Can Social Security survive without benefit cuts?

With Republicans now controlling Congress and the presidential elections looming, the debate over how to close Social Security's long-term budget deficit -- always a hot-button topic -- is sure to heat up in the months to come.

There's not much doubt that the program has a long-term funding deficit. The Office of the Chief Actuary of Social Security recently released a report estimating that if the present Social Security law isn't changed,the shortfall in the long-range actuarial balance is about 2.88 percent of covered payroll. In other words, to put it in personal terms, your share of that deficit is very roughly about 2.88 percent of your pay. So, if your annual compensation is $100,000, then either you and your employer will need to contribute an extra $2,888 each year, or adopt the equivalent value of a benefit cut, or some combination.

In a very general sense, there are really only three ways to close this gap: increase taxes, reduce benefits or institute some combination of the two. The actuary's report analyzed the cost saving (or increase) associated with 121 possible changes to Social Security taxes and/or benefits. This report doesn't make recommendations for specific changes, rather it's intended to provide input for policymakers to make decisions about the deficit.

While we don't have the space to review all these possible changes, let's see if it's possible to close the funding deficit just with payroll tax increases on workers, tax increases on retiree benefits and/or changes to how the Social Security trust fund is invested. This helps address the position some analysts and commentators take: Social Security provides only a basic level of retirement benefits and that any benefit reductions to close the funding deficit would cause significant harm to the security and well-being of our nation's retirees.

Payroll tax increases on workers

If the Social Security maximum tax base of $118, 500 is eliminated and the current tax rate of 12.4 percent is applied to all payroll compensation, with no corresponding increase in benefit credits, the long-term deficit would be reduced by 82 percent. (The 12.4 percent rate is the sum of the employer and workers' payroll tax rates.)

While this possible change might come close to reducing the deficit by itself, it could be politically unpalatable. For workers earning over the current maximum taxable base, this is a tax increase with no corresponding increase in benefits.

A second option would be to eliminate the maximum tax base and count compensation above the current wage base for benefits. This plan, however, would reduce the deficit by just 66 percent.

A third option would be to make an immediate, across-the-board increase in the payroll tax rate for all workers from the current rate of 12.4 percent to 15.5 percent in 2015. This change would completely do the trick, reducing the deficit by 102 percent.

However, given the current political climate regarding tax increases, this might be a nonstarter. Phasing in increases in the tax rate over a period of years would reduce the deficit by amounts ranging from 19 to 49 percent.

The actuary's report analyzes various combinations of changes in the tax base and the tax rate, and various phase-ins of these changes, which all translate to reductions in the deficit that generally fall below the above amounts. So it seems that raising the wage base and/or raising the payroll tax rate can make serious dents in the long-term deficit, but by themselves won't eliminate the deficit unless there's an immediate tax increase that isn't phased in.

Another possibility would be to apply the payroll tax rate of 12.4 percent to the value of employer-sponsored health insurance, which currently isn't subject to Social Security payroll taxes. This would reduce the Social Security deficit by 36 percent.

This change also might be politically toxic, given the widespread use of employer-sponsored health plans and the fact that this would be a regressive tax increase that would affect lower- and middle-income workers the most. That's because the value of employer-sponsored health insurance generally doesn't depend on compensation and would represent a much greater percentage of total compensation for lower-paid workers compared to higher-paid employees.

Increase income taxes on retiree benefits

If all retirees' Social Security benefits were subject to federal income taxes, the Social Security deficit would be reduced by 7 percent. Currently, retirees' Social Security income is fully exempt from federal income taxes only for lower-income retirees:

• For single filers with adjusted gross income below $25,000, all of the Social Security benefit is exempt from federal income taxes.
• For married filers, the threshold is $32,000.

If your adjusted gross income is above these amounts, only a portion of your Social Security benefits is exempt from income taxes. This portion decreases as total income increases and levels out at 15 percent.

Because most of the Social Security income of higher-income retirees is already subject to income taxes, taxing everyone's Social Security benefits would affect lower-income retirees the most.

Invest the trust fund in equities

Investing 40 percent of the Social Security Trust Fund in equities would reduce the deficit by 15 percent, assuming a real annual return of 5.4 percent. If you assume a slightly higher real return -- of 6.4 percent -- the deficit would be reduced by 21 percent. This potential change has some interesting ramifications: If the government accumulates widespread ownership of private businesses, some people might call this socialism.

The last time Congress passed major legislation to balance Social Security was in 1983, when it approved a package that increased Social Security taxes and reduced benefits. It looks likely that once again, a politically feasible solution to eliminate the current Social Security deficit will need to combine tax increases with benefit reductions.

As you can see, closing the deficit will entail some hard choices.