Social Security Adds to Senior Poverty

A new paper from the Independent Institute written by Edgar Browning describes how the return on Social Security contributions is bad for Americans.

One of the most common arguments supporting Social Security is that it reduces poverty among the elderly. Last week, Barack Obama stated that, “Social Security has lifted millions of seniors and their families out of poverty. Without it, nearly 50 percent of seniors would live below the poverty line.” This is almost certainly untrue.

Social Security affects poverty among the elderly in two offsetting ways. While it reduces poverty by providing income to retired persons, it discourages private saving during the working years—ultimately decreasing the private assets people bring to their retirement. The net effect of this is increased poverty among the retired population.

To understand this conclusion, it is important to compare the rate of return on taxes paid that is generated by Social Security to the rate of return people could receive on their private saving. For those retiring in 2008, the average implicit real (inflation-adjusted) rate of return on Social Security taxes paid was slightly below 3 percent—and it is scheduled to decline to under 2 percent in the next forty years. In contrast, if people retiring in 2008 had invested the taxes they paid into Social Security in a balanced portfolio (60 percent stocks and 40 percent bonds), they would have received a return of 5.5 percent.

The difference between a 5.5 percent return and a 3.0 percent return may not sound like much, but in annual returns compounded over a lifetime, this difference has a huge influence on the income available during retirement. In fact, the annual retirement income provided by a 5.5 percent return is double than that provided by the 3.0 percent return of Social Security. Even more compelling, an investment in the stock market averages a 7 percent real return, which would mean an annual income of three times what Social Security provides.

In short, it is likely that we would have fewer poor among the elderly had they been free to invest their taxes in private assets. Once Social Security’s rate of return drops to below 2 percent, it will only continue to aggravate poverty in the future.

While this simple comparison is compelling, it overlooks the huge hidden costs of this system. By reducing the incentive for workers to save privately for their own retirement, we reduce the economy’s saving and investment in productive assets. This means the economy grows more slowly as a result of Social Security and people end up with lower incomes even before they pay their taxes. When this cost is taken into account, the real return from Social Security to those retiring today is actually negative!

And things are only going to get worse. Although Obama assures us, “the underlying [Social Security] system is sound,” economists have emphasized for years that this is not the case. Today, government expenditures on Social Security and its companion retirement program, Medicare, are 7.3 percent of GDP. However, the Boards of Trustees of Social Security and Medicare tell us that figure will rise to 15.2 percent by 2040 if we don’t change the rules for determining benefits.

Ultimately that means we will have to more than double tax rates to pay the benefits Congress has unwisely legislated. Or we will have to cut benefits in half, or some combination. Raising taxes would be disastrous—imagine a 35 percent payroll tax rate (compared to the present 15.3 percent) and higher income tax rates as well. And since Medicare is partially funded by the federal income tax, its rates would have to rise as well.

Neither option is attractive, but cutting benefits is clearly preferable since people would then depend more on private saving. Most economists favor gradually raising the retirement age as the least painful way of cutting benefits. But the longer we wait, the harder it is to implement this option and the more likely we will be forced to accept substantially higher taxes.

The elderly poor, as well as the rest of us, are ill served by politicians who systematically downplay the huge costs of Social Security and delay confronting what is indeed a true crisis.