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A Fair Proposal For Social Security, Inspired by Paul Krugman

This post is a continuation of discussions on Social Security with the last one at Paul Krugman Wrong Again. There, I discussed the Old-Age and Survivors Insurance Trust Fund {Social Security} and what the report from 1945 said about projections going out to the year 2000. Along the way we saw that Paul Krugman skimmed over the material to confirm that they had a very good prediction on percentage of population 65 and over to population aged 20 to 64, but failed to notice that they assumed less percentage receiving benefits in the older category. This goes to the heart of the Social Security's Demographic Challenge. The following graphically shows the ratio of "covered workers" (i.e. payroll tax payers) to beneficiaries.

From the last post, we saw that up to a third of people over 65 were not expected to receive benefits, and adding in the fact that over a quarter of new "reward" recipients is based on disability, then it seems clear that the ratio above would not be nearly as hard on younger taxpayers without these two factors added to their burden.

In this post, I want to further explore his main points from Paul Krugman's blog post at Live Long And Prosper.

This is a really terrible idea, for at least three reasons.
1. The retirement age has already been increased to 66, and is scheduled to rise to 67. So any further increase would mean pushing retirement back to unprecedented ages. Yes, a lot of people live to 70; how many of them are really able, easily, to work that late into life?
2. While life expectancy is rising, life expectancy at age 65 — which is what is relevant here — isn’t rising nearly as fast.
3. Finally, disparities in life expectancy have been rising sharply, with much smaller gains for disadvantaged socioeconomic groups and/or those with less education than the average. Yet these are precisely the people who depend most on Social Security.

According to Krugman, the really terrible idea was to raise the age for the full Social Security benefits to kick in. He does raise some important issues with regards to what is just and fair, but to claim that something is "unprecedented" does not indicate that it is not the most logical thing to do. There are many unprecedented facts that make these unprecedented actions necessary. Longevity is now unprecedented as more people born today can expect to live longer including to retirement age and then beyond. Thus the pool of beneficiaries is unprecedented now and will only get more dramatic as the baby boomers retire. In fact, the demographic chart of the US is quite unique in that a group of cohorts are larger than the groups of older as well as younger cohorts. The chart below shows that bulge from the web site AGE DISTRIBUTION. It is easy to see the two largest bands are in the range 35 to 44.

Here Are "Just The Facts", Obama (Paul Krugman)
Let us now look at some the graphs that are provided by Social Security Administration at Fast Facts: Figures About Social Security, 2010.

New Benefit Awards, 2009
Benefits were awarded to about 5.7 million persons; of those, 48% were retired workers and 17% were disabled workers. The remaining 35% were survivors or the spouses and children of retired or disabled workers. These awards represent not only new entrants to the benefit rolls but also persons already on the rolls who become entitled to a different benefit, particularly conversions of disabled-worker benefits to retired-worker benefits at full retirement age.

The table that accompanies the above passage and pie chart gives the total percent of new recipients as 57% for retired workers and dependents. Thus 43% fall under the other two categories of disabled workers and survivors of deceased workers. Also new awards for disabled recipients are growing at a faster rate than simply retiring recipients at a rate of 2.6% vs. 1.9% respectively as the growth trends are shown below.

Looking at the facts in the Supplemental Security Income (NYSE:SSI) program is even more lopsided with respect to retired vs. the other categories. On top of this, benefits for non-retiring recipients is actually higher that retiring recipients.

Are Social Security taxes regressive?

The Economist magazine brings up some important points about the progressivity of payroll taxes. The first being the obvious fact that payroll taxes are taxed on the first $106,800 per year and afterwards are not taxed, thus the percentage of payroll taxes to income decreases. The second point being based on marginal utility from the last dollar earned. This takes some value judgments of what the value of various cohort groups are. But once this theory is used then how would any tax policy be anything other than regressive? How high of tax rate would it have to be on the top 400 American earners to the bottom one percent so that both marginal utilities would equalize? But more importantly, for our discussion here, is whether the tax and benefit structures are fair and equitable. In this regards the Economist provides some important points.
But the folks who claim the payroll tax is regressive do not take into account that it is not so much a tax, but a contribution to a forced saving/social-insurance scheme. Over 12% of payroll taxes fund Social Security (this includes old age and disability). The amount of payroll taxes paid during your working years determines your benefit. The benefit formula for Social Security is highly progressive. The lower your average earnings the higher a benefit you get relative to your contribution.

The Economist goes on to summarize two studies from the National Bureau of Economic Research. The first showing that the actual return on investments from payroll taxes for "low earners earn a 5.19% internal rate of return on their contributions to Social Security, while high earners get just 0.54%." The second points out that the rates look more progressive when factoring in disability benefits and survivorship benefits, and they also question the assumptions that the poor get less benefits because they die earlier and start work earlier. Reasons for shorter life expectancy should also be evaluated for factors attributed to less disposable income along with occupations that they participate in and those that are "lifestyle choices". For example, the trend that higher income social groups have reduced consumption of cigarettes while lower income groups have been slower at reducing consumption where even higher taxes and costs have not diminished this trend as significantly.

Policies that Redistribute Income
It is quite difficult to give a summary of all the aspects of redistribution but some aspects are shown through the calculations of expected benefits by Social Security Online at Your Retirement Benefit: How It Is Figured. The first and second steps are to record the yearly taxed income over the taxable income history of a group of cohorts by age and adjust the earnings based on the Indexing Factors which are derived from the Average Wage Indexing Series. The link to indexing factors produces a vector of indexes for each year of workers born including future dates based on expected growth of averages wages. Simply add 62 to the year born to determine which is the year of "eligibility". This indexing factor gives more weight to earnings early in the working career than later. Although maybe small in the grand picture, it does provide more return on dollars invested for entering the work force earlier.

The third step is to pick the top 35 adjusted income years and add them up. This results in individuals that work more than 35 years pay into the system with no additional benefits in SS. It is difficult to know ahead of time which years will be more beneficial for the calculations. So starting early, maybe not be such a great advantage since more years working with no more benefits. This does seem to open up the possibility of the program being changed to make eligibility not strictly on age but by number of years paid into the system above a minimum threshold in income. Most pension systems work this way, so why not the biggest pension plan out there? So somewhere between 40 to 45 years working seems reasonable. Take for example the minimum for this program is 45, then the person that starts working at 17 retires in 62, while the person that finishes schooling at age 28 retires at 73.

The fourth step is to divide the total adjusted income by 420 which is number of months in 35 years, which results in the average monthly wage adjusted income. Step five is the key to how the whole system provides more returns for dollar invested than high income earners. The first $761 is multiplied by 90% and then has further kinks in the benefits per dollar taxed at 32% for between $761 and $4,586, and another kink above $4,586 with a multiplier of 15%. Thus for example to get the most return on the payroll tax a worker would need to earn $9,132 but since indexing the worker needed to earn just over $618 in 1951. Step 6 is just to add up the individual calculations on benefits and step 7 to reduce this amount by 25% which is the expected SS benefits.

What does this all mean?
Those that have the greatest needs from Social Security look to be getting more benefits over time from the disability and survivorship benefits allotments. This then calls into question whether raising the age of full retirement benefits for Social Security will help that much, or whether it just limits the growth in the secondary aspects. Those factors could be such things as dependents not getting stipends as early in both Social Security and SSI, increased number of years of work over the 35 years for maximum benefits under SS, and delayment in receiving health benefits.

If the system was suppose to be designed as to be a non-discriminatory benefits package then providing two ways to become eligible seems reasonable. One based on age that may need to be adjusted based on life expectancy like it currently is designed, and the second way is through longevity in the work force like pensions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: No specific positions mentioned.This was meant as continuation of the post {not published/instablog} at SA: