Top Ten Myths of Social Security: Myth #2 – Economic Growth will Save Social Security

Posted by Jeffrey Brown on Dec 6, 2010

Filed Under (Retirement Policy, U.S. Fiscal Policy)

A few weeks ago, I posted the first in a series of myths about Social Security (click here for the first one). Today, I want to tackle a second major myth concerning Social Security, namely, that we need not concern ourselves about Social Security’s shortfalls, because the problem will go away thanks to economic growth.

Some Social Security analysts and commentators argue that the economic growth assumptions in the Social Security Trustees’ Report are too pessimistic, and that with higher economic growth, Social Security’s finances will remain strong for the foreseeable future. One of the highest profile supporters of this view is Paul Krugman, who wrote in a 2005 editorial that “faster growth will yield a bonanza of payroll tax revenue that will keep the current system sound for generations to come.”

If only it were so easy! Unfortunately, this myth sounds plausible to many, especially when the statement is being made by a Nobel Laureate (although I should hasten to add that Krugman won his Nobel prize for research completely unrelated to Social Security, a topic on which he has no particular academic expertise).

The basis for this myth is that the Social Security Trustees’ Report assumes a rate of economic growth over the next 75 years that is lower than the historical growth rate over the past several decades. If one were to simply increase the assumed rate of economic growth to this historical level, Social Security’s financial woes would appear much less severe.

Importantly, the assumed low rate of economic growth does not arise from a pessimistic view about future productivity growth. Indeed, the long-run rate of productivity growth assumed in the 2010 Trustees Report for the next seventy-five years is 1.7%, which is in-line with total productivity growth over the past five economic cycles (covering the period 1966-2007) (see p. 93 of 2010 Trustees Report) Rather, the low rate of economic growth stems from the assumed reduction in total employment growth On pages 100-101, the Trustees discuss their assumptions in detail, noting that this growth slow-down is attributable to the slowing of growth of the working age population, a “natural consequence of the baby-boom generation approaching retirement and succeeding lower-birth-rate cohorts reaching working age.” While one might argue that their specific assumptions are pessimistic, it seems hard to argue with the basic logic that some reduction in the growth rate of total employment is justified, given that the entire baby boom generation will move from being part of the labor force to being entirely out of the labor force over the next seventy-five years.

More generally, while it is correct that higher rates of economic growth lead to higher tax revenues in the future, it is important to understand that in a wage-indexed system such as ours, future benefit obligations also grow when wages rise. Specifically, the current Social Security benefit formula is designed to hold benefits constant relative to a retiree’s average (wage indexed) lifetime income. As average earnings rise, therefore, so do promised benefits. Thus, while economic growth does improve the long-run sustainability of the system (a point made by Brad DeLong, among others), under most reasonable assumptions the need for policy changes is not eliminated. Indeed, if the economic growth rate were increased to historic levels, this would only postpone the onset of cash flow deficits by a few years.

More generally, analysts are no doubt correct to assert that the actuarial and economic assumptions used to evaluate the future cash flow problems of Social Security are, in fact, just assumptions. It is certainly true that any set of projections will, ex post, likely turn out to be wrong. But uncertainty about the future cuts both ways, suggesting that while Social Security’s future cash flow may turn out to be better than expected, they could also be worse than expected. Prudent planning for the future should actually place more weight on the downside risk than on the upside potential.

The bottom line is that, yes, future projections are subject to considerable uncertainty. But to avoid making politically difficult policy corrections based on the fact that the future might turn out better than expected strikes me as unwise. Rather than using the existence of uncertainty as an excuse to avoid responsible policy actions, policymakers should look for ways to reform the Social Security system so that it is more resilient to unexpected demographic and economic shocks.

9 Responses to “Top Ten Myths of Social Security: Myth #2 – Economic Growth will Save Social Security”

  • Jimmy G says:

    It does seem that even if economic growth occurs and people continue to earn more and therefore pay more into Social Security this could help to close the nations funding deficit. However, as people earn more throughout their lives they will earn more after retirement as well. For this reason, and several others, the Fiscal Commission is trying to bring about Social Security reform. The changes proposed involve altering the benefit formula, increasing the retirement age, reducing the annual COLA, and several other changes. These proposed changes could help eliminate 45%, 21%, and 26% of the funding gap respectively. Relying on economic growth and a hands off approach to solve the Social Security problem is not the corrective action we can expect to see work. Reform is necessary in order for the funding gap to be reduced and eventually eliminated.

  • Disen C says:

    It’s definitely a myth…
    Take China for example, the economic growth is among the highest in the world, yet the government is also struggling to pay the retirees. I would suggest that rather than hoping economic growth can save Social Security, the government should implement something substantial, even something radical like private accounts to eliminate the funding problem ( I know new problems will arise).

  • Michael Wehrli says:

    Unfortunately, I’m not sure we have any leaders in Washington with the courage to truly reform Social Security. Touching the issue has been synonymous with political failure. As a college student I would like to thank our leaders for passing the issue to my generation. I’m hopeful for imminent reform but unfortunately pessimistic at the same time. I fully support the ideas presented by the Commission, especially increasing the retirement age as well as the Social Security cap on taxable wages.

  • Rohan Sahasrabudhe says:

    One of the hidden problems with assuming that increased growth will improve Social Security’s viability is that people’s saving habits also change with an economic boom, and the implications of behavioral economics/finance.

    As per the data here:
    The personal savings rate has increased since the beginning of the economic downturn. This goes contrary to the actions of the Fed, which has decreased the interest rate to encourage spending. Thus in reality, people would have less personal savings in times of economic prosperity. Even if the economy improved (and strengthened Social Security), there is the possibility that a decrease in personal savings would leave anyone with a savings or retirement account less prepared for retirement.

  • N. Vainisi says:

    Too often and for too long we have been promised some sort of action on Social Security. I was happy to see the Simpson-Bowles commission suggest raising the retirement rate, but the snail’s pace at which the rate will increase is frustrating. We have a climate where parties are unwilling to compromise or yield their position on any issue, social security being one of the most important. They will make the assumption that revenues will increase in the future as wages rise because it is easier than finding a tangible, realistic reform. Meanwhile, anyone entering the workforce right now will be forced to deal with our inaction 30-40 years down the line.

  • Hillary Haen says:

    I am happy to see that you pointed out the obvious… we are growing at too rapid a rate and living too long for economic growth to take care of social security. Our country has a growth rate of about .85% per year, and every year citizens gain about .1 years of life. I can’t understand how individuals who see those facts can attribute the economic growth to assisting the funding for social security. I do understand though, that there is no real easy solution, therefore it’s hard to criticize those who just want to see the problem go away.

  • Da Hyun Kim says:

    I really like how Rohan brought up the economic concept of the relation between people’s saving habits and the market condition. It is definitely so true that when there is an economic boom or when the economy is stable/growing, consumers tend to spend more and save less. Hence, we should not naively assume that economic growth will automatically better our social security problem because it is likely that people will save less for their retirement as well. As Jimmy said, we need an actual program or action in place than passively waiting for the “assumption” to correct our decades of unsolved problem.

  • Ross D. says:

    As many of these comments relate to the overall savings rate of the general population, I’d like to point out the burden that the Commission’s report puts on the middle to upper level income classes. Many of the people in the middle income class especially, are the citizens who provide the foundation for our society (providing jobs, individual savings, etc). These individuals are not fairly represented within the proposed Social Security system. The new taxes will severely impact their own personal savings and it is not fair to place the burden of the Social Security system on them as well.

  • Pengfei Yu says:

    If personal retirement accounts are established, the money that goes into them will not be available for benefit payments. However, these accounts can be funded initially from the excess revenues that Social Security collects each year. Even after the Social Security surplus ends, taxes diverted to personal retirement accounts will not be lost, as the money in them will be available to help pay for younger workers’ retirement benefits. This will reduce the amount of general revenues that Social Security will require in the future.