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The best way to fix Social Security

The best way to fix Social Security
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With the Social Security trust fund projected to be depleted within the next 15 years, policymakers have started to consider the changes needed to keep the trust fund solvent. While they often disagree about the details, there is broad support for making those changes in a progressive manner, placing larger net burdens on those retirees with more resources.

There are two possible strategies for improving Social Security finances while making the program more progressive. One strategy, embraced by some policymakers, is to raise taxes on high earners, which would raise enough revenue to keep Social Security solvent and also pay for benefit increases. Another strategy, for which some polls find popular support, is to reduce benefits for well off retirees. Either strategy, or a combination of the two, could achieve the goal of reducing the Social Security shortfall while protecting seniors with the greatest need. If policymakers pursue the benefit reduction strategy, however, they need to do it right.

A tempting but flawed approach would cut Social Security benefits for retirees with high current annual incomes. That approach is already used to some extent. Seniors with annual incomes above certain thresholds must pay income tax on part of their benefits, thus effectively reducing benefits based on annual income. The Heritage Foundation and former Governor Chris Christie proposed directly reducing benefits for retirees with higher annual incomes, sometimes known as means testing.

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As we have explained, however, reducing Social Security benefits based on annual incomes would create serious economic problems. Seniors would change their behavior to lower their reported income and avoid the benefit reductions. They might cut back their hours or retire sooner, or they might engage in financial manipulation, such as editing the timing of Social Security claims or withdrawals from retirement accounts.

Economists generally agree that annual income, which fluctuates from year to year, is an unreliable measure of long term economic well being. For older individuals, reducing benefits based on annual income would unfairly penalize retirees who saved more throughout their working years. Workers who sacrificed to set money aside for retirement, and thus ended up making larger withdrawals from retirement accounts, would receive smaller benefits than those who spent more in their working years.

There is a better way to make Social Security more progressive on the benefit side, which is to reduce benefits for retirees with higher lifetime labor earnings. That approach builds on the progressive benefit formula today, which links the monthly benefit of each retiree to a measure of the lifetime earnings on which he or she paid Social Security taxes. Although monthly benefits are higher for retirees with higher lifetime earnings, they are less than proportionately higher. In other words, high earning retirees receive more dollars each month, but get a lower rate of return on the Social Security taxes that they paid throughout their working lives.

The way the benefit formula tilts against retirees with high lifetime labor earnings has drawn relatively little public complaint. The formula could be made more progressive by lowering benefits for retirees with high lifetime earnings. Lifetime labor earnings is a good, though imperfect, measure of the need for Social Security benefits because it measures a key aspect of the ability to prepare for retirement. Moreover, reducing benefits based on lifetime labor earnings would neither penalize saving nor reward financial manipulation. It would impose little penalty on working into old age, as earnings in old age only comprise a small part of lifetime earnings.

This approach could be implemented by changing the benefit formula so that monthly benefits would rise more slowly with lifetime labor earnings than they do today. We could alternatively go a step further by scrapping the benefit formula and having Social Security pay a flat benefit that is not linked to lifetime earnings. To reduce penalties on working, benefits could still be higher for retirees who have worked for more years. Of course, any changes would have to be phased in gradually for future retirees.

A similar approach could be applied to Medicare. Current law requires retirees with higher current annual incomes to pay higher premiums, so a better approach would impose higher premiums on retirees with higher lifetime labor earnings. Increasing the progressivity of Social Security by cutting benefits for well off seniors would be a reasonable way to address the financial difficulties of the program, however, the details do matter. Targeting benefits based on lifetime labor earnings would protect those retirees in need while avoiding the most harmful economic effects.

Sita Slavov is a professor at the George Mason University Schar School of Government and a visiting scholar with the American Enterprise Institute. Alan Viard is a resident policy scholar at the American Enterprise Institute.