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Fed Governor Lays Out Plan to Finance Social Security and Medicare

Gramlich proposes removing wage caps, extending retirement age

April 21, 2005 – In what may be the most specific proposals for this political debate about meaningful reform of Social Security and Medicare were presented today by Edward M. Gramlich, a Federal Reserve Governor, who says raise the retirement age and remove the cap on the wage level for Social Security taxes.

A major point in his speech at Widener University, Chester, Pennsylvania, is that both programs – Social Security and Medicare – should be managed under the same criteria. For example, the taxes for both should be on all wages and the age levels for receiving benefits should be the same.

“On net, the changes recommended here might improve the overall balance of Social Security plus Part A of Medicare by about 3.5 percentage points of taxable wages and salaries. These steps alone are enough to finance Social Security in perpetuity. Or, they could finance Social Security for seventy-five years and extend the life of Part A trust fund by about three decades,” Gramlich said.

He noted the problems for Medicare are far worse than for Social Security but most of the debate and discussion has focused on Social Security for three reasons:

1. Because of numerous legislated and designated advisory councils, groups are forced to make Social Security proposals more often than Medicare proposals.

2. The Social Security numbers are less daunting—“it is hard enough to deal with unfunded liabilities of $11 trillion, but it is virtually impossible to deal with unfunded liabilities of $70 trillion.”

3. The changes to Social Security “just involve money--cutting benefits means cutting someone's defined-benefit pension payments. Cuts in Medicare, on the other hand, while partly mitigating financial burdens on the aged, could also involve the much more difficult question of limiting, or even rationing, health care treatments. Medicare cuts could be quite literally a life-and-death affair.”

Gramlich participated in the Social Security debate earlier as chair of the 1994-96 Social Security Advisory Council.

He chose to skip any discussion of the Bush proposal for personal investment accounts in the Social Security program, saying he would “leave aside questions about privatizing Social Security or "carve out" or "add on" individual accounts.”

“I will focus only on ages of eligibility and tax rates for both programs,” he said. And said he recognized his proposal “is only partial, a first step.”

He said he would also skip the difficult questions about “the structure of Medicare--whether and how to make more use of economic incentives or rationing.”

In a much more direct manner than often used by Chairman Alan Greenspan, Gramlich explained his ideas.

His first point was suggesting removal of the $90,000 cap on taxable wages in Social Security, which he also recognized as a tax increase. He said this, too, was a first step in treating the two programs the same.

“Today, Medicare Part A is financed by a 2.9 percent combined payroll tax on all wages, and Social Security is financed by a combined 12.4 percent combined payroll tax on wages up to $90,000, a threshold that is increased each year with the growth in wages,” he explained..

“Let's treat both programs alike by taxing all wages for both programs,” he said..

He said in part the removal of the cap merely adjusts for the fact that because of the widening of the income distribution, substantially more wages are above the cap than in earlier times. “But the main reason for removing the taxable payroll cap is that both programs together are woefully underfunded, and this would be a small step in the direction of fiscal responsibility.”

In addressing benefits, he said, “We already have two relevant retirement ages for Social Security--the so-called normal retirement age (NRA), at which an individual qualifies for full benefits on the basis of his or her earnings history; and the age of early eligibility (EEA), at which an individual can receive actuarially reduced benefits. Historically the NRA has been 65 and the EEA has been 62. Recently the NRA has begun slowly climbing from 65 to 67 and is now near 66, but the EEA has remained fixed at 62.”

He said is a good rationale for raising the NRA beyond age 67, but also said, “I also think we should raise the EEA at the same pace.”

There are two reasons:

   > As the NRA rises with no change in the EEA, the actuarial reductions get larger and larger. Pretty soon, benefit payments at the EEA get pretty low, and what we are thinking of as a retirement insurance program becomes progressively less so.

   > Because of shifting demographics, the country will just plain need more workers to pay for growing retirement costs. If all workers were perfectly rational in comparing benefits and costs, they could possibly decide for themselves when to retire. But study after study has shown that many workers seem to be highly myopic and retire at the first instant at which they are eligible for any money at all from Social Security. In such cases a reasonable policy response is to nudge workers in the direction of working longer careers by the simple expedient of moving the EEA up along with the NRA.

He said we should keep the age factors consistent in both programs. “Confusion already exists because people qualify for full benefits under Medicare at age 65 and full benefits under Social Security at an age nearing 66. As the NRA increases for Social Security, the disparity will widen and the confusion will grow. So at the slowly rising NRA, I would give full benefits for both Social Security and Medicare.”

He said early retirement at the EEA, should rise at the same slow rate as the NRA,

“I would give actuarially reduced benefits for Social Security and early buy-in opportunities for Medicare. One illustrative schedule is that individuals might be allowed to buy in to Medicare by paying, say, 90 percent of the average Medicare costs for parts A, B, and D once they hit the EEA, 60 percent a year later, 30 percent a year later, and only the standard part B and D premiums when they fully qualify for Medicare,” he stated.

Recognizing the programs he different he said we should “proceed cautiously.”

“Medicare is a health insurance program, and health insurance performs two functions--it mitigates financial loss for households getting treatment, and it permits households to get health treatment in the first place. To the extent that the latter motive is dominant, as it could be for low-income or disabled households, measures to raise the eligibility age could be problematic. For this reason, it would be important to provide a generous schedule of buy-in substitutes for households with low-income or disabled beneficiaries, to encourage greater use of health care in the years before the NRA. The subsidies could be offset by surcharges on the premiums for well-off households, who could more easily afford the buy-in.”

He suggested several ways to make the changes in the age differences in the programs.

“I begin with the underlying logic for a rising retirement age. Historically most workers contributing to Social Security have been males. Males in my grandparents' generation who were lucky enough to attain age 65 could be expected to live, and collect benefits, for another thirteen years. Males in my grandchildren's generation lucky enough to attain age 65 are projected to live another twenty years. Had the NRA not been raised, this factor alone would have made Social Security a better deal by almost 60 percent for the younger generation.

“Obviously there have been many other changes in society, the economy, and Social Security over this time. But, still, it is my guess is that if the designers of Social Security had known back in the 1930s that postwar life expectancies would increase so significantly, they would have built rising retirement ages into the system. Of course, when asked, people do not favor rising retirement ages. But given the various undesirable choices for moving these programs back toward actuarial soundness, a slowly rising retirement age seems far and away the fairest across generations.

“One standard for how fast to raise the retirement age is to invoke life expectancies. Life expectancies at age 65 speak to the question of how many years into retirement individuals are likely to collect benefits. Life expectancies at age 20 address the question from a different perspective--as individuals enter adulthood, we might have them spend a constant percent of their time in work and retirement.

“The age-65 standard shows that, for males born between 1875 and 1995, life expectancy at age 65 has increased 7.4 years, an average of 0.6 years every decade. It also turns out that life expectancy has increased more rapidly for those born in the twentieth century--over this shorter period improvement has been about 0.7 years every decade.

The age-20 proportionate standard works out as follows. In 1940, at the dawn of Social Security, 20-year-old males could expect to work another 45 years and to live just 1.9 more after retirement. That is, they could expect to spend 96 percent of their remaining life in the work force and 4 percent in retirement. Today, 20-year-old males can expect to live another 55.6 years. If they were to spend 96 percent of that time in the work force, the NRA would be slightly more than 73. By this standard, the NRA would have advanced 1.4 years every decade.

Health status is also relevant. One measure is the share of men near death, defined as being in the last two years of life. In 1960 this share, for men around today's Social Security early retirement age of 62, was about 6 percent (figure 2). In 2000, the share of 68-year-old men near death was at this baseline level of 6 percent. By this health standard, in 40 years healthy life expectancies have increased 6 years, or 1.5 years per decade.

One can also consider a broader measure of health status. Since 1970 the National Health Interview Survey has asked a direct question about health status. Typically, the proportion of people describing their own health as fair or poor is taken as a measure of poor health status. Since the numbers bounce around, I have made comparisons with trend lines estimated by Cutler, Liebman, and Smyth (figure 3).1 The trend lines show that, in the mid-1970s, 28 percent of men aged 62 reported that their health status was fair or poor. By the mid-1990s the 28 percent standard was not reached until men were about 73, an improvement of 11 years in just two decades. By this standard, the retirement age should increase by a whopping 5.5 years per decade.

These health standards give varying estimates, so the conclusions are not as tight as for life expectancy. But they suggest that health standards are improving even more rapidly than life expectancies. If the retirement age were increased about a year per decade from the standpoint of life expectancy alone, the increase would be more rapid from the standpoint of health status. A sensible compromise would seem to be to raise the NRA and the EEA slightly more than a year every decade--maybe three months every two years--a pace slightly slower than the present rate of increase for the NRA. This rate of increase should be reviewed periodically to adjust to future changes in health status or life expectancy.

There is one final point. A standard argument against raising the retirement age is that people are working physically demanding jobs and are simply not able to continue. Of course, workers can and do switch careers as they age, or claim early retirement. But it still makes sense to look at the share in demanding jobs, as is done in table 3. In 1950, one-fifth of the work force worked in jobs judged by the Labor Department to be physically demanding. But this share has dropped an average of 24 percent per decade since then. By 1996 it was down to only 7.5 percent of workers in physically demanding jobs, and by the time any of my suggested measures take effect, the share should be on the order of 3 or 4 percent--not zero, but probably not high enough to argue against measures to raise the retirement age at a gradual rate.

It is not popular to raise the retirement age. Workers have a valid desire to consume some of their increasing productivity in the form of leisure time, or earlier retirement. At the same time, Social Security and Medicare together pose huge financial problems. It is also not popular to raise payroll taxes, or to ration health care. Among very unpleasant alternatives, raising the retirement age seems to be one of the fairest approaches across generations.

Budget Savings
Let's then take a policy change that raises the retirement age three months every two years, or 1.25 years every decade, and taxes all wages for both Social Security and Medicare. How does it stack up?

The tax change is easy to compute. Right now about 85 percent of wages are taxable and this coverage rate is slated to decline slightly over time. Applying the 12.4 percent tax rate to the15 percent of wages that are untaxed leads to an effective change based on now-taxable wages and salaries of 2.1 percentage points. This change more than solves the seventy-five-year Social Security problem (for the intermediate assumptions), and solves more than half of the infinite-horizon Social Security problem. It is only a first step, but a strong one.

Increasing the NRA by three months every two years would improve the actuarial balance of Social Security by slightly less than 1 percentage point of taxable wages and salaries. I ignore any cost-saving effect on Medicare, permitting the early buy-in costs for low-income households to use up any budget savings from higher premiums for high-income households whose primary breadwinner is just over 65. If we were to combine this increase in the retirement age with a few standard measures to improve the horizontal equity of Social Security--including all newly-hired state and local workers and using a chained price index--the total improvement reaches about 1.4 percentage points.

On net, the changes recommended here might improve the overall balance of Social Security plus Part A of Medicare by about 3.5 percentage points of taxable wages and salaries. These steps alone are enough to finance Social Security in perpetuity. Or, they could finance Social Security for seventy-five years and extend the life of Part A trust fund by about three decades. Huge general revenue liabilities for parts B and D of Medicare remain, but this package is still a start in dealing with growing retirement costs. As said above, the package of taxing all payrolls for Social Security and advancing the normal retirement age is indeed strong medicine.

My approach here has been to unify proposals for the financial reform of Social Security and Medicare on the tax side and for retirement ages. Will the changes be pleasant or popular? No. Will something like them, or worse, be necessary some day? Yes. We might as well begin now thinking about those changes that seem to be the fairest across generations.

 For the complete speech and the tables and other information presented - Click Here

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