New paper: Policies to reduce uncertainty in Social Security financing

I have a new working paper that examines auto-correction policies for Social Security taxes and benefits that would help adjust for uncertainty regard future demographics. (I talk a bit about adjusting for economic uncertainty, but will do some more detailed work on that in the future.) Here's the basic story, in pictures.

Figure 2 shows the probability distribution of Social Security's net cash flow (income minus outgo), programmed to match the stochastic simulations contained in the Social Security Trustees Report. The median outcome matches the Trustees intermediate projections, but there's obviously a ton of variability. There's about a 1 percent chance we'd be almost in positive cash flow in 2080, but an equal 1 percent chance of cash deficits of 12 percent of payroll. What can policy do about this?

Figure 2: Stochastic simulation of Social Security cash flows, SSASIM model

One policy option is to index initial benefits to price growth rather than wage growth. This will definitely improve expected outcomes for solvency – based on the intermediate projections, this chance alone would fix financing in perpetuity. However, price indexing also increases uncertainty regarding system financing, because benefits no longer adjust to changes in wages (higher wage growth equals higher benefits, lower wage growth equals lower benefits). Figure 4 below illustrates: the median outcome is a lot better than current law, but the level of uncertainty is actually higher.

Figure 4: Stochastic simulation of cash flows under price indexing, SSASIM model

So here's an alternate idea: index changes in taxes and benefits to changes in the ratio of workers to beneficiaries. Long-run, demographics are the biggest sources of variation in system financing (because most of the economic uncertainty gets handled through wage indexing of benefits). The worker-beneficiary ratio accounts for both changes in fertility (workers) and mortality (beneficiaries). If we index to that, we'll account for much of the uncertainty in the long run.

Figure 6 illustrates indexing of benefits to the worker-beneficiary ratio, although the paper also contains a similar chart showing tax indexing. I set things up so that the average affect of the change on solvency would equal that of price indexing – that is, sustainable solvency based on cash flows. However, the level of uncertainty is far smaller.

Figure 6: Stochastic simulation of cash flows under dependency indexing of benefits, SSASIM model

This approach has several advantages. First, it helps deal with the folks who claim the Trustees are pessimistic and there's no real problem lurking in the future. If so, there's no danger in implementing auto-correction policies, since they only make changes as needed. This might help get reform enacted sooner, which is important. Second, auto-correction policies keep financing on a stable basis, which helps smooth burdens more reliably between generations. Without auto-correction, policymakers are likely to wait until the last minute to make changes, which inevitably pushes larger burdens off onto later generations. Third, auto-correction policies give future generations the chance to change Social Security as they wish, from a baseline of solvency rather than insolvency.

There are some other issues to address, such as indexing for economic uncertainty, how to deal with uncertainty regarding how future outcomes are modeled – e.g., the large change in Social Security solvency that occurred in the 2008 Trustees Report was principally due to changes in how immigration was modeled, not to assumptions regarding immigration levels. But as a general class of reforms, I think auto-correction policies have an important role to play.

Plus, Obama policy guru Jason Furman also likes them, which means we may see them sometime in the future.