Radical Reform of Social Security requires starting at the root, and that root is its real purpose and goals today, in 2010.  What are we really trying to accomplish with this program?  What are the basic problems for which we should supply social safety nets, and how do we best supply and sustain them?

2010 is more like the 1935 of Social Security’s birth during the Great Depression than any other time in American history so far.  It is a time of Great Recession, when macroeconomic events have created new poverty and exacerbated old.  Unemployment has destroyed wage income, and plummeting stock markets have devastated savings from earlier and other incomes.  Nonetheless, asking this root question of purpose yields distinctly different appropriate approaches from those we’ve been following, only slightly tweaked, for almost 75 years.

In 1935, FDR was responding to the ruination of nest eggs through collapse of the stock market.  He was particularly interested in the suffering of people who were too old to replace these losses through years of extra work and saving.  They had become poor too late to help themselves, and Society stepped in to provide this help.

Today, even as FDR’s Social Security system approaches bankruptcy, it does only a mediocre job providing financial ease in old age.  Even worse, the very structure of social security causes harmful effects to the economy in general and the working poor in particular.

According to the Social Security Administration, Social Security checks only provide 39% of a retiree’s income.  American workers must not only pay their Social Security taxes, but put money away at the same time if they want to avoid poverty in old age.  Needless to say, there is not much “security” in such a system.  Most people will not be able to survive on $1100 or  $1200 per month.  The current Social Security System does not successfully protect against poverty in old age.

Furthermore, Social Security has a number of negative indirect effects. The program may actually make a substantial number of people poorer in many of the years before retirement. “Contributory financing” is attractive to Americans who like to think that other people have paid for what they’re getting from the government.  But in the case of Social Security, this translates into the practice of early forced “saving” through payroll taxes to replace earned income for the elderly after retirement.  The result is more poverty, less employment, and higher underemployment in hopes of less poverty tomorrow — a tomorrow far, far away for many and never reached for those who die early.

Payroll taxes are a noxious form of taxation at all times, but particularly when high rates of unemployment are a national concern, as they are today.  These taxes discourage employment by creating a wedge between what businesses have to pay to hire or keep workers and what workers get to keep.  From 1937 to 1948, this difference was relatively small.  To finance Social Security benefits, employers and employees were each taxed 1.0% of the wages they paid out or took home. Medicare had yet to be invented, so its payroll taxes didn’t add to the total.  Social Security now taxes all workers at a rate of 6.2% of all their earned income up to $106,800, and employers have to match withholding with another 6.2% of their own. (Medicare adds another 1.45% to each side, for a total burden of 15.3%.)

The poor, it is often said, don’t pay income taxes.  The Earned Income Tax Credit has certainly made this true for some.  But the income ceilings for eligibility are pretty low, and everyone with a job paying above that level sends at least 7.65% of his or her earned income to the government.  “At least” because “writing the check” is different from “paying in a true economic sense.”  If businesses can get away with lowering wages in response to payroll taxes, they will.  Their total costs (wages plus their share of taxes) then go up by less than the taxes, and labor’s income (wages minus their share of taxes) go down by more. Business has then shifted some of the tax burden to Labor.  For workers earning minimum wage, the results can be even more draconian.  Employers can’t shift any of the burden to these employees, but they may lower their wage to zero, firing or never hiring people whose productivity is regarded as less than the total of minimum wages plus payroll taxes.

The situation gets even more deplorable.  Social Security may be part of what traps the poor in an even deeper sense.  The payroll tax not only causes poor people to lose income today by reducing employment and after-tax income.  It also causes losses in future income.  Entry-level jobs don’t just provide current income. Part of their rewards are hidden and deferred — on-the-job training, investment in human capital that can lead to better jobs and entry into the middle class.  Investing in human capital doesn’t just occur through formal education.  And it’s every bit as important a source of economic growth and prosperity as investing in machinery.

Growing the economy requires getting out of this Great Recession and increasing investment in equipment as well as in people.  Investment in extra capital tends to increase labor productivity even when the new equipment is just like the old.  The effect is even more positive when new capital embodies new technology.  Unfortunately, Social Security is probably holding back recovery and holding back growth.

To hire new workers, employers have to be very optimistic about economic recovery and not too concerned about future tax increases and other changes in the rules.  Reverse Keynesianism may actually be taking hold today. Deficit spending may actually be holding back private spending. Businesses may be cutting back as all that “job creation spending” previously known as “stimulus spending” raises anxiety about exploding deficits and debt and how they’ll be financed. Social Security plays a negative role here, too. Not only does it require current taxes that discourage employment, it has future unfounded liabilities that reduce entrepreneurial confidence and optimism as we all anticipate future tax hikes.

Few, if any, of these negatives are offset by the salutary effect of all the forced “saving” driven by payroll taxes. More saving, absent recession, means more investment, and more investment means more growth.  But none of that payroll revenue has actually been saved.   Our government is saving nothing for the elderly. It has never saved anything for the elderly.

What we have is a pay-as-we-go program, with a pledge to support today’s and tomorrow’s elderly by imposing payroll taxes on today’s and tomorrow’s workers.  Demographic change has put us on a frightening trajectory of massive and accelerating unfounded liabilities.  In 1950, 16.5 workers supported each retiree. Because of the baby-boomer bulge and increased life expectancy, this number has fallen to 3.1 today, and within 20 years it’s expected to drop to a mere 2.1.

The horror story of unfunded promises has received a lot of publicity of late. Less acknowledged is what has happened to earlier surpluses in the system: they were diverted to the payment of other government programs.  In 2008 alone, the Social Security surplus was $180 million, with a cumulative total of $2.4 trillion.  No wonder Mark Brandly urges us to “[t]hink of it as an exponentially larger version of Bernie Madoff’s Ponzi scheme.”  (See  “The Social Security Scam”.)Trillions of dollars of regressive payroll taxes can’t even be justified as “contributory financing”.  This is shameful diversion and warrants more exposure from the press.

While Social Security has done nothing directly to increase savings, the program has at least two indirect consequences for private savings.  On the one hand, people with jobs and therefore mandatory contributions to Social Security are likely to save less because this program “guarantees” defined benefits for their retirement years.  On the other hand, they may not believe this guarantee and increase savings not just because Social Security is insolvent but also because most efforts to improve its balance sheet are likely to include increased income taxes.  Small solace, this, because the extra savings will go ultimately to debt and deficit reduction, not to new ideas and the equipment that embodies them.

Poverty at all ages is our real problem, and the Social Security program as it exists today should accordingly itself be retired.   It’s certainly old enough, it’s not properly structured, and its goals are insufficiently wide.  Created in a crisis, it’s worsening today’s crisis.  Even in times of prosperity, it has created  poverty in efforts to avoid poverty.  Well intentioned, Social Security deserves a proper memorial service, but buried it definitely should be.

The next column will discuss alternatives to the current social security system.

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.