April 17, 2014

The Myth Of The 2.2 Percent Solution

Volume III, Number 1
January 10, 1997


Each year, the Trustees calculate a measure of Social Security's long-term fiscal health called its "actuarial balance." In 1996, this balance was determined to be minus 2.2 percent of taxable payroll. In theory, this is the total amount by which we would have to raise taxes or cut benefits, starting today, to keep the Social Security trust funds solvent over the next seventy-five years.

Those who would minimize Social Security's troubles regularly trot out this measure (and this figure) as evidence of how small the problem is. How can anyone seriously talk about a crisis, they say, when that crisis could be solved by a "mere" 2.2 percent of payroll tax hike? The press, assuming that because this number is official it must be meaningful, routinely repeats it.

There's just one catch: Actuarial balance greatly understates Social Security's true burden on our future. Unfortunately, the recent report of the Social Security Advisory Council gives new ammunition to defenders of the status quo. While the council was divided about reform options, all members lined up behind actuarial balance as the basic measure of Social Security's long-term health. Such unanimity is puzzling. This indicator not only misleads the public about the magnitude of the future fiscal burden posed by Social Security, it says nothing about the program's impact on national savings and generational equity, the concerns that led five of the council's thirteen members to advocate that we transition to a funded system of personally owned accounts.

The Central Fallacy

In the framework of actuarial balance, Social Security will be solvent until the year 2029 -- meaning that, until then, its trust funds are projected to possess sufficient assets to cover current-law benefit promises. If we were to enact the 2.2 percent s olution, the trust funds would be solvent for the next seventy-five years.

The problem is that this solvency is an accounting fiction. Actuarial balance assumes that trust-fund surpluses accumulated in prior years constitute genuine economic savings that can be drawn down to cover trust-fund deficits incurred in future years. Th ey don't. Since the assets held by Social Security consist of nothing but Treasury IOUs, when it's time for the trust funds to redeem them Congress must raise taxes, cut other spending, or borrow more from the public to raise the cash.

What really matters is Social Security's operating balance -- that is, the annual difference between its outlays and its earmarked tax revenues. Under current law, this balance is due to turn negative in 2012 and widen to an annual deficit of $650 billion , or 3.8 percent of payroll, by 2029, the last year the trust funds are technically "solvent." Even if the 2.2 percent solution were enacted, Social Security would still face large and steadily growing operating deficits starting in 2021.

Status quoists will counter that trust-fund assets do indeed constitute genuine savings because, if Social Security had not run surpluses, the federal government would have run larger deficits. This is an interesting argument -- but there's little evidenc e to support it.

Behaviorally, the argument implies that our political system tracks and targets some desired balance in the rest-of-government, rather than in the unified budget. This isn't so. Over the past dozen years (the era in which we built up today's trust-fund as sets), there have been many plans and processes aimed at balancing the unified budget, but none aimed at balancing the budget excluding Social Security. Remarking on Washington's failure even to attempt this, Senator Moynihan notes that Social Security's surpluses have simply allowed Congress to tax less and spend more than it otherwise would, and so denounces them as a "fraud." As for the future, no one, least of all the status quoists, is insisting that we run a $104 billion unified budget surplus in 20 02 -- which is what will then be required to balance the budget excluding Social Security.

This budget reality explains an apparent paradox that the status quoists often pose: If individuals and private pension funds are engaged in genuine savings when they invest in Treasury bonds (and they are), why then is such investment by the trust funds fundamentally different? The reason is that when a private citizen decides to buy a Treasury bond, it doesn't induce Congress to incur a larger debt than it otherwise would.

Admittedly, the whole question of how Social Security surpluses do or do not change the overall budget balance (and national savings) will strike many Americans as quite abstract. A more vital question is whether what the status quoists are advocating for future fiscal policy makes any sense given where our economy and society find themselves today. The logic of actuarial balance rests on a fantastic proposition -- namely, that America's lofty savings rate in the 1990s, due to the thriftiness of governmen t, is paying in advance for a sumptuous deficit banquet twenty years from now. In other words, it's OK to save less than we ought tomorrow because we're saving more than we ought today.

In the end, there's only one possible defense of trust-fund accounting, and that is to insist that Social Security is an entirely separate realm of government -- not just another federal agency, but a kind of independent republic exempt from the sovereign ty of Congress. Thus, if we didn't save enough publicly in the 1980s and 1990s, it's the fault of the rest of government. And if we will need to undertake some draconian belt-tightening in the 2020s and 2030s, that too is the fault of the rest of governme nt. But why should we think of Social Security this way? Not because the contributions are owned or managed by the workers who make them and not because the benefits are economically funded or legally guaranteed. None of this is true. As it turns out, the most often-cited reason for why Social Security should be considered a self-contained deal is that it's a trust fund. Thus does the logic become a perfect and empty circle.

Other Misconceptions

Entirely apart from the savings fallacy, there are several other misconceptions about actuarial balance, and in particular the 2.2 percent solution, that need correcting.

  • The 2.2 percent solution is hardly trivial. If enacted as a tax hike, it would mean a tax increase of $69 billion this fiscal year. From now to 2002, it would mean an increase of $467 billion -- a larger tax hike than Dole's proposed income tax cut. A tax hike of this size is inconceivable in today's political climate. Certainly, no one would dream of calling it "small" or "bearable" if it were actually (and not just rhetorically) proposed.

  • It's already too late to enact the 2.2 percent solution, since this figure presupposes that the reform was implemented starting in 1996. Yet each year that we delay, the level share of payroll required to bring the trust funds into balance rises. Let 's assume that the earliest we could enact a savings package is 2002. This delay would raise the required savings by roughly 0.4 percentage points -- to 2.6 percent of payroll.

  • The forgoing calculation assumes that 2070 will forever remain the horizon for trust-fund solvency. In other words, it assumes that while we today would require the trust funds to be in balance over seventy-five years, our children will be satisfied with forty years and our grandchildren will drive over the cliff with their eyes closed. But Social Security has always (and sensibly) been required by law to calculate its balance over a full seventy-five years. Assuming this remains true, each passing y ear will add a new higher-cost year and subtract a new lower-cost year, raising the savings needed to balance the trust funds by roughly 0.06 percentage points per year in every future year. By 2002, the required savings will be about 0.4 percentage point s higher -- that is, it will be 3.0 percent of payroll, not 2.6 percent. And even if this savings were enacted, the total will keep climbing in later years -- to 3.5 percent by 2010, 4.1 percent by 2020, and 4.7 percent by 2030.

  • Even these figures may understate the magnitude of the required savings. If we accept the Trustees' "high-cost" scenario, whose key economic and demographic assumptions more closely reflect the actual experience of the past two decades, the number th e status quoists cite (2.2 percent) would instantly rise to 5.7 percent.

The Real Issue

In the end, trust-fund accounting sidesteps the real issue, which is not how to meet some official solvency test, but how to ensure Social Security's economic sustainability and generational equity. It is these concerns that have led a growing number of v oices, including the five Advisory Council members, to advocate transitioning to a funded system of personally owned accounts. By linking benefits to genuine economic savings, such a reform not only addresses the fiscal challenge. It would generate much h igher returns on contributions for future retirees, and hence would redress the cascading pattern of generational inequity that now destines each new birth cohort of Social Security participants to receive a worse deal than the last. It deserves a serious hearing.

As for the 2.2 percent apologists, one gets the impression that they don't much care about these broader questions, and that their only real purpose is to minimize changes for current and soon-to-retire beneficiaries by making Social Security look solvent on paper. Let's not be fooled by the trust-fund shell game.

FACING FACTS AUTHORS: Neil Howe and Richard Jackson CONCORD COALITION EXECUTIVE DIRECTOR: Martha Phillips

The Concord Coalition web pages were designed by Marla Parker and Krista Reymann. These pages are now maintained by Craig Cheslog. . Last updated: 24 Apr 1997