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.

President Obama is expected to announce today a $3.8 trillion budget with a $1.2 trillion deficit for FY2011.  Here’s the context within which he will reveal his plan.  For decades now, the federal debt acquired through years and years of deficit spending has been the “elephant in the room” – the huge presence nobody talks about but everyone knows is there.  In last week’s State of the Union address, however, debt joined unemployment as the two most urgent issues facing America as Obama enters his second year as our President.

Last year, the White House and Congress went “Keynesian” in a big way as the real-estate bubble popped and started to pull Wall Street and Main Street down with it.  In crisis mode, they quickly passed stimulus bills designed to unfreeze credit and prevent the rate of unemployment from reaching double-digit percentages through a combination of renewed lending and “shovel ready” government spending to increase overall demand.

Last fiscal year, our federal deficit reached a record $1.4 trillion, and it’s projected to total $1.7 trillion this fiscal year, the first quarter of which has already seen spending exceed revenue by $389 billion, a 17% increase over the same period a year before. But as we enter February, unemployment resists declining below 10%, and debt as normally configured has reached almost $12,300,000,000  – or roughly $40,000 for every man, woman and child in America.

On January 12, the Obama Administration announced that its Council of Economic Advisers determined that the $787 billion stimulus program “saved” or “created” between 1.5 and 2 million jobs during 2009. Using the upper bound, that’s $393,500 per job. The “what if” ‘s of history cannot be proved, they can only be stated.  But even if we accept the upper bound as a true of the extra unemployment we’d have suffered if the Administration’s policies had not been implemented, it’s hard to conclude that our money has been well spent.  At best, each job has cost us $393,500, while none is regarded as permanent and the average compensation for comparable work is surely less than $75,000 on an annual basis.

<em>Pace</em> John Maynard Keynes and his new followers, it looks as if new government spending programs and the concomitant deficits are hurting, not helping recovery. Consumers, savers, and businesspeople alike worry about which taxes are going to increase and by how much to avoid continued debt explosion.  We also worry about what’s going to happen to interest rates and their effect on private borrowing expenses and the carrying costs of the national debt.

How, then, should we analyze the debt and its effect on the economy?

First of all, it’s ridiculous and misleading to compare today’s $12 trillion with, say,1950’s  $357 billion because of the cumulative effect of inflation over the last 60 years.   And we should also correct for growth in the economy.  After all, whether a $200,000 private mortgage is extravagant and foolhardy or modest and frugal depends upon the income of the borrower.  The following graph basically makes both of these corrections.

As is the case with most statistics, the tone of the story depends on its starting point.  Begin in 1945 if you want to relax, in 1980 if you’re okay with having your blood pressure soar.

Either way, two other adjustments are also appropriate. We should rework the numbers for automatic stabilizers, and we should separate government spending into consumption and investment categories, just as we do for private spending.

The Beltway doesn’t have to change anything to get some Keynesian stimulus spending going.  As unemployment increases, welfare payments will rise and tax revenues will fall, increasing or creating deficits.  If there’s any validity to Keynesian Economics, these quick developments are appropriate, and fair assessment of deficits should reconfigure the sums with these formulaic changes in mind.  We should find out, in other words, what the difference between spending and taxing would be at a level of employment considered “full”.

Our evaluation of debt should also depend in part on whether it’s being acquired through consumption or investment spending. We should be less concerned about deficit spending that finances investments than we are about deficits fueled by transfer payments properly categorized as consumption. Just as the probity of taking on a $200,000 mortgage depends on income (and its security), so is it sometimes okay and even good to take on some debt when acquiring an asset like a home, but not so good to finance a shopping bender in the Mall of America or a new car (which loses half its value right off the lot).

Unfortunately,“investment” is a malleable term that politicians will use to their advantage and not to ours.  Is the War in Iraq an investment in our future (which includes national security, itself dependent on reliable supplies of oil)?  Is Obama’s likely proposal of a huge increase in spending on education an investment in our youth, the individuals whose payroll taxes will be funding our Social Security checks?  Or, absent reform, is it more like income redistribution and consumption?

The issue of Social Security demands more scrutiny.  It also requires grit.  While insight is gained, the comfort our graph of debt/GDP can provide if we start with the Truman years is trashed.  The US could reduce national debt as a fraction of national income after World War II fairly easily because budgets weren’t encumbered by entitlement programs as they are today.  The value of these programs is not in question.  The problem is their cost, both in dollars and in flexibility and control. Baby-boomer demographics were not in play during the  1940s.

The unfounded future liabilities in entitlement programs like Social Security and Medicare dwarf all other deficit and debt concerns.  Neither has a nest egg adequate to the soaring payouts the formulas predict as baby boomers become eligible for benefits and are expected to live longer than their parents and be supported by taxes on a smaller work force. Last year alone, the combined debt of these two programs rose $5 trillion
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The fiscal health of our federal government is also worse than today’s debt figures would indicate because they fail to include off-budget items like subsidizing Fanny May and Freddie Mac.  Last week, the Congressional Budget Office reduced its guesstimate of another decade of their financial support by a whopping $20 billion. Yea!  But that leaves $79 billion still expected to be expended and begs the question of why these important players in the real-estate bubble remain “outsiders” even though any pretense that they’re run for a profit should long have been abandoned.  Time will tell, but the move to increase their loss limits does not auger well for us taxpayers.  It’s a cheap trick for the government to take quick credit for the positive effects of subsidizing mortgages through Fan and Fred, their cousin Ginnie Mae and uncle FHA, while failing to account for all the default risks accumulating as loss ceilings rise.

And then there are all the times the federal government improves its budget by fobbing off responsibility for funding certain programs to the states.  Medicare mandates are one example of this cost shifting.  In assessing government debt issues, we should be looking at all three levels of government – national, state and local, with an eye not only to their totals but to whose debt is really whose.  Should federal mandates really be paid by the states?  For what government spending should the counties, cities and towns be responsible?

Another matter involves the cost of servicing all this debt.  Like entitlement programs, interest payments are a huge part of overall government spending – indeed, its fourth largest category.

To whom are all these interest payments made? In times past, almost all debt holders were Americans, so we could call these payments mere “transfers” among our citizens.  Increasingly, however, our debt goes overseas, where China, Japan and the UK are currently our largest debtors.  Their holding our debt helps finance our trade imbalances and keeps our interest rates lower than they might otherwise be, but it also makes us vulnerable to outside change and exchange-rate issues.

It’s a good thing that we are now talking about the Elephant of Debt in the room.  The focus for reform, however, should not be debt but rather the growth in government spending, expected to reach 35% of GDP this year.  That’s the real, and even larger elephant whose presence we’ve been ignoring.

In the case of pulling an economy out of recession, it can be argued, although not with complete confidence these days, that additional government spending can actually increase private production.   In the case of full employment, however, all government spending takes the place of private spending.  If it’s funded by debt, interest rates may rise and “crowd out” private investment.  If it’s funded by taxes, the consequent declines in consumer demand and company profits will also cause private investment to decrease.

The key issue then becomes whether diverting resources to government use improves the public weal or not.  The consequences of whether the spending is financed by today’s taxes or by tomorrow’s taxes, for all their importance, remain secondary.  An important difference would involve whether voters respond more strongly to tax or debt increases and through their response can impose adequate spending restraint on politicians approving the programs.

How do we change the current trajectory of the ratio of government spending to GDP?  Given all the worthy entitlements and the difficulty of defining and controlling “waste”, the most attractive option is to grow the economy.  Investment in equipment, technology and people is key.  The question, then, is whether and to what degree the government, rather than the  private sector, should undertake these investments.  We already know that predictability in tax and regulatory legislation is a necessary first step.