Tinkering With CPI Won't Erase Social Security's Insolvency

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2031 is likely the next 2012. No, the Mayan calendar hasn't been reinterpreted -- but the Social Security Administration's statistical projections have, and it's not looking good.

A new study by professors Gary King of Harvard University and Samir Soneji of Dartmouth College finds that the Social Security Administration's (SSA) $2.7 trillion trust fund that is supposed to fund the retirement of baby boomers, will be exhausted in 2031 -- two years earlier than the SSA's original projection. Indeed, 2010 was the first time in more than 25 years that Social Security ran a deficit; spending $49 billion more in benefits than revenues generated, and this will become a permanent state ofaffairs unless something is done.

The Congressional Budget Office (CBO) last November warned that "the federal budget is on an unsustainable path under current policies." Even though Social Security's unfunded liabilities are some of the biggest drivers of this fiscal unsustainability (after Medicare), the recent fiscal cliff deal did nothing to address them. That must change come March, when the next round of deficit reductions talks take place, and the changes must be substantial if fiscal apocalypse is to be avoided.  As of now, the lame ones that Republicans have proffered won't cut it.

The big Republican idea for putting Social Security spending on a fiscally sustainable footing involves changing the way the program calculates Cost-of-Living Adjustments (COLAs) for beneficiaries. Essentially, Republicans suggest switching the price index used to determine COLAs from the current one to a chained Consumer Price Index (CPI), something that CBO estimates could save $100-$220 billion over the next 10 years.

Here's why: Historically, chained CPI has increased at a 0.33 percent lower annual rate than CPI-W (the Consumer Price Index for Urban Wage Earners and Clerical Workers) -- the current price index used. And going forward, the CBO projects, it will be 0.25 percent lower than the CPI-W. The reason is that within its basket of goods, chained CPI allows for the substitution of goods, which the current index does not. For example, if beef prices start to go up relative to chicken prices, the chained CPI assumes that consumers will buy chicken, whereas the current index does not.

Although Republicans lost the chained CPI battle, it's likely that the fight will be renewed when the next round of deficit reduction gets under way. There is even speculation that the Obama administration will now support the idea instead of using it as a bargaining chip to negotiate with Republicans.

But chained CPI is neither a fair nor an adequate way to bring fiscal balance to the program.

Republicans argue that it offers a more accurate measure of inflation than the CPI-W. But that's not the case, at least not when it comes to seniors. For starters, seniors have vastly different spending habits than the rest of the population, but the chained CPI places too much emphasis on products seniors don't buy and not enough on ones they do. Also, seniors have far less flexibility than the general population in substituting goods: they can't exactly substitute the rising cost of drugs and medical procedures with something else. Using the chained CPI would therefore lower their COLA adjustments less than warranted. Indeed, the most accurate measure of the inflation that effects seniors is the CPI-E (E for elderly), but that would likely result in higher -- not lower -- COLAs for beneficiaries.

The proposal that was being discussed during the cliff negotiations also would have indexed the nation's tax code to chained CPI. But this would lead to a hidden, across-the-board tax increase for all working Americans through a phenomenon known as "bracket creep." Bracket creep occurs when wages rise over time, partly as a result of inflation; bumping people into higher tax brackets. These inflation-led wage increases push people into a higher-income threshold and hence into a higher tax bracket if taxes are not adjusted for inflation. This is why not-so-wealthy people are now getting caught in the Alternative Minimum Tax trap. With chained CPI reporting a lower inflation rate than the current index, a lot of people making the same real income would be pushed into a higher tax bracket, forcing them to pay more in taxes. The CBO estimates $72 billion in new tax revenue could be generated through this hidden tax on Americans.

Add in this $72 billion in tax revenue with the savings from a reduction in COLA (which will depend on how Congress decides to soften the blow to the most needy on Social Security), and you're looking at somewhere in the neighborhood of around $180 billion in savings over 10 years. Sounds like a lot, but not all of this would go towards Social Security. The additional $72 billion in tax revenue would be pumped into the government's coffers, not necessarily Social Security, which is self-funded and off budget.

The SSA's projections show that switching to a chained CPI would only reduce outlays by 2.5% over the next 10 years.  This might buy a little more time, but is certainly not a fix. That's because after the SSA's surplus runs dry, it needs an additional $30.5 trillion, in 2012 dollars, to avoid a deficit (unless benefits are not severely cut) and remain sustainable for the next 75 years. The SSA says that the number drops to $8.6 trillion if it invests the money over the next 75 years and can get a 2.9% return above the inflation rate. Lots of luck there. 

Social Security spending is a major problem, but the chained CPI is a band-aid approach to fixing a gaping wound in our budget. It will leave seniors worse off without actually stopping the long-term bleeding in the federal budget. No doubt, any attempt to put Social Security on sound fiscal footing would impose some hardship on seniors. But chained CPI will hurt seniors without restoring long-term solvency to the program. It's time to fundamentally rethink the Social Security State.


Victor Nava is an economic research assistant at Reason Foundation.

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