Highlights

Testing the Matsui View.   Using the Social Security Solvency Simulator, we test this view by implementing "a two percent solution." In other words, we raise the total payroll tax by nearly two percentage points.

A "Two Percent Solution" Doesn't Work.  By 2075, at the end of the forecasting period, we discover Social Security on the verge of insolvency. We also see a significant portion of the Federal Budget devoted to paying interest on Treasury bonds owned by Social Security.

If the problem cannot be solved with a "two percent solution," then Mr. Matsui is clearly in error when he characterizes the solvency challenge as "a two percent problem." What is the real size?

Perhaps Even "A Thirty-Three Percent Problem."  On the other hand, if one prefers to view the problem from a retiree's perspective, it turns out to be "a thirty-three percent problem." If nothing is done to fix Social Security's solvency problem, payable benefits eventually drop by thirty-three percent.

Many who support the Democrats on Social Security have bought into the wishful belief that the solvency problem is only "a two percent problem." As the following Simulator-based analysis shows, this notion woefully understates the severity of the problem.

Introduction

California's Robert Matsui, first elected to Congress in 1978, serves on the House Ways and Means Committee, and its Social Security Subcommittee. As the subcommittee's ranking Democrat, Mr. Matsui often serves as the spokesperson for House Democrats on Social Security issues.

How has Congressman Matsui sized up the Social Security's solvency challenge? In his committee comments, he sometimes characterizes the challenge as "A Two Percent Problem."

"A Two Percent Problem"? For the past several years, Social Security's annual Trustees' Report has projected a long-term negative actuarial balance worth about two percent of taxable payroll. The actual calculation varies slightly from year to year.

[Such calculations always use the discounted present values of future cash flows, a practice we'll analyze in more detail in a future Simcivic Update. For a brief technical comment on how Simcivic calculates actuarial balance, see our note at the end of this Update.]

In other words, a payroll tax increase of two percentage points would presumably dispose of the insolvency problem.

The fact that Congressman Matsui sometimes characterizes the threat of insolvency as "a two percent problem" doesn't necessarily mean, of course, that he's ready to propose a higher payroll tax as the Matsui Plan. Nor does it mean that he's ready to put it forward as the Democratic Party's plan.

Nevertheless, his contention that this is "a two percent problem" has been echoed quite often by a good many Democrats and their liberal supporters. A two percent hike in the payroll tax, one percent from workers, another one percent from employers, is often mentioned as a workable option for solving Social Security's two percent problem.

And it's certainly an option that deserves testing. If the problem is indeed "a two percent problem," as Congressman Matsui says, then "a two percent solution" should be the answer, shouldn't it?

Is it? You can test this strategy for yourself with a few mouse clicks and some typed input. Just visit our Social Security Solvency Simulator.

How to Test the Two Percent Solution

It's a good idea to start by noting the size of the problem. Once the Simulator's java code has loaded, click on the "Results" tab. Study the information on the top left hand side of the Results page. Here's what you'll see:

Notice the line "Actuarial Balance of -1.93%." If we follow Congressman Matsui's line of thinking, we'll have solved the insolvency problem once we figure out how to achieve an actuarial balance of 0.0%.

Can we do that? Can we change the tax rate enough to produce an actuarial balance of exactly 0.0%? With the Simulator's help, we can.

Adjusting the Tax Rate to Produce an Actuarial Balance of Zero

Next, click on the "Decisions" tab, then click on "Taxes." Note the tax rate input boxes. You can enter almost any tax rate you like. With a little trial and error, you'll find that a tax rate of 13.35% produces an actuarial balance of precisely zero. [All calculations have been performed using figures from the 2001 Trustees Report. Once the Simulator is updated with figures from the 2002 Report, slight changes should be expected.]

Click "Settings OK." Click "Run the Numbers."

What have we done? We have now implemented a "two percent solution." (A 1.95% solution, to be precise.]

The results of our test show up at the top of the first Charts page. Social Security's long-term actuarial balance is no longer stuck in its hole. The target, an actuarial balance of 0.0%, has been achieved.

Now for the bigger question: Have we succeeded? Has lasting solvency been achieved? Look carefully. Decide for yourself.

Using Chart 1A, note the expected impact on Social Security's Trust Fund. With the payroll tax raised to 14.35%, higher surpluses over the next few years drive Social Security's Trust Fund to a sum equaling nearly forty percent of GDP by year 2025.

Then, as the last members of the Baby Boomer generation reach retirement age, in the early 2030's, the size of the Trust Fund, relative to GDP, begins to shrink. With a vastly expanded elderly population dependent on Social Security, the Trust Fund by 2075 is on the verge of insolvency.

What we have called "The Two Percent Solution" turns out not to be a solution after all. Social Security's long-run insolvency issue has only been postponed, not eliminated.

Chart 1B tells the same story from the perspective of Social Security's Funds-to-Benefits Ratio.

Measured as a multiple of benefits due, Trust Fund shrinkage becomes visible more than a decade earlier than it does in Chart 1A.

The end result is not in doubt. Were Charts 1A and 1B to be extended out another five years, to 2080, we'd see the final collapse. We'd see the Trust Fund zero out. We'd see the Funds-to-Benefits line turn from yellow to red as it hits zero in the late 2070's. But we're not done with our analysis yet. There's more to be learned.

Viewing the Two Percent Solution from a Revenue Perspective

Now look at Chart 3A, which shows Benefit Sources as a Percent of Gross Domestic Product.

Tax receipts are noticeably higher, as expected. The cash flow gap between taxes received and benefits paid has shrunk, and the gap is fully covered, from the early 2020's until well into the 2060's, by interest payments from the Federal Treasury. These payments are shown in pink as "Trust Fund Earnings." The Trust Fund generates substantial interest income for quite some time.

Now look closely at the final ten years. By the mid-2060's, Social Security's financial condition has weakened greatly. Its interest receipts are no longer sufficient. It begins selling off its capital assets, i.e., its Treasury bonds. As it sells its bonds back to the Treasury for cash, the graph shows a growing share of Social Security's annual cash needs being met by "Trust Fund Capital" (in purple). A serious danger signal.

Now click the "Switch" button, so that you can see Chart 3B, "Federal Cash Flows from/to Social Security, as a Percent of Gross Domestic Product." This chart lets you see how cash flows to and from Social Security behave from a Federal Budget perspective. Cash flowing into the Federal Budget shows up above the 0% line. Cash flowing out shows up below the line.

Fueled by higher payroll tax receipts, the surplus that Social Security provides to the Treasury in return for Treasury bonds is initially quite sizeable. But soon, by about 2020, Social Security no longer has a surplus that it can use for buying Treasury bonds. Instead, Congress soon finds itself making interest payments to Social Security, paying on the Treasury Bonds that it sold to Social Security during the years of Social Security's surplus.

Interest payments to Social Security quickly become a significant part of the Federal Budget. Chart 3B shows them as a percent of GDP. Bear in mind that the total Federal Budget normally runs about twenty percent of GDP. This gives us a simple rule of thumb: 1% of GDP is roughly equal to 5% of the Federal Budget.

From Chart 3B, it's easy to see that interest payments to Social Security will most likely represent about five percent of the Federal Budget from the early 2030's into the late 2050's. Then the total starts to climb.

By the late 2060's, Congress finds itself spending roughly seven percent of its budget on Social Security, as it buys back the Treasury bonds Social Security still owns.

What we're testing as "a two percent solution" for Social Security eventually ripens into "a five, six, or seven percent problem" for the Federal Budget.

A Modest Tweak Reveals the Benefit Impact

With the tax rate set at 14.35%, Social Security is not yet insolvent in 2075, but it's on the verge. What if we adjusted the Simulator, just slightly, so that we could see the insolvency occur in 2074, within the time period the Simulator now covers? How would Social Security's capacity to pay benefits be affected?

All that needs to be tweaked is the tax rate. Trim the tax rate from 14.35% to 14.2%, click "Settings OK," click "Run the Numbers," and the Simulator recalculates the numbers and re-displays the results almost instantly.

Insolvency in 2074

With the payroll tax trimmed modestly, the Trust Fund zeroes out in 2074 (Chart 1A).

And the Funds-to-Benefits Ratio, as one might expect, has also zeroed out (Chart 1B). The ratio falls to zero and the line turns from yellow to red. Social Security's asset reserves are gone.

A Sharp Drop in Payable Benefits

Payroll tax receipts continue to arrive, of course, but they aren't sufficient to pay the benefits due. Chart 2A, Payable Benefits as a Percent of Currently Scheduled Benefits, shows the consequences for beneficiaries. In 2073, currently scheduled benefits are paid in full. In 2075, two years later, payable benefits fall to 77% of their legislated value.

If you click on the "Results" tab, along the top, you'll find the same story again, viewed from a slightly different angle. Note the line, near the top of the Results page, on the left hand side, showing the cash flow situation in 2075:

The numbers are rounded to the nearest trillion. Even if we allow for the fact that the story is being told in 2075's inflated dollars, it is clear that Social Security's beneficiaries in 2075 are suffering quite a setback. (If we reversed our tax rate tweak, the picture would improve. But only slightly.)

What Is the Problem's Real Size?

Simcivic is committed to rigor. In our view, if the two percent solution we've just tested isn't a genuine solution, then the problem should not be called "a two percent problem." The solvency crisis deserves a more accurate name. What should it be called? The Simulator can help us.
A little trial and error shows the appropriate tax rate.

A payroll tax of 15.7% is the lowest tax rate that delivers a stable Funds-to-Benefits Ratio in the out-years of the forecasting period. As we note, from Chart 1A, a payroll tax of 15.7% can be expected to generate a staggering amount of Trust Fund assets, worth roughly 70% of GDP by 2075.

Nonetheless, that's exactly what it takes, using the payroll tax strategy, to produce a stable Funds-to-Benefits Ratio in the 2070's. Anything less, and lasting solvency hasn't truly been achieved.

A payroll tax of 15.7%, 3.3 percentage points higher than today's 12.4% rate. Social Security's lasting solvency assured. Benefits payable into perpetuity at one hundred percent.

As Paul Harvey might now say, "What's the rest of the story?"

Starting in the mid-2020's, Social Security stops buying Treasury Bonds and starts collecting interest on the bonds it already owns. As time goes on, interest payments to Social Security rise from half a percent of GDP to one percent of GDP. (From about two-and-a-half percent of the Federal Budget to five percent.)

Even a 3.3% Solution creates an ongoing burden for the Federal Budget.

Summary

As the Simulator shows, a "two percent solution" is a long way off from securing lasting solvency for Social Security. It does raise the payroll tax. It does postpone the day of reckoning. And it certainly weighs down the Federal Budget with several decades of interest payments to Social Security. But a two percent solution is not a genuine solution to Social Security's solvency challenge.

If we measure the problem from a payroll tax perspective, as Congressman Matsui does in characterizing it as a "two percent" problem, the solvency problem is actually "a 3.3% problem."

In "Payable Benefit" terms, the solvency problem is "a Thirty-Three Percent Problem," since, if nothing is done, payable benefits will decline 33% by 2075. (See Simcivic Update #2)

The Simcivic Social Security Solvency Simulator has given us several ways to test the validity of Congressman Matsui's problem statement. As this Simulator-based analysis shows, Mr. Matsui's "two percent" remark significantly understates the severity of Social Security's insolvency challenge.

Steven H. Johnson
President, Simcivic

A note for the serious specialist: Social Security's 2001 Trustee Report shows a negative actuarial balance of 1.86%. Our Simulator, starting with the same numbers, calculates a negative actuarial balance of 1.93%. Why?

Here's the difference. Even though payroll tax receipts at current rates aren't sufficient to pay full benefits throughout the full forecasting period, Social Security assumes that all benefits will ultimately be paid. And they assume, accordingly, that well-to-do retirees will pay income taxes on their full Social Security retirement benefits, taxes which flow back into Social Security.

Simcivic takes a more conservative approach. If the money isn't there to pay full benefits, full benefits may not be paid, nor can we expect full taxes on those benefits to be collected. Expected receipts from the taxation of retiree benefits are marked down accordingly. Since we don't credit Social Security with quite as much future income, our actuarial balance calculation is slightly worse.

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Stay Tuned for Future Simcivic Updates

• MIT's Nobel Prize-winning economist Franco Modigliani wants Social Security's Trust Fund to invest in the stock market.

Is Professor Modigliani on the right track?

Is Robert Johnson's wealth-building strategy on the right track?

• The Social Security Administration uses a calculation called "actuarial balance" to measure its insolvency problem.

Is the SSA on the right track?

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