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January 19, 2005
Sometimes wages grow faster than prices; sometimes it's the other way 'round
Much is being made about the Bush administration's proposal to shift from wage indexing of social security benefits to price indexing. See, for example, here.
And there is the now famous Peter Wehner memo that has been posted on many blogs, including Brad DeLong. One paragraph reads:
It's worth noting that wage indexation was not part of the original design of Social Security. The current method of wage indexation was created in 1977, under (you guessed it) the Carter Administration. Wage indexation makes it impossible to "grow our way" out of the Social Security problem. If the economy grows faster and wages rise, this produces more tax revenue. But the faster wage growth also means that we owe more in Social Security benefits. This has produced a never-ending cycle of higher tax burdens, even during periods of robust economic growth. It is the classic case of the dog chasing his tail around the tree; he can run faster and faster, and never make any progress.
Given all the discussion of the shift to price indexing, I thought I would look at how wage indexing came about. The memo is correct. It did happen in 1977. The following is from the New York Times, May 10, 1977 (page 55):
Inadvertently, as it turned out, Congress in 1972 created what virtually all analysts regard as an overly generous inflation-adjustment formula for calculating the initial benefits of newly retired persons. It takes account of both wage inflation and price inflation.
Breaking that link is called "decoupling." Mr. Carter proposed that Congress do this by eliminating price rises from the calculation of initial benefits and by using a wage-ratio formula that would maintain the ratio of benefits to final pre-retirement earnings at the present 45 percent. Thereafter, benefits would escalate with the Consumer Price Index, as they do now.
Without decoupling, the Administration said, by the year 2020 some retired persons might be drawing benefits at a 60 percent ratio. Some might draw more than 100 percent of their earnings in their last working year.
And then there is the September 10, 1977 New York Times (page 8):
In addition the Republicans also proposed a new formula for calculating initial benefits of retired persons that would undo the over-compensation for inflation that Congress adopted in 1972. All sides agree that this formula must be changed.
...
Joseph A. Califano Jr., the Secretary of Health, Education and Welfare, criticized the Republican decoupling formula on the ground that it would lead to initial retirement benefits in the future 6 percent below what the present formula would produce.
The Republicans have said as much. They maintain that such an adjustment is fair because the 1972 formula led to an increase in benefits that was 6 percent greater than the increase in the cost of living.
However, the Republicans contend that no one who retired before the formula was changed would suffer a reduction in benefits, nor would any future beneficiary have to accept less than he would have been entitled to under the pre-1972 formula.
So, yes it was during the Carter administration, but it was bi-partisan. And truthfully, in looking at the news accounts of the time, people were much more concerned about the changes in the payroll tax rates than the change in the indexing method. The bottom line is that between 1972 and 1977 inflation caught Social Security between a rock and a hard place. Wage indexing was a way to reduce the burden on the system caused by inflation. It worked. Then the pendulum swung back in the other direction. Today, we find ourselves in an equal, but opposite situation.
In any case, wage indexing was not a plan to expand benefits. Quite the contrary, it was a plan to slow the growth of benefits in a time of high inflation.
Tyler Cowen at Marginal Revolution has a defense of the Bush proposal to freeze benefits in real terms. I'm not sure I'm ready to, as he puts it, "push the 'yes' button" on this just yet. That said, a compromise might be in order here. The formula does not have to be all or nothing in either direction. Honest folks on both sides should take a look at how to moderate the increases in benefits without reverting to what some might see as Draconian cuts. As Tyler suggests, the big problem is medical care, and there are probably better ways to solve that problem than by growing Social Security. I'll give it a cautious "yes" with a heartfelt plea for compromise.
My only problem with the change is the extent to which it may affect workers not yet at retirement, but who have read their annual statement from Social Security and used it in their retirement planning. I would be much more comfortable with an indexing change that affects new workers or very young workers so that accurate expectations may be formed. Ideally, if the private accounts are only phased in for the younger workers, I would start the indexing change there as well. Expectations matter. Start reform with the young, and if it works, expand it over decades.
Posted by William Polley at January 19, 2005 01:10 AM
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