How To Restructure Social Security

Washington is abuzz with talk of entitlement reform. In his latest offer on the fiscal cliff negotiations, President Obama has proposed slowing the growth of entitlement spending. More generally, both parties recognize that returning these entitlement programs to solvency will entail politically painful cuts to promised benefits, increases in tax revenues, or both.

Talking about the level of entitlement spending is a good start, but it misses a major opportunity for reform. The Social Security program currently encourages early retirement, which reduces the ratio of workers to retirees and increases the strain that entitlement programs place on the federal budget. By improving the structure of Social Security, we can make the program fairer, increase economic growth, and boost tax revenue.

To see how we might reform the structure of Social Security, we need to get into the nitty-gritty details of how the program works. Social Security benefits are financed by a payroll tax on earnings. While the payroll tax discourages work, it doesn't always do so to the same extent as the income tax. That's because, while working subjects a person to the payroll tax, it can also lead to higher future Social Security benefits. As a result, people don't necessarily feel the full pinch of the tax.

This means that if we want to look at how Social Security affects work incentives, we need to know how additional work translates into higher benefits. Retirement benefits are based on a person's average earnings over his or her career. But Social Security doesn't average all years of a person's earnings; it selects only the highest 35. In addition, people with higher average earnings receive a smaller monthly benefit as a percentage of their earnings. For married people, there's another wrinkle. Married people can receive spousal or survivor benefits - which are based on their spouse's work record - if these are higher than the benefit available from their own record.

The first problem with this benefit structure is that it gives an unfair advantage to those who choose shorter careers. Consider someone who is deciding whether to work for one more year or to retire. If this person has had a long career, his or her average earnings are already quite high, so working an additional year won't raise Social Security benefits by much. And if this person has already worked for 35 years, then working an extra year won't raise benefits at all unless that year's earnings make it into the top 35. As we describe in a recent article, many studies show that older workers frequently get little additional benefit from their payroll tax contributions.

There are several reforms that can help address this problem. For example, we could exempt workers who reach a certain age or accumulate a certain number of work years from the payroll tax. John Laitner at the University of Michigan and Daniel Silverman at Arizona State University demonstrate that such a reform is likely to induce delayed retirements and boost income tax revenue. And Andrew Biggs, our colleague at the American Enterprise Institute, estimates that exempting workers aged 62 and older from the payroll tax could almost pay for itself.

The second problem with the Social Security benefit structure is that it discourages second earners from working and discriminates against two-income families. That's because many second earners don't anticipate higher Social Security benefits from working more; rather, they expect to collect spousal and survivor benefits regardless of whether they work. Also, because single-earner couples do not pay additional payroll tax in exchange for the non-working spouse's benefit, they get a better deal from Social Security compared to two-earner couples.

One way to address this problem is to replace spousal and survivor benefits with earnings sharing, in which each spouse gets credit for half the couple's total earnings. Alan Gustman of Dartmouth College and Thomas Steinmeier of Texas Tech University show that this reform can substantially increase the labor force participation of older wives. Melissa Favreault and Eugene Steuerle of the Urban Institute demonstrate that such a reform would help equalize the treatment of one-earner and two-earner couples.

As fiscal realities force us to take up the question of entitlement reform, policy options like these - which focus on the structure of Social Security - should be on the table. While such reforms will not entirely allow us to dodge difficult decisions on cutting benefits or hiking taxes, they will make the adjustment less painful by reducing barriers to work at older ages.

Americans are living longer. That's great news, but if longer lives are not accompanied by longer careers, longevity will impose financial strain on entitlement programs. Social Security exacerbates this problem by encouraging early retirement and discouraging work by second earners. By redesigning Social Security to improve work incentives, we can encourage older workers to stay in the labor force, boosting both economic output and tax revenue.