
Lengthening the averaging period typically results in lower
benefits, since more years of low earnings in the past are likely
to be included and this lowers the average lifetime wage and,
hence, benefits.

As a result of a Supreme Court decision in early 1977 (Califano
v. Goldfarb), a husband is entitled to the spouse benefit under
the same conditions as a wife.

The replacement rate may also be defined as a percent of earnings
over some period other than the year preceding retirement. For
example, the replacement rate is sometimes defined as benefits
as a percent of average monthly earnings over the averaging
period, or over the highest five-year or ten-year span.

that benefits are not subject to income taxation.
Therefore, if
benefits were compared to earnings net of taxes, replacement rates
would appear to be somewhat higher, particularly at higher income
levels.
In addition, the after-tax benefit structure would appear
somewhat less progressive.
TABLE 3. MONTHLY BENEFITS AND REPLACEMENT RATES FOR WORKERS IN VARIOUS CIRCUMSTANCES:
SECOND HALF OF 1976, IN DOLLARS

Replacement Rates a/

Monthly Benefits

Worker c/
with
Median
Earnings

Worker 6/
with
Maximum
Earnings

Worker b/
with Low
Earnings

Worker c/
with
Median
Earnings

Worker d/
with
Maximum
Earnings

Worker Retiring
at Age 65
at Age 62

208
166

320
252

387
304

0.56
0.45

0.43
0.34

0.31
0.25

Worker Retiring
at Age 65 with
Dependent Spouse
at Age 65
at Age 62

312
286

480
440

581
533

0.85
0.74

0.65
0.60

0.47
0.43

Worker Retiring
at Age 62 with
Dependent Spouse
at Age 65
at Age 62

270
244

410
370

494
446

0.73
0.66

0.55
0.50

0.40
0.36

Circumstances

SOURCE:

Worker b/
with Low
Earnings

U.S. Department of Health, Education, and Welfare, Office of the Assistant
Secretary for Planning and Evaluation.

The replacement rate is defined here as the constant dollar value of the 1976
benefit divided by the constant dollar value of the 1975 wage for retiring
workers with the assumed earnings histories.

Hypothetical worker earning half of the median earnings of males during each year
of the averaging period.

Hypothetical worker earning the median wage for males during each year included
in the averaging period.

Hypothetical worker earning the maximum earnings subject to the social security
tax during each year included in the averaging period.

Prior to 1972, benefits were increased periodically by legis
lation.
In 1972, however, the law was amended to provide for
automatic annual increases in benefits for retired workers and
dependents whenever the Consumer Price Index rises 3 percent or more
since the last benefit increase. Although such ad hoc adjustments
have resulted in some fluctuation in the replacement rate, the rate
had averaged about 32 percent (see Table 4). The 1972 across-theboard benefit increases and automatic indexing provisions moved
replacement rates up to the 40-percent range. Moreover, a technical
flaw in the way indexing was instituted is likely to result in
substantial increases in replacement rates in the future.
This
double indexing problem is discussed in detail in Chapter IV and in
Appendix A of this report.

TABLE 4.

SOURCE:
a/

SOCIAL SECURITY REPLACEMENT RATE FOR A 65-YEAR-OLD MALE
RETIREE EARNING THE MEDIAN WAGE

Year of
Retirement

Replacement
Rate a/

1953
1954

0.301
0.291

1955
1956
1957
1958
1959

0.344
0.330
0.312
0.320
0.351

1960
1961
1962
1963
1964

0.330
0.327
0.325
0.313
0.306

1965
1966
1967
1968
1969

0.314
0.302
0.289
0.310
0.296

1970
1971
1972
1973
1974
1975
1976

0.311
0.349
0.342
0.381
0.388
0.404
0.433

U.S. Department of Health, Education, and Welfare, Office
of the Assistant Secretary for Planning and Evaluation.

The replacement rate is specified here as the constant dollar
value of the benefit in the year of retirement divided by the
constant dollar value of the median wage in the year prior to
retirement. The benefit is that for a hypothetical male earning
the median wage for each year in the averaging period.

CHAPTER III.

THE FINANCING
ALTERNATIVES

PICTURE

1985:

ISSUES

AND

THE RECENT DECLINE IN THE TRUST FUND BALANCES
Between 1970 and 1977, the combined assets of the Old-Age and
Survivors Insurance (OASI) and Disability Insurance (DI) trust funds
declined from 103 percent of annual outlays to 66 percent. (Table 5
traces this trend.)
At root, the decline is the result of slow
growth in the economy, a development which was not included in the
forecasts of the early 1970s when the present benefit structure and
tax rates were legislated. Three major factors contributed to this
drop in the trust funds' assets:

Payroll tax receipts have grown more slowly than antici
pated because of the high unemployment since 1974 and the
unusually slow rate of growth of real hourly wages (wages
adjusted for inflation) since 1972. Indeed, real wages
actually went down in 1974 and 1975.

Outlays grew rapidly, partly as a result of the sharp
increase in 1972 of real benefit levels (the purchasing
power of benefits). Moreover, in response to the rise in
unemployment, combined with the higher benefit levels, the
number of beneficiaries rose. 1/ (It should be noted that
although inflation leads to increases in outlays, it also
leads to increases in revenues, and therefore has little
net impact on the trust fund balances in the very short run.
As will be discussed later, however, under the benefit
computation provisions of the current law, inflation does
have a strong effect over the long run.)

It has been estimated that a rise in the unemployment rate of two
percentage points, lasting two years, will increase the number
qf retired workers by 1 percent and the number of disabled
beneficiaries by more -- by 5.4 percent. An increase in benefits
relative to average wages also has a small effect on increasing
retirements. See L. H. Thompson and Paul N. Van de Water, "The
Short-Run Behavior of the Social Security Trust Funds,"
Technical Analysis Paper No. 8. Office of Income Security, U. S.
Department of Health, Education, and Welfare, July 1976.

9 3 -4 86 0 - 7 7 - 5

TABLE 5.

ASSETS OF THE OLD-AGE, SURVIVORS INSURANCE (OASI) AND
DISABILITY INSURANCE (DI) PROGRAMS FOR SELECTED CALENDAR
YEARS 1960-1977: ASSETS AT THE BEGINNINGS OF YEARS AS
PERCENTS OF ANNUAL EXPENDITURES

Trust Funds

Year

OASI and
DI Combined

OASI

1960
1965
1966
1967
1968
1969

186
110
95
99
101
103

180
109
96
101
103
102

304
121
83
83
83
111

1970
1971
1972
1973
1974
1975

103
99
93
80
73
66

101
94
88
75
68
63

126
140
140
125
110
92

57
47

55
47

71
49

1976
1977 a/
SOURCE:
a/

1976 Annual Report of the Board of Trustees of the Federal
OASDI Trust Funds.

Estimated by the Congressional Budget Office.
o

Disability insurance beneficiaries have increased since the
mid-1960s much more rapidly than can be explained by
changes in benefit levels or unemployment, although these
factors have been demonstrated to be significant.
Among
the other possible causal factors are:
increasing aware
ness of the program; liberalization in the provisions;
increasing value of medicare benefits for which DI benefi
ciaries are eligible; and the introduction of the Supple
mental Security Income program (SSI) in 1974, which sup
plements DI for workers with low benefits and provides
access to medicaid.

THE NEXT DECADE
The future course of the economy will have a strong effect on
social security revenue and outlays, but predictions about the
economy generally have a wide range of error.
In addition, it is
difficult to estimate how the growth in numbers of beneficiaries will
respond to economic events, as well as to other factors.
These
uncertainties contribute to the difficulty of forecasting the
financial status of the social security system.
In order to obtain information about the possible outcomes, a
statistical model of the OASI and DI systems has been used to project
social security outlays and revenues over the next few years. ZJ The
model estimates the response of social security revenues, outlays,
and trust fund balances to various economic and demographic factors.
These factors include the unemployment rate, the rates of wage and
price increases, the growth of the labor force, and the growth of the
aged population.
With the model, the future status of the OASDI system can be
simulated under different sets of economic assumptions. Projections
based on the model may fall wide of actual developments. They should
be interpreted only as indicating what one particular model shows
under some particular assumptions about future economic develop
ments. Actual events may be worse or better than the assumed paths.
And the model may not perfectly capture the effect of economic and
other events on the growth in beneficiaries and benefit levels. Z/
Two sets of economic assumptions have been used in this paper
to simulate the future status of social security (see Table 6). Both
sets start off with a common economic forecast through 1978. One,

The model was originally developed by L. H. Thompson and Paul N.
Van de Water of the Office of Income Security Policy, Department
of Health, Education, and Welfare; it has been slightly modified
by the Congressional Budget Office.

The Social Security Administration (SSA) uses a different model
for projecting the status of OASDI. For the past few years, the
SSA model has tended to show a somewhat larger increase in OASDI
beneficiaries than the CBO-modified HEW model, and therefore
results in a somewhat more rapid decline in the OASDI trust fund
balances using the same economic assumptions.

however, projects a high growth path after 1978 whereby unemployment
drops below 5 percent in 1980 and levels off at 4.3 percent in 1982.
The other set of assumptions projects a lower growth path w’ith
unemployment leveling off at 5.5 percent in 1981.

TABLE 6. ALTERNATIVE ECONOMIC ASSUMPTIONS FOR CALENDAR YEARS 1977-1985

II
High Path

I
Low Path
Percent
Increase in: b/

Year a/

Wages
1977
1978
1979
1980
1981
1982
1983
1984
1985

8.9
7.4
6.9
6.2
5.8
6.4
6.7
6.7
6.8

Unemployment
Rate e/

Prices d/
6.2
5.3
5.0
4.6
4.5
4.5
4.5
4.5
4.4

Percent
Increase in: b/
Wages c/

6.8
6.3
6.1
5.6
5.5
5.5
5.5
5.5
5.5

8.9
7.5
8.4
7.2
8.5
7.6
7.9
8.0
8.2

Unemployment
Rate e/

Prices d/
6.2
5.3
5.5
5.2
5.4
5.7
5.6
5.6
5.6

6.8
6.3
5.4
4.7
4.4
4.3
4.3
4.3
4.3

Dates represent last quarters.

Increase from fourth quarter of preceding year to fourth quarter of stated
year.

Average annual earnings,

Consumer Price Index,

Percent of civilian labor force.

Under both sets of assumptions, revenues fall short of outlays
each year, and the balances in both the OASI and DI trust funds
decline until they are eventually depleted (see Table 7). The rate
of decline, however, is faster under the lower growth path, and the
funds in the combined OASI and DI funds collapse altogether in 1982.
Under the high growth path, the combined OASDI funds are depleted in
1983. Viewed separately, the DI trust fund is in much more immediate

TABLE 7.

STATUS OF SOCIAL SECURITY CASH BENEFIT PROGRAMS UNDER ALTERNATIVE ECONOMIC
ASSUMPTIONS, CALENDAR YEARS 1977 - 1985: IN BILLIONS OF DOLLARS
High Path dj

Low Path a/

Receipts

Outlays

Balance
at End
of Year

Funds as b/
Percent of
Outlays

Receipts

Outlays

Balance
at End
of Year

Funds as Jd/
Percent of
Outlays

72.6
80.0
87.0
95.2
101.9
109.5
117.1
124.8
132.8

75.2
83.2
90.8
99.3
108.0
117.2
127.5
138.7
150.9

32.8
29.6
25.8
21.7
15.6
7.9
-2.5
-16.4
-34.5

47.1
39.4
32.6
26.0
20.1
13.3
6.2
c/
£/

72.6
80.0
87.8
97.4
105.9
115.7
125.1
134.6
144.6

75.2
83.2
90.8
99.3
108.4
118.4
130.0
143.0
157.3

32.8
29.6
26.6
24.7
22.2
19.5
14.6
6.2
-6.5

9.6
11.0
11.8
12.8
14.7
15.7
16.5
17.3
18.0

11.7
13.3
15.1
17.1
19.3
21.7
24.4
27.5
31.1

3.6
1.3
-2.0
-6.3
-10.9
-16.9
-24.8
-35.0
-48.1

48.7
27.1
8.6
c/
c/
c/
c/
c/
Ç/

9.6
11.0
11.9
13.1
15.3
16.6
17.7
18.7
19.7

11.7
13.3
15.1
17.1
19.4
21.9
25.0
28.5
32.5

3.6
1.3
-1.9
-5.9
-10.0
-15.3
-22.6
-32.4
-45.2

48.7
27.1
8.6
c/
c/
c/
c/
c/
£/

82.2
91.0
98.8
108.0
116.6
125.2
133.6
142.1
150.8

86.9
96.5
105.9
116.4
127.3
138.9
151.9
166.2
182.0

36.4
30.9
23.8
15.4
4.7
-9.0
-27.3
-51.4
-82.6

47.3
37.7
29.2
20.5
12.1
3.4
c/
c/

82.2
91.0
99.7
110.5
121.2
132.3
142.8
153.3
164.3

86.9
96.5
105.9
116.4
127.8
140.3
155.0
171.5
189.8

36.4
30.9
24.7
18.8
12.2
4.2
-8.0
-26.2
-51.7

47.3
37.7
29.2
21.2
14.7
8.7
2.7
c/
c/

OASI
1977
1978
1979
1980
1981
1982
1983
1984
1985

47.1
39.4
32.6
26.8
22.8
18.8
15.0
10.2
3.9

DI
1977
1978
1979
1980
1981
1982
1983
1984
1985
Total
OASDI
1977
1978
1979
1980
1981
1982
1983
1984
1985

SOURCE: Congressional Budget Office estimates.
a/

See Table 6 for economic assumptions underlying the projections.

b/ Funds at start of year as a percent of outlays during the year.
c/ Fund depleted.

danger than the OASI fund, and it is depleted in 1979.
The more
rapid depletion of the DI fund is associated with the large and
unexpected increases of beneficiaries in this program over the past
several years.
Even taking into account the uncertainties of the projections,
it appears unlikely that the balances in the social security trust
funds could, under currently legislated tax rates, rebound to any
thing near their former levels. Although an economic recovery and a
high rate of economic growth over the next few years would slow the
deterioration in the trust fund, it is unlikely to compensate for the
permanently depressing effect on future revenues of several years of
little or no growth in real wages (wages adjusted for inflation) and
of slow growth in employment.
The tax rates in current law were
legislated before the economic slowdown and, therefore, do not
compensate for the reduced revenue base. In addition, revenues from
interest on the trust funds are automatically lowered because of the
diminished size of the trust funds.
After 1985, the long-range effect of the high inflation rates
of the past few years will begin to be felt. The provision in the
current benefit computation procedure, which overadjusts for infla
tion the benefits awarded new retirees, begins to have a perceptible
effect on costs about a decade after a high rate of increase in the
Consumer Price Index occurs. Thus, the temporary short-run problem
created by a depressed economy is eventually merged into the long-run
problem considered in more detail later in this report.
OPTIONS FOR THE SHORT RUN
Some action must be taken to keep the DI trust fund from
collapsing during the next two years. Although the OASI fund is in a
stronger position than the DI fund, it, too, is declining. By 1980
or 1981, the OASI fund could reach levels that many analysts would
consider dangerously low if no action were taken to stabilize it
before then.
There are many options for resolving the short-run financing
problems of the social security system. Among the choices are that:
o

Revenues could be raised by increasing payroll tax receipts
(with a hike in the tax rate, a hike in the wage base, or
some combination of both);

Some portion of the health insurance (HI) payroll tax could
be transferred to OASDI;

General revenue funding could
either as a grant or a loan;

Some combination of the above could be done. 4/

transferred

OASDI

Of course, the financing problems of the system could also be
eased by measures that would result in reduced outlays. For example,
both the Ford and Carter budgets for 1978 included proposals that
would limit the amount of benefits going to certain groups. 5/ For
1978, the Ford revisions were estimated to save $1 billion, and the
Carter revisions about $800 million.
Other fundamental revisions with even greater potential for
savings in both the OASI and DI programs have been suggested. The
House Ways and Means Committee has been studying the particular
problem of the rapid increase in DI beneficiaries and has published
several reports that examine ways of restricting future growth. (>/

The proposal made by the Carter Administration adopts a combina
tion, with some modifications and new emphases. For a discussion
of the proposal see Appendix B.

Both the Ford and Carter budgets proposed: to eliminate a
provision that permits retirees electing to retire before age 65
years to receive an initial lump-sum payment in exchange for
reduced future benefits (a cost savings in the short run but not
in the long run); and to change their retirement test to an
annual basis, eliminating the monthly test.
The Ford budget
proposed to phase out student benefits under social security
over a four-year period.
The Carter budget proposed to cap
student benefits rather than phase them out. See Social Security
Benefits for Students, CBO Background Paper, May 1977.

See Public Hearings Before the Subcommittee on Social Security
of the Committee on Ways and Means, House of Representatives,
94th Congress, Second Session, May 17, 21, 14, June 4, 11, 1976.
Also see the Subcommittee's Explanatory Material and Relevant
Background Reports to H.R. 15630, Disability Insurance Amend
ments of 1976, introduced by James Burke, Chairman of the
Subcommittee.

Major changes in the benefit structure or aspects of program eligi
bility, however, are likely to require considerable evaluation and
discussion.
And even if any such changes were supported by the
Congress, they would take time to put into place.
Since the
financing issues require consideration now, the primary emphasis is
likely to focus on how to provide additional funds.
FUNDING FROM OASDI TAXES
Continued reliance on traditional means of financing OASDI
(i.e., with an earmarked tax on covered earnings) will necessitate an
increase in tax receipts to bring the weakened OASDI trust funds to
the desired level.
But when should taxes be raised?
And by how
much? The answers to these questions depend in part on what role the
trust funds are expected to play in the future.
Social security finances, as has already been observed, are
extremely sensitive to changes in economic conditions.
No trust
funds reserves would be needed, of course, if tax rates were con
stantly adjusted up or down to conform to economic shifts. But such
a policy would be highly impractical. In addition, it would result
in tax increases during recessions, and such an action could be
harmful to economic recovery.
For these reasons, many observers
consider it prudent for a pay-as-you-go system to build up sufficient
balances during periods of prosperity to insure that commitments can
be paid in the event of a recession without requiring any increases
in taxes during the period of high unemployment.
Once economic
recovery began, however, taxes would have to be raised to rebuild the
trust fund revenues again.
What level of balances should be held to serve as a contingency
in the event of an economic downturn? The answer depends partly on
the severity of recessions considered likely. Another consideration
is whether, in order to maintain public confidence, the reserves
should never be allowed to fall below some minimum level. One study
has determined that if future recessions were expected to be at least
as deep and long as the current one, a reserve of 60 percent of a
year's outlays would be needed in the OASI fund at the onset of the
recession. This requirement would maintain a balance in the funds
that would fall as unemployment rose, but would not reach zero before
economic recovery had reduced unemployment below 6 percent. At this

point taxes would have to be raised.
7/ If an extra margin were
required for public confidence, the contingency reserve level would
have to be higher than 60 percent of annual outlays at the start of a
deep recession.
Smaller reserves could be maintained in the trust funds during
prosperity if loans or grants from general revenues were available,
on a standby basis, to finance fund deficits that might result from
recessions. If loans were actually required, social security taxes
would eventually have to be raised to repay them.
If general
revenues were transferred to the trust funds on a nonrepayable basis,
the transfer would ultimately be paid through higher income taxes or
reductions in federal spending.
There are two ways to increase revenues through the payroll
tax. One is a hike in the tax rate. The other is an increase in the
amount of earnings subject to the tax.
And, of course, both
alternatives could be combined. Each alternative is briefly consi
dered below.
Increase the Tax Rate
The Ford Administration's budget for fiscal year 1978 proposed
a three-step increase in the combined employer-employee OASDI tax
rate, to add 1.1 percentage points by 1980.
It is estimated that
these increases would prevent the combined OASDI trust funds from
falling below 40 percent of outlays by 1982.
The Carter budget,
however, did not adopt the tax rate increase. 8/

See Paul N. Van de Water and L. H. Thompson, "The Social Security
Trust Funds as Contingency Reserves," Technical Analysis Paper
No. 9, Office of Income Security Policy, U. S. Department of
Health, Education, and Welfare, July 1976.

The proposal for funding OASDI made by the Carter Administration
in June does not include either a tax base or tax rate increase
for 1978, but relies on general revenues and a shift from the
hospital insurance fund in that year. Starting in 1979, however,
OASDI taxes are increased in various ways (predominantly through
a tax base hike for employers). See Appendix B for a description
of the proposal.

9 3 -4 8 6 0 - 77 - 6

One objection to raising social security taxes in 1978
(whether through a tax rate or tax base hike), is that doing so could
hold back economic recovery at a time when unemployment is still
likely to be high.
This restrictive effect could, however, be
counter-balanced by a reduction in another tax, such as the federal
income tax. The outcome of such a tradeoff would tend to reduce the
overall progressivity of the tax system since the income tax is a
more progressive tax (see Table 2).
Again, however, this effect
could be minimized by an income tax reduction that was scaled to
benefit low-income families with earnings.
A payroll tax rate increase (but not a tax base increase) may
have specific disadvantages for low-wage earners since, after a
period of time, it may reduce their employment opportunities. 9/ It
should be noted that any increase in the payroll tax would be in
addition to the 0.4 and 0.5 percent increases that are already
scheduled for the hospital insurance component of the payroll tax in
1978 and 1981.
One alternative to an immediate increase in the tax rate is to
take temporary measures to ensure the payment of social security
commitments.
This would either permit the postponement of a rate
increase until economic conditions improved or allow time for the
consideration of other options.
As an immediate measure (which would require legislation) to
insure that the DI trust fund is not exhausted, a portion of the
total payroll tax could be shifted from the OASI fund to the DI fund.
Such an expedient would avoid an increase in the total payroll tax
during the present period of high unemployment, although it would
involve a substantially larger tax increase, or infusion of other
funds later.
Shifting revenues from OASI to DI, of course, would
9/

The portion of the social security tax levied on employers
serves, in effect, as an increment to the minimum wage. When
payroll taxes are increased, employers gradually shift at least
part of the tax increase to workers in the form of lower wage
increases.
When workers are at the minimum wage, however,
employers cannot require employees to absorb the tax in the form
of lower wages, so the payroll tax increase would act as an
increase in the minimum wage.
Workers whose skills could not
command the cost of employment (the minimum wage plus the payroll
tax and the cost of any fringe benefits) may then suffer a
decline in employment prospects.

accelerate the decline of the OASI trust fund balances. The combined
OASDI trust funds are projected to have reserves of only about 21
percent of a year's outlays at the start of 1980.
Increase the Taxable Earnings Base
Payroll tax revenues can also be increased by raising the
maximum earnings subject to the tax.
At present, the taxable
earnings base is $16,500, and this ceiling increases automatically
each year at a pace that is related to the rate of increase of
average covered wages.
Because few workers are at high-earnings
levels, however, a substantial increase in the ceiling would be
required to obtain the same amount of revenue that could be derived
from a small increase in the tax rate.
For example, either alternative -- a tax rate increase or a tax
base increase — would raise an equivalent amount of revenues through
the year 1983. Under either alternative, revenues would maintain the
trust fund balances above 30 percent of outlays. The specifics of
these options are:
o

An increase in 1978 in the combined employer-employee OASDI
tax rate of 0.8 percent and 0.2 percent in 1981, which would
increase the rate from its present level of 9.9 percent to
10.9 percent;

An increase of 63 percent in the taxable earnings base.
This would raise the base to $28,800 in 1978 and $42,900 by
1983. (The increases scheduled under current law raise the
base to $17,700 in 1978 and $26,100 in 1983.) As a result of
the hike in the taxable earnings base, the proportion of
workers with all of their earnings below the ceiling would
rise from the current level of 85 percent to 96 percent in
1978 and thereafter.

An increase in the taxable earnings base is sometimes
preferred to an increase in the tax rate because it would increase
the progressivity of the social security tax. Only those families in
the top two-fifths of the income distribution could have a member
earning more than the current maximum. JO/ An increase in the tax
10/ Of course, not all families in the top two-fifths would have such
an earner since many families have high total income because of
two earners, each below the maximum.

rate would be paid by families at all levels of income, although it
would be concentrated among the highest three-fifths of all
families, who pay most of the social security tax.
On the other
hand, this remedy has been criticized because it raises revenues at
the expense of future program costs.
Since benefits are based on
taxable earnings, a rise in the earnings base would result in higher
benefits in the future for high-wage earners, thereby adding to the
long-run size and costs of the system. JH/
Another criticism of a substantial increase in the wage base is
that it might result in a reduced demand for private pensions and
other savings among high-income households. The large tax increase
would reduce income that could be used for savings, and the promise
of higher benefits would reduce the incentive to save.
As a
consequence of such a decline in savings, capital accumulation -- and
therefore economic growth -- could diminish.
FUNDING FROM GENERAL REVENUES
The decision to use some general revenue funding for social
security, as opposed to a continued, exclusive reliance on the
payroll tax, depends on fundamental choices about the overall
function of social security.
Observers who view social security
simply as a transfer payment from current workers to current benefi
ciaries regard the payroll tax as part of the total tax system.
Viewed in this way, the OASDI tax can be seen as undesirable, since
it tends to decrease the overall progressiveness of the tax system.
Viewed as a transfer program, there may also be difficulties in
justifying earnings-related benefits and other aspects of the
benefit structure.
Other observers, who view social security primarily as a
compulsory savings system, regard the payroll tax as a mandatory
contribution toward an earned retirement benefit. Although the link
between benefits and contributions is weak, many people feel that the

11/ Under the present benefit structure, a substantial increase in
the wage base would actually increase the deficit in the long
run, since costs would go up more than revenues.
Under a
decoupled system such as that proposed by the Ford and Carter
Administrations (see Chapter IV and Appendix A), the increased
costs would not necessarily exceed the increased revenues in the
long run.

link is important to public support of the program; some would make
the link stronger. Another argument cited for funding through the
payroll tax alone is that it promotes restraint, since increases in
benefits must usually be accompanied by increases in the earmarked
payroll tax.
It has been suggested that the burden of the payroll tax on
low-income families is better dealt with through direct tax relief
rather than by revising the means of financing social security. In
this regard, the Earned Income Credit, passed by the Congress in
1975, has been viewed by some as an offset to the payroll tax, since
it provides relief from federal income tax payments (or direct
payments when there is no tax liability) to low-income families with
dependent children, when their income is based on earnings.
Of course, the general revenues that could be used to support
social security must come from some place -- from an increase in the
federal deficit, an increase in income or other federal taxes, or a
reduction in other government spending. The extent to which general
revenue funding restricts economic expansion and is less regressive
than a payroll tax increase depends on how it is ultimately financed.
For example, if the federal deficit were simply enlarged, general
revenue funding would not restrict the economy. If general revenue
funding of social security benefits ultimately resulted in a reduc
tion in low-income housing assistance or compensatory education
benefits, the outcome would be quite regressive. This is because the
payroll tax falls most heavily on families with incomes above $10,000
a year, and these housing and education benefits are concentrated on
families with incomes considerably below that.
SHIFT THE HI TAX TO OASDI
Another proposal for funding, suggested by the 1975 Advisory
Council, is to shift all or a portion of the medicare hospital
insurance (HI) payroll tax to the OASDI programs.
Since medicare
benefits are based on hospital expenses incurred, and not on prior
earnings, some of the arguments against using general revenue
funding for OASDI do not apply for the HI program.
Medicare,
however, is now a $22 billion program and is growing rapidly. Future
funding of medicare out of general revenues could, therefore, imply
substantial increases in the federal income tax, depending on the
extent of the transfer from HI to OASDI and future medicare expendi
tures.

CHAPTER IV.

THE LONG-RANGE FINANCING PICTURE —

TO 2050

In setting tax rates for the Old-Age, Survivors and Disability
Insurance (OASDI) system, the Congress follows a general principle:
estimated future income to the trust funds should equal estimated
future outgo.
A 75-year planning period has been adopted by the
Congress and the funds' trustees. It is important for the planning
of the finances of social security, therefore, to make long-run
projections of revenues and expenditures.
Future revenues and expenditures of the social security system
will depend on many factors. Revenues will be affected by the size
and composition of the work force, which in turn will be determined
by factors such as the birth rate, immigration, mortality rates, and
the proportion of the population in the labor force at different
ages. Revenues will also be influenced by the rate of increase in
earnings and prices.
Benefit payments will depend on the size and
composition of the retired beneficiary population and on their past
earnings.
These factors, in turn, depend on many of the elements
mentioned above.
The future course -- and interaction -- of all
these determinants obviously is unknown. In order to get an idea of
what may happen, one can look at long-term projections made according
to a variety of possibilities.
Table 8 shows OASDI expenditures as a percentage of taxable
payroll projected to the year 2050.
Four sets of assumptions are
made regarding the major variables:
o

The fertility rate (the average number of births a woman has
in her lifetime);

The rate of inflation (rate of increase in the Consumer
Price Index); and

The rate of increase in average real wages.

The projection to the year 2050 is highly sensitive to these
factors and in the way they interact with each other.
A low
fertility rate increases the burden of benefits (benefits as a
percent of taxable payroll) primarily because of its effect on the
size of the working population: the bigger the rate of increase in

TABLE 8.

PROJECTED EXPENDITURES OF THE OLD-AGE, SURVIVORS AND
DISABILITY INSURANCE SYSTEM AS PERCENT OF TAXABLE PAYROLL
UNDER CURRENT LAW AND DIFFERENT LONG RANGE ASSUMPTIONS,
FOR SELECTED CALENDAR YEARS 1976-2050
(percents)

III

Rate of Increase
in Real Earnings a/

2.25

2.0

1.75

1.25

Rate of Increase
in Prices b/

3.0

4.0

5.0

Fertility Rate c j

2.3

2.1

1.9

1.7

1976 (actual)
1985
1990
2000
2010
2020
2030
2040
2050

10.9
10.4
11.1
11.7
12.8
15.5
17.2
16.6
16.3

10.9
11.2
11.8
12.9
14.9
19.2
22.7
23.1
23.5

10.9
11.2
12.1
13.4
16.0
21.3
26.0
27.5
28.6

10.9
12.0
13.1
15.3
19.6
28.2
37.2
42.1
46.0

9.9
9.9
9.9
9.9
9.9
11.9
11.9
11.9
11.9

Average
1976 to 2050

13.8

17.0

18.9

25.5

10.9

Assumptions

OASDI
Tax Rate
Schedule
(Current
Law)

Year

SOURCE:

1976 Annual Report of the Board of Trustees of the Federal
OASI and DI Trust Funds.

Average annual taxable earnings expressed in dollars of constant
purchasing power.

Consumer Price Index.

Estimated average number of births a woman would have during her
lifetime assuming she followed the pattern of births estimated
for each age group of women in the stated year.

real wages (wages in dollars of constant purchasing power), the lower
the benefit burden. V The higher the rate of inflation, the bigger
the burden because of a provision in the current law that results in
rapidly accelerating benefit levels when inflation increases.
Set I of the assumption packages results in the lowest-cost
forecast because it combines the highest rate of fertility, the
lowest inflation, and the highest real wage rate increase. Set IV
results in the highest-cost forecast because it uses the most
pessimistic assumptions. Sets II and III correspond to the assump
tions that have been used as the basis for the central forecasts in
the 1975 and 1976 trustees' reports.
Although the differences in outcomes are wide, all sets of
assumptions considered indicate an increase in social security
expenditures as a percent of taxable payroll after the year 2000.
Under current law, the OASDI tax is set at 9.9 percent of taxable
payroll, rising to 11.9 percent in 2011 and thereafter.
If future
developments should follow any of the projected paths in Table 8, tax
payments scheduled under current law would not be sufficient to meet
long-run expenditure commitments.
By the year 2050, expenditures
would exceed revenues by 4 percent of taxable payroll even under the
most optimistic set of assumptions; they will exceed revenues by 34
percent of taxable payroll under the most pessimistic assumptions.
If, on the other hand, tax rates were set to cover current costs, the
rates would have to be raised by those amounts.
The central assumptions used in the recently released 1977
trustees' report are somewhat different from those of the 1976
report.
Because some of the changes lead to increased future
expenditures as a percent of payroll and others have the opposite
effect, the net effect on the long-range cost estimates is close to
the 1976 estimates. In the 1977 report, expenditures as a percent of
taxable payroll are projected to be 19.2 percent over the 75-year
period compared to 18.9 percent in the 1976 report.
The long-run
inflation rate and real wage rate assumptions are the same in both
reports.
The differences result from a higher fertility rate
assumption in the 1977 report, a lower mortality rate projection, and
various other changes.
V

A higher rate of increase in average real wages reduces the
benefit burden partly because the revenue base increases. Rapid
growth in real earnings, however, also tends to reduce the rate
of benefit increase since the benefit formula is progressive,
providing for falling replacement rates as earnings rise.

Such a bleak picture of the financial future of social security
is in large part the result of two factors:
o

A dramatic demographic change whereby the ratio of retired
persons to workers will rise sharply above present levels;
and

A provision in current law that results in an unintended
overadjustment for inflation.

A significant share of the long-run deficit can be eliminated
by correcting this latter provision; the correction is sometimes
referred to as "decoupling" the system.
Several proposals for
decoupling have been made. Because this highly technical issue is
likely to be a current concern of the Congress -- and because letting
a long time go by before doing something about it can be costly -the remainder of this paper focuses on decoupling.
There are, of
course, many other changes in the social security system and its
financing that could also have significant effects on the long-run
fiscal situation.
These are noted; but a full discussion of the
alternative remedies for social security financing is beyond the
scope of this report.
REVIEWING THE ASSUMPTIONS
Because of the strong effects that different assumptions can
have on estimates of long-run expenditures and the long-run deficit,
the assumptions themselves must be carefully examined. Each year the
OASDI trustees choose the assumptions they believe are most likely to
reflect future developments.
In their 1973 report, the trustees
forecasted only a very slight 75-year deficit under current law, as a
result of adopting high fertility and low inflation assumptions. In
subsequent reports, the assumptions chosen became increasingly
pessimistic, primarily in response to changing economic and demo
graphic developments. Such assumptions, however, are best evaluated
in the context of their long-run historical patterns. A review of
the available information about future patterns is in order before
turning to the issue of over-adjustment for inflation.
Fertility and Mortality
With a system such as the current social security system, in
which current flows of revenues finance current benefit payments,
the relative sizes of the beneficiary and working populations are
crucial in determining the extent of the financial burden.

Although the proportion of the working age population that
actually works obviously affects the size of the working population
and the proportion of the eligible population that chooses to retire
affects the beneficiary population, the basic demographic con
straints are the number of persons at working and retirement ages.
Under each set of assumptions shown in Table 9, the population of
retirement age (persons age 65 years or older) is projected to grow
sharply as a percent of the working-age population (persons 20 to 64
years old). The sizable population born during the post-World War II
baby boom will start reaching retirement age after the year 2010.
But at that point, the working population will be composed, at least
in part, of the groups born during the period of sharply declining
fertility starting in the late 1960s. (The fertility rate is defined
as the average number of births that the average woman is projected
to have over her lifetime). From now on, fertility rates will, in
large part, determine the size of the working population after the
turn of the next century.
What is a plausible projection for future fertility?
The
historical pattern indicates a long-term decline in the fertility
rate in the United States. From rates of 5.4 births per woman in the
mid-nineteenth century, there was a fairly steady decline, reaching
3.6 in 1900, 3.0 in 1925, and 2.2 in 1940. Against this long-term
decline, the very high fertility rates of the postwar baby boom,
which lasted from the late 1940s well into the 1960s (peaking at 3.8
in 1957), appear as an abberation.
(The abnormal sequence of the
Great Depression, which probably depressed birth rates below the
trend, followed by World War II, may well have had an effect on the
unusual swing in the birth rate.)
Since the late 1960s, the
fertility rate has declined to below the level of the 1930s, reaching
an estimated 1.7 births per woman in 1976; this figure is roughly
similar to the rate in other highly industrialized countries today.
The so-called "replacement level" fertility rate, which would result
in a stationary population, is 2.1.
Although fertility may not remain at its present low level,
there have been significant changes in social and economic behavior
that could cause future fertility to remain close to current levels.
People are marrying later than they used to and wives are in
creasingly likely to work.
For these reasons among others, some
observers assume the fertility rate will stay on a low plateau around
the replacement rate level of 2.1 births per woman; others believe a
long-term rate close to 1.9 is more likely.
In this latter case,
even if the proportion of women who work continues to increase, there
will be a decline in tax-paying workers to support social security

TABLE 9.

PROJECTIONS OF THE U. S. POPULATION OF RETIREMENT AGE AS A
PERCENT OF THE WORKING AGE POPULATION UNDER ALTERNATIVE
FERTILITY ASSUMPTIONS: SELECTED YEARS 1985-2050
Fertility Rate —

Year

1.7

2.1

2.3

1975

18.9

1985

19.5

1990

20.3

2000

20.3

2010

21.3

20.9

20.7

2020

28.4

26.8

26.1

2030

37.5

33.6

31.9

2040

39.2

32.8

30.2

2050

38.9

30.6

27.4

SOURCE:

1977 Annual Report of the Board of Trustees of the Federal
OASI and DI Trust Funds.

Estimated average number of births a woman would have during her
lifetime assuming she followed the pattern of births estimated
for each age group of women in the stated year.

NOTE:

The population of retirement age is defined here as 65 years
and over. The population of working age is defined as 20 to
64 years of age. The underlying mortality assumptions are
those of the 1977 trustees' report, which indicate an
improvement of 18 percent over the assumptions of the 1976
report.

beneficiaries. This is a major reason why the projections show such
a large increase in social security outlays relative to receipts.
Less attention is often paid to the mortality assumptions
underlying the projections. When mortality improves at older ages,
the number of beneficiaries increases and the average beneficiary
collects benefits for more years. The projections in Table 9 reflect
the assumptions of the 1977 trustees' report which is more optimistic
in this respect than the 1976 report. The projection of mortality
improvements may still be regarded by some as too low. The mortality
improvements of the 1977 report translate to a life expectancy of
70.8 years for men and 79.6 years for women in the year 2050.
If
these estimates should be surpassed (some countries have already
reported life expectancy for men as high or higher than these
figures), then the ratio of beneficiaries to workers would be still
higher.
Wages
Since 1950, there has been a decline in the growth rate of
average annual real wages caused by several factors.
During the
1950s, real wage growth averaged 2.3 percent and then fell to a rate
of 0.7 percent in the decade 1965 to 1975. Part of this decline is
the result of changes in the composition of the work force: as
teenagers and women entered the labor force in growing numbers, there
was an increase in the proportion of part-time and inexperienced
workers just entering the labor force; these people start at low wage
rates. The recession has also affected the very low averages of the
last few years.
Many analysts believe, however, that the decline in produc
tivity over the past decade is due to a longer-term slowdown in the
rate of economic growth, which could well continue into the future.
Such a trend may be offset to some extent as the proportion of
teenagers in the population declines and as women develop more
experience and attachment to the labor force. It seems likely that
the rate of real annual wage increase will rise above the rates
experienced in the 1965 to 1975 period. Because of the uncertainty
about future economic growth, however, this rate could average
anywhere from about 1.0 to 2.5 percent a year.
Both the 1976 and
1977 trustees' reports project a growth in real wages of 1.75 percent
a year.

Prices
Because there is considerable uncertainty about the deter
minants of the rate of inflation, it is especially difficult to
forecast changes in the price level.
Historical experience shows
that the Consumer Price Index rose at an average rate of 2.5 percent
a year during the entire period 1929 to 1975; it rose another 3.3
percent between 1950 and 1975.
Of course, there has been con
siderable fluctuation within periods. The average rate of increase
for the period 1960 to 1970 was 2.8 percent a year, but it rose at a
5.5 percent rate between 1965 and 1975.
The last few trustees'
reports have used a long-run inflation rate of 4 percent a year for
their central set of assumptions.
THE PROBLEM OF OVERINDEXING
Before the 1972 legislation that introduced overindexing, or
coupling, into the computation of social security benefits, the
table for determining benefits could be changed only by legislation.
Legislative changes in the table were made on an ad hoc basis. For
persons already receiving retirement benefits, once the amount was
determined, it stayed fixed at the same dollar amount throughout
retirement unless (or until) it was changed by legislative action.
Obviously, as prices rose, and in the absence of legislative
action, the real value of this fixed benefit would erode. So ad hoc
increases were enacted periodically to maintain the purchasing power
of benefits. The increases were implemented by a method that applied
not only to the benefits of those already retired, but also to the
potential benefits of those people who were still in the work force.
The 1972 amendments made these increases automatic and tied them to
increases in the Consumer Price Index (CPI).
It was not foreseen,
however, that the procedure that had worked in the past could produce
undesired results once it was made automatic, especially in a period
when inflation was higher and wage growth lower than they had been or
were anticipated to be.
How

the

automatic

benefit

adjustment

operates

is outlined

below.
A retiree's social security benefit is determined through a
procedure that applies a benefit rate table to the average monthly
earnings (AME) on which the individual paid a payroll tax during his

working life.
As of July 1976, the benefit rate table provided a
monthly benefit for a worker retiring at age 65 approximately
according to the following formula:
137.77 percent of the first

$110.00

25.51 percent of the next

$250.00

50.11 percent of the next

$290.00

22.98 percent of the next

$175.00

46.83 percent of the next

$150.00

21.28 percent of the next

$100.00

55.04 percent of the next

$100.00

20.00 percent of the next

$100.00

30.61 percent of the next

$100.00

The amendments of 1972 established the following method for
automatic adjustment of the benefit table for inflation: if the CPI
increases by 3 percent or more since the last annual adjustment, the
benefit rates in the table are all raised by the same percent. Thus,
if the CPI were to rise by 10 percent next year, the schedule given
above would provide 152 percent instead of 138 percent of the first
$110 of AME, 55 percent instead of 50 percent of the next $290, and
so on.
For those who are already retired and who therefore have fixed
wage histories (that is, fixed AMEs), this adjustment mechanism
achieves the desired effect: it simply adjusts the value of the
social security benefit for cost-of-living increases.
The same
benefit rate table applies for those who are still working, however,
and for this group the provision results in an unintended over
indexing of future benefits. 2J This occurs because workers who are
still employed do not have fixed wages.
Rather, their wages
typically increase by the rate of inflation plus a productivity
factor of one percentage point or two. Thus, without any adjustment

The system is said to be "coupled" because the same formula is
used for indexing the benefits of those already retired and for
indexing the potential future benefits of those who are still
working.
It is not the coupling feature, that produces the
problem, however, but the particular form of the adjustment.
Nonetheless, the word "decoupling" has come to be used to refer
to all proposals designed to correct the flaw, even those that
technically are coupled systems.

of the benefit schedule for inflation, the benefits of future
retirees would rise, because inflation tends to push up the worker's
wages, and benefits rise with wages. The automatic indexing of the
rates in the benefit schedule thus represents a second adjustment for
inflation. In sum, inflation raises wages, and as a result, workers
move higher up in the benefit schedule; but at the same time, the
benefit rates are adjusted so that each step in the schedule is also
associated with a higher dollar benefit. 3/
The effect of this automatic adjustment is cumulative. If high
rates of inflation persist over a number of years, the so-called
"replacement rate" -- defined here for simplicity as the ratio of the
new retiree's benefits to his wages in the year before retirement -could increase sharply. 4/
Indeed, it is possible for benefits
eventually to exceed pre-retirement earnings.
And as replacement
rates rise, so does the burden to the taxpayer.
High replacement
rates are translated into a high ratio of total benefit payments to
total taxable earnings, which in turn implies a high OASDI tax rate
on earnings.
The replacement rate applying to workers who had earned the
median wage and retired in the mid-1970s is about 43 percent. Table
10 shows how replacement rates and implied tax rates would vary by
the year 2045 under different assumed rates of increase in future
wages and prices and if the "coupled" benefit adjustment provision in

In order to insure that wage increases would be reflected in
higher benefits and higher taxes, the maximum wage taxed by
social security is automatically increased by the rate of
increase in money wages. But because of the progressivity in the
benefit table (outlined above), an increase in wages does not
increase benefits proportionately. This is discussed further in
the text.

As noted above, the replacement rate can be defined using any
number of different denominators. For some purposes it would be
preferable, for example, to define it using average monthly
earnings (AME) as the denominator, since this is the base
directly used in the actual benefit calculation procedure. The
overindexing flaw would, however, have a roughly similar effect
on changes in the replacement rate regardless of whether AME or
earnings in the year before retirement are specified in the
denominator.

current law were allowed to continue.
As the table shows, small
changes in the long-term rate of price and/or wage growth produce
large changes in the replacement rate and in the implied tax rate.

TABLE 10.

REPLACEMENT RATES AND IMPLIED ÒASDI TAX RATES IN THE YEAR
2045 UNDER CURRENT LAW AND ALTERNATIVE ASSUMPTIONS ABOUT
FUTURE WAGE AND PRICE INCREASES
Case
E

Case
F

Case Case
H
G

Case
A

Case
B

Case
C

Case
D

Average Annual Rate
of Increase in
Prices
Money Wages
Real Wages

0.5
2.5
2.0

2.0
4.0
2.0

4.0
6.0
2.0

6.0
8.0
2.0

8.0
10.0
2.0

10.0
12.0
2.0

4.0
5.0
1.0

6.0
7.0
1.0

Replacement Rate a/
in 2045

115

110

Implied Tax Rate b/
in 2045

SOURCE:

Lawrence H. Thompson, An Analysis of the Issues Involved in
Securing Constant Replacement Rates in the Social Security
OASDI Program (Appendix
Office of Income Security
Analysis, U. S. Department of Health, Education, and
Welfare.

Ratio
amount
before
always

Combined employer/employee tax rate
payments on a current cost basis.

of the constant dollar value of the primary insurance
(PIA) to the constant dollar value of earnings in the year
retirement for a man retiring at age 65 years who had
earned the median wage.

needed

fund

benefit

It should be noted that the rate of increase in wages
inherently tends to reduce the replacement rate, and to some extent,
this works to offset the effect of the overadjustment for price
changes. 5/ This occurs because the benefit rate table is pro
gressive, providing for lower replacement rates at higher levels of
earnings. As a result of this offsetting effect of wage increases,
replacement rates can even decline in the future under certain
combinations of wage rates and price increases. Such an outcome is
illustrated by Case A in Table 10, where the replacement rate
declines to 30 percent by the year 2045 under the conditions of an
inflation rate of 0.5 percent and wage rate increases of 2.5 percent
a year.
With higher rates of inflation and money wage increases
(going from Case A to Case F), but with real wage increases staying
the same, the automatic benefit provision raises the benefit rates in
the benefit table by an amount that more than compensates for the
dampening effect of rising wages. Thus, replacement rates rise.
The importance
replacement rates can
H. For the same rate
sharply when the rate

of
be
of
of

wage
seen
price
wage

increases in dampening the rise in
by comparing Cases C and G, and D and
increase, replacement rates rise more
increase is lower.

At the time the 1972 amendments were drafted, future price and
wage increases in the neighborhood of those applying to Cases A and B
were deemed plausible. In these ranges, replacement rates would be
relatively stable.
The automatic provision for indexing future
benefits received little attention because combinations of wage and
price increases that cause great instability were not seriously
considered. Since then, the rate of inflation has risen appreciably
and the rate of growth in real wage rates has fallen. A situation
close to Case H would not be regarded as totally implausible now.
But because there is much uncertainty about the economic forecast,
the future growth of benefits and replacement rates is highly
uncertain.

Another offsetting effect is produced by the lengthening in the
wage-averaging period, which increases by one year until the
early 1990s.
As the number of years of earnings mounts, more
years in the past are included, and since these are generally
years of lower earnings, the average monthly earnings (AME) on
which benefits are based tend to be pulled down.

The extreme sensitivity of social security benefits to the
rate of price and wage increases is widely believed to be
undesirable, both because it can treat workers of different genera
tions in a capricious manner and because it allows for the system to
be controlled by the vagaries of the economy rather than by the
conscious actions of policymakers.
OPTIONS FOR REVISING THE BENEFIT STRUCTURE
Because of the potentially serious fiscal consequences of the
current overindexed system, there has been considerable interest in
adopting a new procedure to adjust the benefits of present and future
retirees for inflation.
Any change in the benefit adjustment
mechanism, though, is likely to affec.t the amount of benefits
received and of taxes paid by future beneficiaries and workers.
Therefore, implicit in any such mechanism are value judgments
regarding the distribution of resources between different genera
tions of workers and retirees, and among those working and those
retired at any given time.
Judgments regarding the distribution of resources may be
reflected in the replacement rate -- the ratio of benefits to a
measure of pre-retirement earnings. As discussed above, under the
present coupled system, the relation between benefits and earnings
is not under control and varies erratically with rates of price and
wage increases. Under a system that corrects the overindexing flaw,
the relationship between benefits and earnings could be determined
as a policy objective.
There are many ways to correct the provision in current law
that leads to overindexing. One approach, originally suggested by
the report of the Quadrennial Advisory Council on Social Security, is
represented by the
"Social
Security Benefit
Indexing
Act"
(H.R. 14430), proposed by the Ford Administration in 1976. 6/
Another approach is represented by the Hsiao proposal (H.R. 12334T,
named for William Hsiao who directed a panel established to advise
the Congress on social security. Like the current law, both the Ford
Administration and Hsiao proposals provide for increases in benefits
that keep pace with the cost of living for persons already retired.
The two proposals offer different answers, however, to the question

The Carter Administration has recently made a similar proposal.
See Appendix B.

of how fast future benefits should grow relative to the average
earnings of future generations of new retirees. (The precise equity
implications of either plan involve highly complex considerations,
which should be taken into account by writers of legislation in this
area. JJ While this report cannot treat all the relevant technical
issues fully, the interested reader will find some further dis
cussion of these topics in Appendix A.)
Roughly speaking, the Ford Administration's proposal provides
increases in the social security benefits of successive generations
of new retirees that keep pace with increases in the standard of
living of the working population.
The Ford proposal uses a procedure that aims to keep the
replacement rate constant through time for retiring workers with the
same relative income position, regardless of the real level of income
achieved.
For example, a worker retiring in the year 2050 who had
always earned the median wage would enjoy the same replacement rate
as the median-wage worker retiring in the year 1978, even though
economic growth is likely to have raised the median wage and made the
worker of the year 2050 very much richer in real terms. Hence this
approach is sometimes described as one that maintains constant
replacement rates.
A numerical (and highly simplified) example can clarify this
approach (see Table 11). Again, the example deals with the hypo
thetical male retiree who had always earned the median wage.
A

A framework for analyzing the equity implications of different
benefit structures is developed in Dean Leimer and Ronald
Hoffman, "Designing an Equitable Intertemporal Social Security
Benefit Structure," Office of Research and Statistics, Social
Security Administration, November 1976. That paper emphasizes
the nature of the components of a benefit structure required to
insure the equitable treatment of beneficiaries within and
between successive beneficiary populations.
The framework
indicates how a benefit structure can be designed to insure that
its operational characteristics accurately reflect underlying
value judgments concerning the equitable distribution of
benefits. Also see "A Framework for Analyzing the Equity of the
Social Security Benefit Structure," U.S. Department of Health,
Education, and Welfare, Social Security Administration, Office
of Research and Statistics, Studies in Income Distribution
(forthcoming).

worker fitting this description and retiring in 1976 would have had
wages in the year before retirement of about $8,600 and received a
social security benefit of about $3,600 if he did not have a
dependent spouse. This retiree's replacement rate was therefore 42
percent ($3,600 * $8,600 x 100). If real wages grew by 2 percent a
year, the median-wage worker retiring in the year 2050 would reach a
pre-retirement wage of $37,200 in terms of today's purchasing power.
Because the Ford Administration's proposal seeks to keep the
replacement rate constant for workers with the same relative income
standing, this worker would receive an annual benefit of $16,400
($37,200 x 0.44). 8/
While the Ford Administration's proposal seeks to maintain
constant replacement rates for workers at the same relative income
positions, the social security benefit structure is progressive and
provides for lower replacement rates at higher levels of earnings.
Over time, as earnings rise, more workers would shift into the upper
brackets of the benefit rate table where replacement rates are lower.
Therefore, if the table were not adjusted, replacement rates on
average would fall. To prevent this, the Ford proposal provides for
an automatic adjustment in the table to compensate for the increase
in wages in the economy. 9/ As a result of this adjustment, larger
proportions of future retiring workers do not move into the upper
brackets of the benefit rate table as the level of earnings rises;
thus, replacement rates for the workers with the same relative income
standing are held constant.
At the same time, however, this procedure implies that
retiring workers with the same absolute level of real earnings will
obtain successively higher replacement rates over time as the
average level of earnings in the economy increases and their relative
standings fall. Going back to the numerical example of Table 11, the
new retiree whose pre-retirement earnings had only kept pace with
inflation (i.e., had real earnings in 2050 remaining at the 1976
median of $8,600) would receive a benefit in the year 2050 of $8,600
in terms of today's purchasing power. The replacement rate would be
100 percent (150 percent if he had a dependent wife), and the worker
would be enabled at the least to maintain his standard of living upon

Because of technicalities in the procedure, the replacement rate
increases slightly.

The wage-indexing procedure
explained in Appendix A.

for

achieving

this

result

TABLE 11

(PART ONE). PROJECTED CONSTANT DOLLARS BENEFITS (EXCLUDING
SPOUSE BENEFIT) FOR NEW RETIREES UNDER THE FORD AND HSIAO
PROPOSALS: FOR REPRESENTATIVE AVERAGE WORKER AND WORKER
WITH SAME LEVEL OF REAL EARNINGS a/
REPRESENTATIVE AVERAGE WORKER b/

Year of
Retirement

Earnings of
Year Before
Retirement

1976

8,600

3,612

1990

11,348

4,993

3,858

2000

13,833

6,087

4,288

2030

25,056

11,025

6,264

2050

37,232

16,382

8,563

SOURCE:

Annual Benefit c /
Ford e/ Hsiao

Replacement Rate d/
Ford e/
Hsiao

Congressional Budget Office calculations based on Social
Security Administration data.

Earnings in constant (1975) dollars; benefits in constant (1976)
dollars.

New retiree (age 65) who had earned the median wage each year of
his working life. Median wage rises 2 percent a year faster than
prices.

Primary insurance amount (PIA).

PIA as a percent of earnings in the year preceding retirement.

These simulations are based on a modified theoretical system
described in the 1976 trustees' report, which is very close to
the Ford proposal.

TABLE 11 (PART TWO).

WORKER WITH SAME LEVEL OF REAL EARNINGS f/
Year of
Retirement

Earnings of
Year Before
Retirement

1976

8,600

3,612

1990

8,600

4,902

3,698

2000

8,600

5,590

3,784

2030

8,600

7,138

3,784

2050

8,600

3,784

100

Annual Benefit c/
Ford e/ Hsiao

Replacement Rate d/
Ford e/
Hsiao

See Part One.

New retiree (age 65) with the past wage history of the median
worker retiring in 1976 (adjusted for inflation).

retirement even if he were solely dependent upon social security.
This is not now the case for new retirees with earnings of $8,600,
and a replacement rate of 42 percent. Of course, the worker retiring
with earnings of $8,600 in 2050 would be much poorer relative to the
median wage worker in 2050 because economic growth would have raised
the median earnings to $37,200 in real terms.
In contrast to the Ford Administration's proposal, the Hsiao
proposal seeks to maintain constant replacement rates for new
retirees with the same absolute real level of earnings, regardless of
their relative position in the distribution of income.
Thus, the
Hsiao formula does not adjust the benefit rate table fully for
increases in the level of wages. (It adjusts only for the inflation
component,
and not for the productivity component of wage
increases.) With economic growth, therefore, more workers will move
into higher real earnings brackets where replacement rates are
lower. As a result, the average real benefit of successive genera
tions of new retirees will rise as their earnings rise, but not as
fast as earnings -- i.e., the average replacement rate will fall.
For workers with the same real earnings histories, however, replace
ment rates are constant into the future.
In other words, under the Hsiao proposal, the current
relationship between a particular earnings level (adjusted for
inflation) and the benefits it yields is frozen.
Under the Ford
Administration's proposal, this relation is altered in order to
compensate for the progressivity in the benefit schedule, which
would lead to a decline in replacement rates on average as more and
more workers shift into higher earnings brackets.
These relationships are also illustrated in the hypothetical
examples of Table 11. Under the Hsiao approach, the worker retiring
in the year 2050 with real earnings of $8,600 in the year before
retirement would get roughly what he gets today ($3,800 in constant
dollars.) 10/ The average worker retiring in 2050, of course, would
receive more because his real earnings would be higher ($37,200).
His annual benefit would rise to $8,600, but the implied replacement
rate would decline to 23 percent ($8,600 f $37,200 x 100).

10/

Because of technicalities in the procedure, the replacement rate
increases slightly.

LONG-TERM COSTS UNDER THE FORD ADMINISTRATION AND HSIAO ALTERNATIVES
Because it provides for higher replacement rates than the
Hsiao proposal, the Ford Administration's proposal would obviously
entail higher future expenditures relative to expected taxable
payroll. Under the central assumptions of the 1976 trustees' report
-- a 4 percent inflation rate, a 1.75 percent average rate of growth
in real wages, and an average of 1.9 births per woman -- the Ford
proposal would result in expenditures estimated at 19 percent of
taxable payroll by the year 2030. This figure should be compared to
26 percent under the present coupled system, and 13 percent under the
Hsiao proposal (Table 12). JQ/
While changes in the assumptions
could produce substantial shifts in the level of expenditures for all
systems, the ranking of the Hsiao, Ford, and current law systems is
likely to remain the same. YLj
As scheduled under current law, taxes over the period 19762050 average 10.9 percent (see Table 12).
Under the assumptions
given, expenditures would still greatly exceed revenues under the
Ford proposal, although not as much as under the current overindexed
system. The Hsiao proposal can essentially be funded with current
tax rates and a slight increase in the taxable maximum.
The increased burden associated with the Ford proposal could
be funded out of increased payroll taxes, although under current cost
funding, taxes might have to rise to 19 percent of taxable payroll by
the year 2030. General revenues would be an alternative source of
funding and would involve raising equally huge sums.
The con
siderations mentioned in Chapter III involved in raising revenues by
either method apply here as well.

11/

The Hsiao proposal incorporates a higher taxable maximum,
however, than do other systems, resulting in a taxable wage base
that is 3 percent larger. When OASDI expenditures are expressed
as a percent of total earnings in covered employment for all
three systems, the difference between the Hsiao system and the
others is very slightly decreased.

12/

For example, estimates of the Social Security Administration
indicated that the assumptions of the 1977 trustees' report
result in slightly higher long-term expenditures as a percent of
payroll for all three systems, while the relative differences
between them remain about the same.

TABLE 12.

PROJECTED OASDI EXPENDITURES AS A PERCENTAGE OF TAXABLE
EARNINGS UNDER THE CURRENT COUPLED SYSTEM AND THE FORD
ADMINISTRATION AND HSIAO PROPOSED ALTERNATIVES a/
Expenditures as a Percent of
Taxable Earnings

Year

Present
Coupled
System

Ford
Administration
Proposal

Hsiao
Proposal

Combined OASDI Tax
Rate Schedule Under
Current Law

1976
1980
1990
2000
2010
2020
2030
2040
2050

10.8
10.7
12.1
13.4
16.0
21.3
26.0
27.4
28.6

10.8
10.7
11.8
12.4
13.4
16.5
18.9
18.9
18.8

10.8
10.6
10.5
10.0
10.0
11.5
12.5
11.9
11.3

9.9
9.9
9.9
9.9
9.9
11.9
11.9
11.9
11.9

Average
1976
to 2050

18.9

15.0

11.0

10.9

SOURCE:

Social Security Administration.

The underlying assumptions are a 1.75 percent rate of growth in
real wages, a 4 percent inflation rate, and a fertility rate of
1.9. Only earnings in covered employment that are at or below
the taxable maximum are included in the base. The Hsiao proposal
incorporates a higher taxable maximum resulting in a tax base
that is 3 percent higher.

Another alternative is to reduce or restrict benefits for
particular categories of individuals.
For example, it has been
suggested that the age of retirement be raised, that the minimum
benefit be abandoned, and that the spouse benefit and/or the student
benefit be reduced or eliminated. V3/
Some selective benefits
reductions may be widely supported.
Others are, however, contro
versial and raise more profound problems about the structure of the
system.
THE COST OF WAITING
The projected costs of OASDI benefits (see Table 13) seem to
indicate that we will not have a problem under the current over
indexed system until close to the turn of the next century when
benefits begin to rise significantly. But it would be a mistake to
infer that decoupling can be postponed with no significant effects.
The decoupling procedure must be started within the next few years if
larger costs later on are to be avoided.
This occurs because
replacement rates for new retirees start to rise, but there is a lag
of about a decade between the time when the first workers retire at
the higher replacement rates and when the bulk of retirees receive
benefits at the higher rate.
Thus, actions affecting replacement
rates now will not influence total costs for many years.
As indicated in Table 13, the difference between decoupling in
1977 versus waiting until 1987 would increase the costs of a system
such as the Hsiao proposal by 1.1 percent of payroll by 1990 and by 2
percent by 2020. The costs of the Ford-proposed system would also be
increased, although not by nearly as much.
OTHER OPTIONS
There are, of course, many possible ways to restructure social
security benefits.
Some would combine the features of the two
proposals discussed above.
For example, the average replacement
rate could be allowed to decline at first as in the Hsiao proposal,
but after reaching a particular level, it could be maintained at a
constant average rate. The Ford Administration's proposal seeks to

13/

For a discussion of the student benefit and proposals to modify
it, see Social Security Benefits for Students, CBO Background
Paper, May 1977.

TABLE 13.

PROJECTED OASDI EXPENDITURES AS A PERCENT OF TAXABLE
PAYROLL UNDER THE FORD AND HSIAO PROPOSALS INTRODUCED AT
DIFFERENT TIMES a/
Ford Administration's Proposal

Hsiao Proposal

Date of Introduction

Year

1978

1988

1977

1987

1980
1990
2000
2010
2020
2030
2040
2050

10.7
11.8
12.4
13.4
16.5
18.9
18.9
18.8

10.7
12.0
12.8
13.8
17.0
19.5
19.4
19.3

10.7
10.5
10.0
10.0
11.5
12.5
11.9
11.3

10.7
11.6
11.7
11.8
13.5
14.5
13.5
12.7

Average
1976-2050

15.0

15.4

11.0

12.5

SOURCE:
a/

Social Security Administration.

Projections assume a 1.75 percent growth rate in real wages, a 4
percent inflation rate, and a fertility rate of 1.9.

maintain the average replacement rate at the level reached at the
time of decoupling. By the late 1970s, however, the average replace
ment rate is likely to be around 45 percent, which is very high by
historical standards. As indicated in Chapter II (see Table 4), the
replacement rate for the median-wage earner averaged around 30
percent over the 20 years prior to 1972.
Under the Hsiao proposal, the average replacement rate
eventually levels off at the point where most workers are in the
highest earnings bracket, with a replacement rate of about 23
percent. Since most workers would have the same replacement rate at
that stage, the benefit schedule would have effectively lost its
progressivity.
Those observers who prefer to have the welfare

functions of social security served by a separate means-tested
program are likely to prefer such a proportional benefit structure.
Others, however, may seek to preserve progressivity.
Another decision would then have to be made: whether to
preserve the progressivity in the benefit structure for workers
retiring at the same time, or whether to adopt a structure in which
replacement rates are constant for all levels of earnings.
In the
latter case of a proportional benefit structure, replacement rates
would also be constant through time for each new generation of
retirees.
One advantage cited for the Hsiao proposal is that it does
permit greater flexibility later on. It is always easier to make the
program more generous rather than less if future circumstances
should require or permit a change.
In fact, it may sometime be
considered desirable to share any increase in benefits between those
who are already retired and those who are coming up for retirement.
Under both the Ford and Hsiao systems, the benefits of those who are
already retired rise by only the rate of inflation which typically
increases by less than the standard of living of the average worker.
Another proposal that could be more readily funded under a Hsiao type
system is the removal of the retirement test, which would enable
potential beneficiaries to collect full benefits after the age of 65
years, regardless of their earnings.
THE ROLE OF SOCIAL SECURITY AND LONG-RUN CONSIDERATIONS
The choice of a decoupling proposal can have important effects
on the future role of social security.
Social security is sometimes viewed as one component of a
three-part income system for the aged; social security can be said to
serve as a compulsory retirement program, which insures that the
great mass of individuals will reach retirement with a modest
retirement income -- one related to past earnings. For persons whose
social security pension does not provide what society considers an
adequate standard of living, there is a second category of income: a
basic grant given by a federally guaranteed income program, such as

Supplemental
Security
Income (SSI), which provides benefits
according to need (i.e. needs-tested). 14/ A third tier of retire
ment income is provided through the private savings and pensions of
individuals.
The extent to which retired individuals of the same generation
depend on these three sources of income is affected by their incomes
over their lifetimes as well as by the demands on that income and by
habits of saving and spending. Retirees with higher lifetime incomes
tend to save more in both absolute and relative terms, and as a
result they retire with higher incomes from private savings and
investments. How able and willing workers are to provide for their
own retirement through savings, pensions, and investments affects
how large compulsory savings through social security should be. The
question then is whether the saving and spending habits of workers
will change on average as their incomes rise in the future.
The Ford Administration and Hsiao proposals seem to reach
different conclusions about this question. These differences stem
from differences in the concept of what is an economic equal. The
Ford Administration's approach assumes that economic circumstances
are determined by the worker's relative place in the income distri
bution.
By contrast, the Hsiao approach defines economic circum
stances in terms of a specific, absolute standard of living.
The Hsiao approach implicitly views the average worker of the
future as a richer man (or woman) if in fact economic growth has
raised his standard of living. He is then expected to be relatively
less dependent on social security benefits when he retires because he
is more likely to have private pensions and savings.
(Private
pension income is also likely to be related to past earnings.) Thus,
the Hsiao proposal allows the progressivity of the benefit structure
to lower replacement rates for future generations as workers move up
into high earnings brackets.
If real wages rise at a rate of 2
percent a year, the earnings in the year before retirement of the
same hypothetical worker would rise to $37,200 by the year 2050; the
replacement rate for him would be 23 percent, compared to the current
average of about 43 percent.
The size of the benefit for this
average worker, however, would still rise substantially in real
terms -- from $3,600 annually in 1976 to $8,600 in 2050.
14/

See the discussion in the Report of the Consultant Panel on
Social Security to the Congressional Research Service, August
1976, and also Alicia Munnell, The Future of Social Security,
Brookings Institution, Washington, D.C., 1977.

The Ford Administration's approach, on the other hand, assumes
that the average worker of the future will not adopt the savings
behavior of relatively higher-income workers today, even though his
income should reach much higher real levels. The average worker will
therefore be as dependent on social security for post-retirement
support in the year 2050 as the average worker is today. Thus, the
Ford Administration's proposal provides the same replacement rate to
the average worker in the year 2050 as to the average worker today;
by the year 2050, however, such a worker will have earned four times
the pre-retirement earnings of the current average amount.
His
guaranteed benefit would be $16,400 (in terms of the 1976 dollar).
Advocates of the Hsiao approach stress that the third tier of
the three components of retirement income -- private savings and
pensions -- is likely to grow in importance.
Certainly the aim of
the Employee Retirement Income Security Act of 1974 is to give
greater assurance of financial protection to private employee
pensions and to make private savings for retirement more attractive
through the Individual Retirement Accounts. J5/ Moreover, higher
levels of future income are likely to lead to greater private
savings, particularly if guaranteed social security benefits are not
so high and if the taxes to pay for benefits are also not so high.
Advocates of the Ford Administration's approach stress that
rising income levels are not a guarantee of higher private savings.
It is necessary, they contend, to maintain higher levels of com
pulsory savings, so that retirement incomes will keep pace with a
rising standard of living.
A system as large and complex as social security, and one that
affects so large a portion of the population, is bound to have
problems, and problems are certain to prompt suggestions for
structural or comprehensive reform.
In deliberations over such reforms, the Congress will
inevitably confront proposals that would increase costs and others
that would lower costs. For example, among the issues that have been
raised is that of the spouse benefit, whereby wives without their own
benefit (occasionally husbands) are entitled to benefits based on
husbands' (occasionally wives') benefits, although no extra contri
butions are required.
Some see this as an unfair transfer to the
15/

See the discussion in Alicia Munnell, The Future of Social
Security, Brookings Institution, Washington, D.C., 1977.

single-earner couple from both the two-earner couple and the single
worker.
Others feel that the wife who works in the home should
receive a fuller entitlement to social security benefits in her own
right. Depending on how the problem is perceived and resolved, the
cost implications of reform differ widely.
Other questions much broader in scope have been raised about
social security.
There is, for example, some controversy over
whether social security has had a detrimental effect on savings and
capital formation.
The question has also been raised whether the
reduction in work among those 62 years and older, which seems in part
to have resulted from the growth of social security, is altogether
desirable. These are among questions that are likely to be debated
both in the short run and over the next few decades.

APPENDIXES

APPENDIX A.

NOTE ON INDEXING

Two proposals discussed in this paper provide alternative ways
for calculating retirement benefits.
The Ford Administration and
the Hsiao proposals differ from each other and from the present
system in the way the procedure for determining benefits adjusts for
rising prices and wages in the economy.
The present benefit computation procedure has two steps.
First, taxable monthly earnings are averaged over a specified number
of years (currently 20 years for most workers) to determine average
monthly earnings (AME).
These AMEs are then applied to a benefit
table, which works very much like the table for determining income
taxes.
The table gives the benefit as a percent of AME for each
additional dollar of AME. These percentages may be called "marginal
replacement rates." The average replacement rate in this case refers
to the accumulated benefit calculated from the table as a percent of
AME.
For a worker
follows:

retiring at age 65, the table is roughly as

AME Bracket

Marginal
Replacement Rate

First $110

138 percent

$290

50 percent

$150

47 percent

— and so on through five additional brackets with a rate of 22
percent applied to the last $100 of taxable AME.
The formula is
therefore progressive — that is, the marginal replacement rate
declines as the AME rises and so the average replacement rate is
lower for workers with higher earnings.
If no adjustment were made for inflation, the progressivity in
the benefit table could result in an erosion of the purchasing power
of benefits.
When the cost of living rises, wages generally

increase, too, either because of an explicit cost-of-living
escalator or through market forces.
(Historically, wages have
increased by more than the cost of living because of productivity
gains.) When wages rise, however, even if it were only because of
inflation, the replacement rate falls and a given worker's benefit
would not rise as fast as prices.
Under current law, an attempt is made to prevent inflation from
eroding benefits by increasing the marginal replacement rates
annually with increases in the CPI. This procedure will maintain a
constant real benefit for those with a fixed AME, which is, of
course, the situation for all persons who are already retired. The
procedure overcompensates, however, for the effect of inflation on
replacement rates for those who are still working and whose wages
keep rising, and therefore results in benefits that rise faster than
wages. This is the source of the overindexing problem.
Increasing the earnings brackets in the formula according to
increases in the CPI will prevent both replacement rate and real
benefits from eroding with inflation. That is, if inflation should
increase by 10 percent in a year, for instance, the AME brackets in
the table shown above would rise 10 percent, changing the values from
$110 to $121, from $290 to $319, from $150 to $165, and so on. Thus,
workers whose earnings were increased as a result of inflation alone
would not move up the schedule into brackets in which replacement
rates are lower. This is the approach of the Hsiao proposal. (The
proposal also indexes the AME for inflation for more complicated
reasons, which are below.)
The Hsiao proposal would allow replacement rates to decline if
this simply came about because wages, hence the AME, rose by more
than the rate of inflation (i.e., because of productivity). The Ford
proposal, however, seeks to prevent the replacement rate from
declining as a result of productivity wage increases. Thus, the Ford
proposal increases the brackets in the table according to the
increase in average wages.
If average wages rose by 12 percent (2

percent more than the rate of inflation), therefore, the brackets in
the table above would increase by 12 percent -- i.e., the $110 would
rise to $123, $290 to $325, and so on. For AMEs that increased by the
average
increase
in wages, replacement rates
would remain
constant. _]/
Both proposals also make adjustments for the way the AME is
calculated.
Because wages are averaged over a long period, past
rates of inflation and economic growth affect the AME. This effect
is especially important because the number of years over which wages
are averaged is scheduled to increase each year until the early
1990s, when all retiring workers will be required to average wages
over 35 years. As the averaging period lengthens, more years of low
earnings will be included and these extra years are likely to be
years farthest in the past.
On average, money wages increase over a working life for three
reasons: prices rise, economic growth raises all wage levels, and
individuals gain more experience and skill with age.
The Hsiao
proposal would index wages included in the AME by a price index (the
CPI) so that wages would be expressed in terms of dollars of constant
purchasing power.
Therefore, wages in past years that are low
because of subsequent inflation would not lower the AME. The Ford
proposal would index wages included in the AME calculation by a wage
index so that wages would be expressed in terms of a constant
standard of living.
Therefore, wages in past years that are low
because of subsequent inflation and economic growth would not lower
the AME.
Both wage indexing and price indexing of wages for the AME
calculation partly mitigate the dampening effect on the AME of
lengthening the averaging period.
(Wage indexing has a stronger
mitigating effect than price indexing.)

Since the average covered wage can increase for reasons other
than productivity (for example, because an increase in the
proportion of teenagers in the work force reduced the average
wage), a simple index may not in fact accurately adjust for
productivity.
To do this would require the construction of a
wage index that was not affected by changes in the skill mix of
the labor force.

The effect of choosing one AME indexing scheme over the other
can have a sizable influence on the determination of benefits among
individuals who vary considerably in the patterns of their earnings
histories.
(Women, for example, tend to have interrupted work
histories and consequently different lifetime earnings profiles from
men's.)
The choice of wage or price indexing with respect to the
brackets also has a powerful effect on the average replacement rate
and future costs of the system.
Considerations in Developing a New Benefit Computation System
There has been a substantial amount of material written on the
subject of indexing, some of it highly technical, that should be
considered by those who will write legislation in this area. While
this paper cannot cover all of these topics, some general points are
particularly important.
It is essential to develop a comprehensive framework for
analyzing the equity implications of social security benefit
structures. 2/
There are five tasks that require explicit
recognition:

Indexing to determine how workers who retire during the
same year should be positioned relative to each other. In
practice, this involves how the AME is calculated and
depends on considerations such as the choice of a method for
indexing past earnings and the choice of an averaging
period.

Establishing the pattern of benefit awards at retirement
within each retirement cohort.
This involves the
determination of the marginal replacement rates that
correspond to each bracket of the AME in the benefit table.

Such a framework is developed in Dean Leimer and Ronald Hoffman,
"Designing an Equitable Intertemporal Social Security Benefit
Structure," Office of Research and Statistics, Social Security
Administration, November 1976.
Also see, "A Framework for
Analyzing the Equity of the Social Security Benefit Structure,"
U.S. Department of Health, Education, and Welfare, Social
Security Administration, Office of Research and Statistics,
Studies in Income Distribution (forthcoming).

Indexing to determine how successive generations of
retiring workers will be positioned relative to each other.
This refers to the question of who will be treated as equals
when retiring workers belonging to different cohorts are
compared.
Technically, this involves the choice of an
index for indexing the AME through time.

Indexing to determine how benefits should be related to the
AME for different generations of workers retiring in the
future.
In practice, this involves the choice of an index
for adjusting the brackets in the benefit rate table
through time.

Indexing to adjust benefits after retirement. In a coupled
system, the same schedule would be used for indexing the
benefits of those already retired as for those coming up for
retirement.
In a technically decoupled system, separate
procedures would be used for the two groups.

There also appears to be some confusion in current policy
discussions about the extent to which changes in the replacement rate
through time can be planned and about the effect of a particular
pattern of replacement rates on the predictability of future program
costs. In general, pre-planned control of the pattern of replacement
rates through time is possible only if the definitions of the
replacement rate (in particular, the denominator, or "replacement
rate base") and the groups of workers for whom the pattern is to be
controlled are consistent with the specifications of the benefit
structure components. For example, it is inconsistent to determine a
retiree's benefits on the basis of indexed AME and to define the
replacement rate as the ratio of benefits to final year earnings.
For example, the Ford Administration proposal does not insure that
the aggregate average benefit rate for each successive cohort is
constant over time.
Nor does the Ford Administration proposal
guarantee constant average benefit rates for workers in the same
relative position judged on their indexed AME (or in their respective
beneficiary cohorts).
The relationship between the specifications of the benefit
structure components and the predictability of future program costs
are also more complex than is often recognized. In particular, there
generally is not a precise correspondence between pre-planned
control of the pattern of replacement rates through time and the
predictability of future implicit tax rates.

APPENDIX B.

NOTE ON PRESIDENT CARTER'S PROPOSALS
FOR FINANCING THE OASDI PROGRAMS

On May 9, 1977, the Administration introduced a new plan for
funding the short-term deficit as well as a proposal for correcting
the overadjustment for inflation that is part of the current law.
The Administration's proposal for raising revenues in the near
term introduces several features not contained in current policy or
legislation.
First, it explicitly defines a target level for the
amount of balances to be held in the trust funds.
Second, it
proposes three mechanisms for raising revenues that have not been
used before to finance the OASDI programs:
o

A tax on all earnings above the currently scheduled taxable
maximum, to be paid only by employers,

A direct transfer from general revenues, and

A transfer from the Hospital Insurance (HI) trust funds.

For future financing, the Administration also proposes to
advance the date of the OASDI tax rate increase now scheduled for the
year 2011 up to a two-stage increase in 1985 and 1990.
The Administration's proposal for correcting the overadjust
ment for inflation is essentially like the Ford proposal, although
there are some differences in technical details.
The President's
decoupling proposal is projected to reduce outlays by 0.5 percent of
taxable payroll averaged over the next 25 years and by 4 percent of
taxable payroll averaged over the next 75 years. Assuming that all
the other funding proposals will be enacted, the combined proposals
would result in an average surplus of 0.5 percent of taxable payroll
over the next quarter century, although they would still leave an
average deficit of 3 percent of taxable payroll over the 50-year
period starting in the year 2001.
The remainder of this note provides more detailed analysis of
the proposal for raising revenues.

FINANCING OASDI DURING THE NEXT FIVE YEARS
The size of the deficit to be funded over the next five years
can be larger or smaller depending on how large the balances in the
trust funds are desired to be. The higher the target amount and the
more quickly it is to be reached, the larger will be the immediate
deficit and the need for additional revenues.
The Administration aims to maintain reserves in the trust
funds equal to 33 percent of a year's outlays.
That target is
designed to meet the criterion that the trust funds should be large
enough to weather a recession almost as severe as the current one, up
to the point where unemployment drops below 6 percent, without having
to raise taxes.
If the OASDI trust funds were totally selfsufficient, reserves equal to half of annual outlays would be needed.
The Administration has proposed a new plan, however, whereby funds
from general revenues would be transferred to social security during
periods when unemployment exceeds 6 percent of the labor force.
During a deep recession, this transfer would increase income to the
trust funds by enough so that initial reserves of 33 percent of
outlays would be sufficient. By the time unemployment fell below 6
percent, the reserves would be very low and so a tax increase would
presumably be required to build up the reserves once more to the 33
percent level.
Table B-l shows how the size of the deficit varies according to
how the deficit is defined. In the first row, the deficit is defined
simply as the excess each year of expected outlays over revenues
anticipated under current law.
If this deficit were closed, the
balances in the trust fund would be maintained at the level reached
by the end of 1977 — $35.5 billion. This fixed dollar reserve would
decline as a percent of outlays, however, since outlays are rising
each year.
The reserves would decline from 36 percent of a year's
outlays at the start of 1978 to 25 percent at the start of 1982. The
larger deficit under the second definition is the excess of expected
outlays over expected revenues plus the amount needed to maintain
balances of 33 percent of outgo — the goal set by the Carter plan.
The third definition of the deficit specifies that balances
are maintained at 50 percent of outgo. As indicated in the table,
the accumulated deficit over the five-year period 1978-1982
increases from $50 billion under the first definition to $91 billion
under the third definition.

TABLE B-l.

PROJECTIONS OF THE SHORT-TERM OASDI DEFICIT DEFINED THREE DIFFERENT
WAYS: IN BILLIONS OF DOLLARS

Definition of Deficit
Additional Revenues
Needed to Cover Outgo a/
Balances when gap is closed b/
Additional Revenues Needed
to Maintain Trust Fund Balances
at 33 Percent of Outgo a/
Balances when gap is closed b/
Additional Revenues Needed
to Maintain Trust Fund Balances
at 50 Percent of Outgo a/
Balances when gap is closed b/

Total
1978-1982

1978

1979

1980

1981

1982

6.9

7.9

9.1

11.5

14.9

50.3

35.5

—

6.8

11.4

12.7

15.2

18.9

65.0

35.4

38.9

42.5

46.2

50.2

—

25.1

13.2

14.6

17.1

20.9

90.9

53.7

59.0

64.5

70.1

76.1

—

Calculated from estimates of income, disbursements, and funds at the end
of the year under current law and alternative II economic assumptions made
by the 1977 Annual Report of the Board of Trustees of the Federal Old-Age
and Survivors Insurance and Disability Insurance Trust Funds.

Balances in the combined OASDI trust funds at the end of the year.

Table B-2 shows how the Carter plan proposes to fund the $65
billion five-year deficit resulting from adoption of the 33-percent
goal for the OASDI trust funds starting in 1978.
COMPONENTS OF THE PLAN
Transfer from General Revenues
The Administration has proposed that a transfer from general
revenues totalling $14.1 billion be made in the years 1978, 1979, and
1980.
The transfer is intended to compensate retrospectively for
payroll tax receipts lost as a result of unemployment exceeding 6
percent of the labor force during the period 1975-1978.
Since the
Administration is expecting unemployment to fall below 6 percent in

TABLE B-2.

PROJECTIONS OF THE CARTER PROPOSAL FOR INCREASING OASDI REVENUES:
IN BILLIONS OF DOLLARS

Additional Revenues Needed
to Maintain Funds at
33 Percent of Qutgo a/
Sources of Additional Revenues b/
Transfer from general revenues
Transfer from HI to OASDI
Increase in employer's tax base
Increase in employee's tax base
Increase tax rate for self-employed
Change in dependency test
Total additional revenues

1978

1979

1980

1981

1982

Total
1978-1982

6.8

11.4

12.7

15.2

18.9

65.0

6.5
1.6

0.1

4.3
2.0
2.6
0.5
0.1
0.3

3.3
2.3
6.1
0.6
0.3
0.5

4.8
10.3
1.1
0.4
0.7

5.4
11.4
1.3
0.4
1.0

14.1
16.1
30.4
3.5
1.2
2.6

8.2

9.8

13.1

17.3

19.5

67.9

—
—
—

—

See Table B-l.

Estimates from "Social Security Financing Proposals," HEW News, U. S. Depart
ment of Health, Education, and Welfare, May 9, 1977.

1979, they do not anticipate that any additional general revenue
payments would be generated.
The Administration is not now requesting a change in the law to
allow for this form of general revenue funding beyond 1980, although
the Administration has indicated that it would be a useful financing
mechanism on a permanent basis.
The Advisory Council on Social
Security, which convenes every four years, will next report in 1978;
a decision about a permanent change is to be postponed until the
Advisory Council has had a chance to consider the issue.
If the Administration plan were made permanent, it would
result in an automatic transfer from general revenues to the OASDI
trust funds whenever unemployment exceeded 6 percent. The amount of
the transfer would be based on an estimate of the reduction in
payroll tax receipts resulting from the excess unemployment. With
such a mechanism, social security would no longer be a completely
self-financing system. Eventually, the amount that has to be raised
through payroll tax increases would be reduced and replaced by the
funds obtained through increases in personal or corporate income
taxes or from a reduction in federal expenditures on other programs.

Whether the distributional effects of this change in the sources of
funding are progressive or regressive would depend on how the general
revenue transfer were ultimately paid for. 1/
The Administration has pointed out that this limited form of
general revenue funding may not be subject to some of the objections
raised about other forms of general revenue funding.
Because the
transfer would be confined to periods of high unemployment, it would
be less likely to provide incentives for relaxed fiscal discipline —
i.e.,
granting
benefit increases without providing explicit
financing for them. Nor would it necessarily lead to a weakening of
the so-called "earned right" principle.

Shift Funds from HI to OASDI
The Administration proposes to shift a portion of the revenues
that will be raised by scheduled increases in the HI tax rate into
the OASDI trust funds. An increase in the combined employer/employee
HI tax of 0.4 percent of taxable earnings is now scheduled for 1978.
Half of this increase would be shifted into OASDI.
Out of the
employer/employee HI tax increase of 0.5 percent scheduled for 1981,
40 percent would be shifted into OASDI.
By 1982, therefore, this
shift would provide the equivalent of an OASDI tax increase of 0.4
percent of taxable earnings paid by employers and employees
combined.
The ultimate source of financing of this proposed shift
depends on the actual pattern of HI expenditures. Under current law,
the HI trust fund will stay roughly at a constant level of annual
outgo up to the early 1980s, according to the Annual Report of the
Board of Trustees of the Federal Hospital Insurance Trust Fund
(assuming all HI tax increases are used by HI and not transferred
elsewhere); after that, it will decline rapidly and become depleted
by the late 1980s. Over the period 1977-2001, the average cost of
the program is projected to exceed the average income by an average
of 1.2 percent of taxable payroll.
The Administration, however,
proposes to contain the rate of increase of hospital costs and
thereby to restrain HI outgo.
If the cost containment proposal is
not enacted, or if it is not as effective as the Administration

]_/

For a discussion of the distributional effects see Chapter II of
the text.

anticipates, and if the shift of funds from HI to OASDI is made, the
HI fund could face exhaustion earlier than the HI Board of Trustees
projects. Depending on these various contingencies, therefore, the
shift could result in some amount of general revenue funding of the
HI program.
Increase in the Employer's Tax Base
Historically, employer and employee have paid an
tax on the employee's earnings up to a maximum dollar
taxable maximum, or tax base, is $16,500 in 1977 and it
to rise automatically each year roughly according to
average wages.

equal OASDHI
amount. The
is scheduled
increases in

The Administration is proposing to eliminate any ceiling on
taxable earnings for determining the employer's share of the tax.
Thus, the employer would pay taxes on the entire payroll although the
employee would continue to pay taxes only on the portion below the
taxable maximum.
Benefits at retirement are now based on taxable
earnings.
The Administration proposes to base benefits on the
employee's taxable earnings not on the higher base taxable to the
employer.
The new employer tax on earnings above the taxable maximum is
to be phased in gradually with incremental increases in the
employer's tax base. By 1981, the full amount would be imposed, and
from that time on, the new employer tax would be the major source for
funding the deficit, providing (as indicated in Table B-2) close to
60 percent of the deficit.
The new employer tax would not be evenly distributed among
employers since firms and industries differ widely in the proportion
of their work force with earnings above the maximum.
In general,
workers with annual earnings that exceed the present taxable maximum
are those with high levels of education or other training.
Therefore, firms using a production technology that requires a
highly educated or skilled labor force would be much more heavily
taxed than the average. By contrast, firms with a less-skilled labor
force, and also those employing more part-time workers, would be
relatively unaffected.
On average, about 15 percent of all covered workers earn more
than the taxable maximum. How this percentage varies from industry

to industry can be seen in the following examples, in which the
proportion of employees above the maximum is estimated to be: 2/

31 percent in the manufacture of office, accounting, and
computing machines,

5 percent in shoe manufacturing,

24 percent in chemical manufacturing,

18 percent in mining,

5 percent in department stores and other general merchan
dising establishments.

Since about 40 percent of college teachers earn more than the
maximum, and since faculty salaries make up a substantial portion of
the costs of higher education, colleges and universities would be
another hard-hit group.
Who would ultimately bear the burden of the employer tax is
difficult to predict. Firms affected by the tax are likely to raise
their prices, which could well depress the demand for their goods or
services; as a result, such firms could resort to cutting back
production and the size of their work force.
Alternatively, they
could try to keep wage increases below what they would have been and
thus shift the tax to their workers. In the long run, firms can try
to change production processes to use more unskilled workers and
part-time workers. They could also accept lower profits, which would
be unlikely except in the shortest run since the option is usually
available to close down and open a new business from which profits
would be higher.
Any of these adjustments is likely to involve
reallocation of workers and other resources.

These estimates are derived from data on the distribution of
earnings by industry reported in the 1970 Census of Population.
The census earnings data were projected to 1977 using the
assumption that the structure of relative wages within each
industry remained the same. Note that the percents given above
refer to the worker's total earnings from all jobs during the
year.
Because some workers (about 10 percent) work for more
than one employer during the year, the percent of a firm's
employees with earnings above the maximum may be somewhat
smaller than the percentages reported above, particularly in
industries with high turnover.

The tax rate to be applied to the employer tax on earnings
above the maximum includes the HI tax rate. The intention, however,
is to transfer this additional income from the HI trust fund to
OASDI.
Increase in Employee's Tax Base
The Administration's plan includes a proposed increase in the
amount of earnings on which employees pay taxes, but this is
relatively small. As indicated in Table B-2, this provision would
increase revenues by an estimated $3.5 billion accumulated over the
five years, 1978-1982.
The proposal stipulates that the taxable wage base would be
increased by $600 above the expected automatic increase in 1979,
1981, 1983, and 1985. The proposed tax base and the tax base under
current law are as follows:
Projected Maximum Earnings Taxable to Employees

Present law
1977
1978
1979
1980
1981
1982
1983
1984
1985

$16,500
17,700
18,900
20,400
21,900
23,400
24,900
26,400
27,900

Admini stration's
Proposal
$16,500
17,700
19,500
21,000
23,100
24,600
26,700
28,200
30,300

Percent of Increase

3.2%
2.9
5.5
5.1
7.2
6.8
8.6

As a result of the proposed change, the proportion of covered
workers with their total earnings below the taxable maximum would
rise slightly, from 85 percent in 1977 to 87 percent in 1983, and
would remain at 87 percent through 1985.
The proposed increase in the employee's tax base would
automatically lead to increased benefits for workers at the taxable
maximum and therefore to increased outlays, although the effect
would not be significant for a number of years.

Increase the Tax Rate for the Self-Employed
The self-employed consist largely of people who run farms and
businesses or have independent professional practices (e.g.,
physicians, lawyers). The self-employed now pay an OASDI tax of 7
percent on their earnings (up to the taxable maximum). This tax rate
is close to 71 percent of the rate paid by employers and employees
combined.
The Administration is proposing to raise the tax on the
self-employed to 7.5 percent starting in 1979, which would bring it
up to almost 76 percent of the combined employer-employee rate.
Between 1950 and 1972, the self-employed rate had been 75 percent of
the combined rate, so this proposal would come close to restoring
that relationship. The increased tax receipts are expected to total
$1.2 billion over the period 1978-1982.
Even if the tax rate for the self-employed is raised to 7.5
percent, they would still be at an advantage compared to other
workers.
Many economists believe that the employer's share of the
social security tax is ultimately shifted back to workers, who
effectively pay the tax through wage increases that are lower than
they would otherwise have been. 3/ A self-employed person, however,
would be entitled to the same amount of benefits as a wage earner
with equivalent earnings even though the total tax contributions of
the self-employed would be lower.
Thus, the return to social
security tax payments would be greater for the self-employed.
Change in the Dependency Test
Until recently, the husband of a worker eligible for social
security could only receive a spouse benefit if he could prove that
he was dependent on his wife for his financial support.
Under
current law, however, wives have not been required to prove financial
dependence to qualify for spouse benefits. A recent Supreme Court
decision (Califano v. Goldfarb) has held that this unequal treatment
of husbands and wives is discriminatory.

See Alicia Munnell, The Future of Social Security, Brookings
Institution, Washington, D.C., 1977 (pp. 86-88).

As a result of this decision, the Social Security Administra
tion must now permit husbands to receive spouse benefits on the same
basis as wives do.
Most husbands would not qualify for spouse
benefits because their own benefits exceed one-half of their wives'.
(A spouse cannot collect both the spouse benefit and his or her own
benefit as a worker). Some husbands have, however, had low earnings
in covered employment because most of their earnings during their
lifetimes were in uncovered employment (e.g. federal employment).
In such cases, husbands often were ineligible if a dependency test
were applied, since their total incomes, including their earnings in
uncovered employment, would have been too high.
This group would
gain from the Supreme Court decision. The resulting additional costs
have been estimated by the Social Security Administration to be about
$500 million in 1978, rising slowly thereafter.
Under the legislation proposed by the Administration, spouses'
benefits for both husbands and wives would be subject to a dependency
test. 4/ The test would compare the income of the husband and wife
over the three years preceding the first spouse's retirement and only
the spouse with the lower income could qualify for the spouse
benefit. 5/ As a consequence of the new test, some wives who would
have become eligible for spouse benefits could lose their
eligibility and most husbands who would have gained eligibility for
spouse benefits under the Supreme Court decision are likely to lose
them. 6/ The savings attributed to the provision are estimated to be
roughly equal to the costs added to the program by the court
decision.

It should be noted that this provision does not deal with the
broader issue of the equity of spouses' benefits when wives with
considerable work experience in covered employment are compared
to wives with little or no covered work histories.

The dependency test could be repeated if it should happen that
at the second spouse's retirement, the determination of the
recipient of the spouse benefit were to change.

The relationship between a husband's and a wife's income in the
three years preceding retirement does not necessarily reflect
the relationship of their incomes over their lifetimes.
For
example, a wife's earnings might exceed her husband's during
the three year period if he were working part-time (e.g. because
he was unemployed or disabled), although prior to that time his
earnings could have always exceeded hers.

Funding OASDI Over the Next Twenty-Five Years and in the Longer Run
The Administration proposes to extend the short-run financing
provisions described above into the future, except for the special
general revenue funding, which is terminated in 1980. Under present
law, in the period 1977-2001, the deficit -- defined as the
difference between projected expenditures and projected receipts as
a percent of taxable payroll — is estimated to average 2.3 percent
of taxable payroll (Table B-3).
The funding provisions described
above would reduce the deficit by an amount equal to 1.3 percent of
taxable payroll on average. Thus, an average deficit of 1 percent of
taxable payroll would remain over the next 25 years.

TABLE B-3.

THE CARTER PROPOSAL FOR FUNDING THE 25-YEAR DEFICIT
IN OASDI: AVERAGES OVER THE PERIOD 1977-2001
Percent of Taxable Payroll
-2.3

Deficit Under Present Law a/
Additional Revenue by Source
Provisions in short-run proposal b/
Carter decoupling plan
Increase in tax rate c/

1.3
0.4
1.1

Total Additional Funds

2.8
+0.5

Net Change (surplus)
a/

Difference between projected expenditures as a percent of
taxable payroll and projected revenues as a percent of taxable
payroll, both assuming the provisions of current law. This
is the average deficit over the 25-year period.

Includes the provisions shown in Table B-2 and described in
the text.

Two-step tax rate increases: 0.5 percent of taxable payroll
(employer-employee combined) in 1985 and 1.5 percent in 1990.

Two additional proposals have been made by the Administration
to reduce the 25-year deficit by an additional 1.5 percent of taxable
payroll. One is a two-step tax rate increase that would increase the
tax on employers and employees combined by 0.5 percent of taxable
payroll in 1985, and by another 1.5 percent in 1990. Thus, the OASDI
tax rate would rise from its present level of 9.9 percent to 11.9
percent by 1990. This is the rate now scheduled under current law to
go into effect in the year 2011.
The other provision, which would further narrow the 25-year
deficit, is the result of adopting a decoupling plan that would
correct the overadjustment for inflation in current law. The Carter
decoupling plan is similar to the Ford proposal described in Chapter
III and Appendix A.
Both proposals use the same formula for
determining the benefits awarded to future generations of new
retirees. The proposals differ only in some technical details of the
method. ]_/
The Social Security Administration has estimated the annual
costs of the OASDI program under the Carter proposal to be about 12
percent of annual taxable payroll averaged over the 25-year period
starting in 1979.
OASDI costs as a percent of taxable payroll,
however, are estimated to rise after the turn of the century,
reaching about 19 percent by the year 2030. The average for the 50year period, 2004-2053, is estimated at close to 17 percent of
taxable payroll.
These cost estimates are roughly the same as those implied by
the Ford proposal. Under both plans, the level of benefits provided
to future retirees would represent a savings compared to the current
system, which overadjusts for inflation (assuming the demographic
and economic projections of the 1977 trustees' report). The benefits
provided under both plans, however, would require an increasing
share of future tax dollars (whether from payroll or income taxes) as
the ratio of retired beneficiaries to workers rises, as anticipated,
in the future.

One technical
difference is that covered earnings for
determining benefits would be indexed up to age 62 instead of up
to the actual age of retirement of the worker. (See Appendix A
for a discussion of indexing.) Another is that the transition
period from the current system to the decoupled system would be
reduced to 5 years from 10 years.

If all the Administration proposals for the 25-year period
were extended into the
75-year period
1977-2051, projected
expenditures would still exceed receipts by an average of 1.9 percent
of taxable payroll.
Thus, the Carter proposal would fund about
three-quarters of the 75-year deficit, which is estimated to average
8.2 percent of taxable payroll under current law.

U. S. GOVERNMENT PRINTING OFFICE : 1977 O - 93-486

Full text of Financing Social Security : Issues for the Short and Long Term

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