Government deficits and debt have reached alarming levels today, and the unfunded liabilities of tomorrow are even more staggering.  The key to attaining fiscal sobriety is entitlement reform, and Social Security is as good a place to start as any.

Established in 1935, in the midst of the Great Depression, Social Security was FDR’s strong response to the difficulties experienced by the elderly, who saw most of their nest eggs disappear with Black Tuesday’s precipitous 12% drop in the stock market and continued declines for more than a decade thereafter.  Already retired from work, what could they do to restore their savings, the assets on which they’d counted to fund their golden years?  Nothing besides hoping for economic recovery.  So FDR thought the Government should help, and it did.

The program was, and remains, one based on “contributory financing”.  Payroll taxes force today’s workers to “save” some of their earned income, with the promise that when they reach the age of 62 they become eligible for monthly checks from the Government.  It’s a laudable goal, to insure that some wages be set aside for those days, and years, when retirement ends earned income and retirees must live off their savings.  But three major factors have rendered the American Social Security System untenable.

First, the Government hasn’t put this forced saving into a savings account for citizens. Rather, the program is run on a “pay as you go” basis.  One reason, itself not unreasonable, is that benefits started flowing so soon after participants started earning credits that current workers have basically been supporting current retirees rather than saving through the Government for their own futures.  The first beneficiary of the program, for example, was Cleveland motorman Ernest Ackerman, from whose paycheck 5 cents was withheld the first day Social Security was up and going, and who retired the next day with a lump-sum payment of 17 cents from the program.

Second, expanding Social Security benefits has worsened the real balance sheet.  In 1939, the program include survivor benefits for spouses and dependent children, and in 1956 it added disability benefits recognizing that wages were lost by injury as well as by aging.  These additions increased program outlays more than the tax base and rates that would fund them.

Third, changes in demographics also altered the balance between future benefits and revenues.   In 1935, no one forecast the Baby Boomer dynamic, an enormous bulge in the population due to unusually high births from 1946 to 1964.  This cohort vastly outnumbers the group working to support them. Additionally, life expectancy and therefore benefit claims have risen significantly from the early days of the program.  In 1930, life expectancy was only 58 for men and 62 for women.  At first glance, then, the program looks rather sinister.  Was FDR going to force people to save for a future they’d never reach?  No.  The figures reflect appalling rates of infant mortality.  By 1940, 53.9% of men and 60.6% of women who reached the age of 21 lived until 65, the original starting point for benefits eligibility.  Those men and women who reached 65 could be expected to live an additional 12.7 and 14.7 years, respectively.  By 2005, these numbers had increased to 17.2 and 20.

The unfortunate result of these three factors is an estimated unfounded liability for Social Security of  $17.5 trillion, swelling the already disheartening official national debt figure of $12.3 trillion by 142%. The good news is that reforming Social Security is not rocket science, although it does require strong political will.   Here are 5 reform steps that could put Social Security on the road to solvency.

1.We should raise the age of eligibility for Social Security benefits. Doing so violates expectations, but so does altering regulations and tax codes, something our Government does quite often. 65 may not be the new 55, but irritating and expensive as it may be, healthcare can now promise us a high probability of longer and healthier lives.  We can and should work longer to reduce the unfounded liabilities of a program designed to help people who cannot or should not work due to truly advanced age or disability.

To give people some time to adjust to the new rules, a schedule should be announced as soon as possible, and it should phase in the increases.  Advance notice reduces “fairness” concerns, but no change can truly eliminate them.

2. We should make all Social Security benefits part of taxable income. We’ve already started in this direction; let’s keep going.

3. Cost of Living Adjustments (COLAs) should operate in both directions. Raising real Social Security benefits by keeping nominal payments constant in last year’s period of falling prices was appalling even before each senior received an extra $250 through Obama’s special handout. COLAs were designed to protect beneficiaries from inflation, not reward them for deflation.  The cumulative effect of this asymmetry aggravates the inequity and fiscal irresponsibility of this approach to changing price levels.

4. We should modify the way Social Security is funded. One quick possibility is continuing to raise the Social Security ceiling for taxable earned income. Another is to raise the rate at which this income is taxed.  A third is to introduce progressive rates for this payroll taxation.

5. We should radically change the way Social Security is funded. Our current context of battling high levels of both unemployment and debt highlights just how unattractive payroll taxes really are. They raise revenue by making employment more expensive for employers and less attractive for employees. No tax is worse in its employment consequences than the payroll tax. None.

But even when we exit the recession, Americans should remain uncomfortably aware that Social Security’s payroll taxes are regressive.  Poorer people tend to enter the workforce early, while the more advantaged are still getting advanced degrees.  The less advantaged not only start paying for their benefits early, they also are likely to stop receiving these benefits early, because of lower life expectancies (a problem mitigated but not eliminated by survivor rights).  Further, almost all of the income of the working class will be taxed to raise revenue for today’s Social Security recipients because it’s almost entirely wage income below the tax ceiling of $106,800.  Meantime, the upper classes will be taxed on only some of their wages and none of their interest and dividends. Surely, there’s a better way to run this program.

The third column in this series on Government Debt will accordingly explore different approaches to providing socially secured incomes for people who have left the workforce because of age or disability.  The suggestions are radical, and they should be.  Social Security finances are on a terrifying trajectory.  The program had laudable objectives in 1935, and they remain worthy today.  In the 74 ½ years since FDR signed the Social Security Act, however, the old means to these ends are no longer the best means to these ends.