Reforming Social Security: A Welfare Analysis

By Pecchenino, Rowena A.; Pollard, Patricia S. | Review - Federal Reserve Bank of St. Louis, March/April 1998 | Go to article overview

Reforming Social Security: A Welfare Analysis


Pecchenino, Rowena A., Pollard, Patricia S., Review - Federal Reserve Bank of St. Louis


The U.S. Social Security System was conceived as a means to ensure a minimum standard of living for the elderly, and it has done so. Poverty rates among the old have dropped, and many retirees can now look forward to a comfortable retirement, funded in part by their Social Security benefits. However, the system's ability to provide future retirees with a comparable retirement income has been called into question, and plans that would fundamentally change the system have been proposed.

When the Social Security System was established in 1935, it envisioned the creation of a large reserve fund to ensure the continued financing of the system. Benefits were not scheduled to be paid to those reaching the age of 65 until 1942 and were to be based on total lifetime earnings of contributors. Before the first dollar was paid out, the system was amended in 1939. Benefits were to begin in 1940 and would be based on average earnings over a minimum covered period, thereby raising the benefits received by the average worker. In addition, coverage for a retiree's dependent children and spouse were added. These changes resulted in an increase in initial payments made by the system and eliminated the idea of building up a reserve fund. Social Security became grounded as a pay-as-you-go system-contributions made by current workers would be transferred in the form of benefits to current retirees. Current workers then would rely upon their children's generation to finance their retirement benefits.

When Social Security was established, it covered only workers engaged in commerce and industry (excluding railroad workers), about 60 percent of the workforce. Over the years, most notably in the 1950s and 1960s, coverage was expanded so that today 96 percent of all jobs are covered by Social Security. There are five categories of excluded workers: 1) federal civilian employees hired prior to 1994; 2) railroad workers (although the railroad retirement program is coordinated with Social Security); 3) state and local employees, if they are covered under a separate retirement program (currently 25 percent of state and local workers are excluded); 4) household and farm workers whose earnings are below some minimum requirement; and 5) self-employed workers with earnings below $400 a year.1

Over the years, the types of benefits have expanded, particularly relating to dependent coverage and survivors. Disability coverage was added, and early retirement programs were instituted. In addition, the benefit formulas were changed, resulting in increases in benefits for all retirees. Thus, while the average single worker who retired at age 65 in 1940 received benefit payments in that year equal to 26 percent of his pre-retirement wage, the average single worker who retired at age 65 in 1997 received benefits payments in that year equal to 45 percent of his pre-retirement wage.2

Not only have the benefits received by retirees been rising, but the number of years a retiree is likely to receive benefits has risen due to increases in life expectancy A person retiring in 1940 was expected to receive benefits for 12 years, if a man, and 13 years, if a woman. In contrast, a person retiring in 1997 is expected to receive benefits for 16 years, if a man, and 19 years, if a woman. The increasing generosity of the Social Security system and the increase in life expectancy have added to the cost of financing the system.

While benefits have risen, so too have the tax rates necessary to fund these benefits. Social Security tax rates are split equally between employer and employee. In 1935, the combined tax rate was 1 percent of wages. Today the combined tax rate is 12.4 percent.3 Demographic and economic changes have raised concerns about the ability of the system to maintain the current levels of generosity without further increases in taxes. With declining fertility rates, the potential growth of the labor force is declining. Furthermore, declines in the rate of productivity growth since the 1970s have reduced the growth in real wages and thus payments. …

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