Feb 28, 2008


Social Security and Medicare are based on a system of funding that the Social Security Administration refers to as partial advance funding. Under this system, taxes are more than sufficient to pay current benefits and also provide some accumulation of assets for the payment of future benefits. Partial advance funding falls somewhere between pay-as-you-go financing, which was once the way Social Security and Medicare were financed, and full advance funding, as used by private insurance and retirement plans. Under pay-as-you-go financing, taxes are set at a level to produce just enough income to pay current benefits; under full advance funding, taxes are set at a level to fund all promised benefits from current service for those making current contributions.

All payroll taxes and other sources of funds for Social Security and Medicare are deposited into four trust funds: an old-age and survivors fund, a disability fund, and two Medicare funds. Benefits and administrative expenses are paid out of the appropriate trust fund from contributions to that fund and any interest earnings on accumulated assets. The trust funds have limited reserves to serve as emergency funds in periods when benefits exceed contributions, as in times of high unemployment. However, current reserves are relatively small and could pay benefits for only a limited time if contributions to a fund ceased. In addition, the reserves consist primarily of IOUs from the Treasury because the contributions have been "borrowed" to finance the government's deficit.

In the early 1980s, considerable concern arose over the potential inability of payroll taxes to pay promised benefits in the future. Through a series of changes, the most significant being the 1983 amendments to the Social Security Act, these problems appeared to have been solved for the Social Security program—at least in the short run. The changes approached the problem from two directions. On one hand, payroll tax rates were increased; on the other hand, some benefits were eliminated and future increases in other benefits were scaled back. However, the solutions of 1983 have not worked. Although the old-age and survivors fund will continue to grow for the time being and will be quite large by the time the current baby boomers retire, benefits will then begin to exceed income, and the fund will shrink as the percentage of retirees grows rapidly. Without further adjustments, the trust funds will have inadequate resources to pay claims in the foreseeable future. Current projections indicate that the Social Security trust funds will run out of money in 2037.

Because of an increasing number of persons aged 65 or older and medical costs that continue to grow at an alarming rate, there is also concern about the Medicare portion of the program. Estimates are that its trust funds will be depleted by about 2023. The seriousness of this problem was made clear by the fact that one of the earliest actions of the second Clinton administration was the passage of legislation to help maintain the solvency of the Medicare trust funds for a few additional years, primarily through encouraging additional enrollment in managed care plans and trimming projected payments to HMOs, hospitals, and doctors.

In the broadest sense, the solution lies in doing one or both of the following: increasing revenue into the trust funds or decreasing benefit costs. Possibilities for increasing revenue include the following:

- Increasing the Social Security and/or Medicare tax rate

- Increasing the wage base on which Social Security taxes are paid

- Using more general tax revenue to fund the programs

- Subjecting a greater portion of income benefits to taxation and depositing the increased tax revenue into the trust funds

- Investing all or a portion of trust fund assets in higher-yielding investments than Treasury securities

- Suggestions that have been made for decreasing benefit costs include the following:

- Raising the normal retirement age beyond the planned increase to age 67

- Raising the early retirement age beyond 62

- Lowering the benefit formula so that future retirees will get somewhat reduced benefits

- Lowering cost-of-living increases

- Imposing a means test for benefits

- Shifting more of the inflation risk to workers through the use of separate accounts for all or part of each worker's contributions, thus giving the worker some control over his or her account

- Increasing the Medicare eligibility age beyond 65

- Increasing Medicare deductibles and copayments

- Increasing the Medicare Part B premium for everyone or possibly only for higher-income retirees

- Lowering or slowing the growth of payments to Medicare providers

- Encouraging or requiring Medicare beneficiaries to enroll in managed-care plans

Any single change will clearly offend one important group of voters or another. As a result, any ultimate solution will probably involve a combination of several of these changes so that everyone will bear a little of the pain.


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