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Why cutting Social Security benefits is a necessary evil

The Motley Fool logo The Motley Fool 9/6/2019 Sean Williams

When it comes to Social Security, our nation's most important social program, I've got good news and bad news.

The good news is that, despite growing fears that Social Security could go belly up or be insolvent by the time future generations of workers retire, these concerns have no merit. Social Security brought in a little over $1 trillion last year and has two recurring sources of revenue -- the 12.4% payroll tax on earned income and the taxation of benefits -- that ensure money will always be flowing into the program for disbursement to eligible beneficiaries.

These two sources of recurring revenue were responsible for $920 billion in aggregate income for the program in 2018. As long as Congress doesn't change how Social Security is funded, it can't go bankrupt. Period.

The bad news is that, while Social Security's survival is virtually guaranteed, the sustainability of its existing payout schedule is not.

According to the 2019 Social Security Board of Trustees report, the program is facing a $13.9 trillion cash shortfall between 2035 and 2093. That's because a number of ongoing demographic changes are weighing on Social Security and are expected to push it from an annual net-cash surplus to a net-cash outflow. The last time Social Security's asset reserves declined in a given year was 1982. And once these outflows start, they're only expected to grow in size, leading to the complete exhaustion of the program's asset reserves by 2035.

So what exactly happens if Social Security's asset reserves (i.e., its aggregate net-cash surpluses since inception) run out? Again, Social Security won't go bankrupt. However, payouts would need to be reduced by up to an estimated 23% for retired workers if Congress fails to raise additional revenue, make expenditure cuts, or do a bit of both. That's worrisome given that more than 3 out of 5 retired workers lean on Social Security for at least half of their income.

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Americans strongly support raising or eliminating the tax cap

If you were to ask the public what method(s) they'd prefer be used to fix Social Security, a majority favors adding new sources of revenue as opposed to cutting benefits.

More specifically, the idea of raising or eliminating the payroll tax earnings cap is tops among all large-scale Social Security "fixes." An informal poll in 2014 from The Washington Post found that roughly 70% of survey takers would stand behind the idea of raising the cap, with no other solution garnering more than 45% support. Survey takers were allowed to choose as many of the 12 options offered as solutions they'd stand behind.

The aforementioned 12.4% payroll tax on earned income (i.e., salary and wages, not investment income) is applicable to earnings between $0.01 and $132,900, as of 2019. The $132,900 level is known as the "payroll tax earnings cap." Although it does adjust upward in step with the National Average Wage Index each year, earnings above this level are exempted from the payroll tax.

Put another way, more than 9 out of 10 workers pay into Social Security with every dollar they earn, while a smaller percentage of well-to-do workers are exempt from the payroll tax on some, or most, of their income. Between 1983 and 2016, the amount of earnings escaping the payroll tax nearly quadrupled from a little over $300 billion to approximately $1.2 trillion.

The idea behind raising or lifting the payroll tax cap is that it would require higher-income earners to pay more into the system. And since raising or eliminating the payroll tax earnings cap would only impact a small percentage of working Americans, it has strong support from most of the public.

Raising or eliminating the payroll tax earnings cap isn't cut and dried

While raising or eliminating the tax cap looks like it would be a clear fix for Social Security's cash woes, it's not as cut and dried as you'd think. While it would certainly add revenue to Social Security each year, which is something the program needs, other factors could weigh on its implementation.

For starters, it could be rightly argued that higher-income workers are already paying their fair share into the system. You see, in addition to there being a payroll tax earnings cap at $132,900 in 2019, there's also a maximum monthly retired worker benefit at full retirement age of $2,861 in 2019. The payroll tax cap exists because there's also a limit to how much Social Security will pay an eligible retired worker each month. In other words, applying the payroll tax to, say, $5 million in earned income if the maximum a worker will receive is $2,861 in 2019 at full retirement age doesn't make much sense.

There's also the not-so-small issue that Republicans in Congress won't support added taxation on Social Security. Rather, the GOP has proposed a number of ways to reduce long-term expenditures from the program (i.e., cut benefits). Mind you, cutting benefits doesn't mean what you probably think it does. The GOP has proposed reducing the lifetime benefits that future generations of workers would collect by gradually increasing the full retirement age. This would cause future generations of workers to either wait longer to collect their full benefits or take a steeper reduction to their benefits if claiming early.

To put things simply: Without Republican support, no amendments can be made to Social Security. That's because 60 votes are needed in the Senate to pass such an amendment, and it's been four decades since either party has had a supermajority of 60 seats. In essence, it's bipartisan support for any Social Security fixes -- or bust!

Sorry, folks, but cutting benefits looks to be a necessary evil

Though I'm fully aware of the negative connotations that surrounds the idea of cutting benefits via a gradual increase to the full retirement age, the fact is that any long-term fix will need to include some form of long-term expenditures reductions -- and I have two reasons to support this thesis.

First, there's increased longevity over the long run.

When Social Security was crafted and signed into law in the mid-1930s, the average life expectancy was 61 years.  Today, it's nearly 79 years. As the average life expectancy has risen almost 18 years, the full retirement age will have increased by a meager two years between 1935 and 2022 (payouts began in 1940).

In layman's terms, we're living longer, and more seniors than ever are reaching the age where they qualify to begin taking their Social Security payouts. What had once been a program designed to provide a financial foundation to seniors for a few years or perhaps a decade has now turned into a program that could support the average 65 year old for two more decades. Gradually raising the full retirement age, or even indexing it to the average U.S. life expectancy, is needed to help address this marked disparity.

The other issue is that raising or eliminating the payroll tax earnings cap doesn't fully account for a steady downward shift in U.S. birth rates.

Since 2010, birth rates in the U.S. have been on a steady decline, with the 1.72 births per woman registered in 2018 representing a record low. Millennials waiting longer to get married, fewer unplanned pregnancies, and better access to contraceptives have all played a role in pushing fertility rates lower. 

The problem is that a steady level of worker replacement is expected by Social Security's Board of Trustees when it develops its long-term projections. Typically, the intermediate-cost model expectation is two births per woman. However, with birth rates declining for almost a decade now, there's a real risk that the worker-to-beneficiary ratio will again drop considerably in about 15 to 20 years. Basically, there wouldn't be enough new workers coming into the labor force to support those leaving it. Even without a tax cap, my suspicion is that the program would still face a potential cash shortfall if these low birth rates persist for any extended period of time.

To be clear, I'm not against increasing taxation to raise revenue. But I believe that any approach to fix Social Security should address as many deficiencies as possible. That means a bipartisan approach, which includes long-term expenditure cuts, is the smartest plan to shore up Social Security.

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