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S. HRG. 109–391

SOCIAL SECURITY: ACHIEVING

SUSTAINABLE SOLVENCY

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

MAY 25, 2005

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

KENT CONRAD, North Dakota

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

RON WYDEN, Oregon

CHARLES E. SCHUMER, New York

KOLAN DAVIS, Staff Director and Chief Counsel

RUSSELL SULLIVAN, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 4

WITNESSES

Holtz-Eakin, Dr. Douglas, Director, Congressional Budget Office, Washington,

DC .......................................................................................................................... 7

Steuerle, Dr. C. Eugene, senior fellow, Urban Institute, Washington, DC ........ 11

Ross, Stanford G., former Commissioner of the Social Security Administration, Washington, DC ........................................................................................... 13

Yin, George K., Chief of Staff, Joint Committee on Taxation, Washington,

DC .......................................................................................................................... 17

George, Hon. Russell, Office of the Treasury, Inspector General for Tax Administration, U.S. Department of the Treasury, Washington, DC .................. 19

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 4

George, Hon. Russell:

Testimony .......................................................................................................... 19

Prepared statement .......................................................................................... 41

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Holtz-Eakin, Dr. Douglas:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 90

Responses to questions from committee members ......................................... 130

Ross, Stanford G.:

Testimony .......................................................................................................... 13

Prepared statement .......................................................................................... 138

Responses to questions from committee members ......................................... 147

Steuerle, Dr. C. Eugene:

Testimony .......................................................................................................... 11

Prepared statement .......................................................................................... 151

Responses to questions from committee members ......................................... 171

Yin, George K.:

Testimony .......................................................................................................... 17

Prepared statement .......................................................................................... 174

Responses to questions from committee members ......................................... 185

COMMUNICATIONS

Clark, David J. ......................................................................................................... 189

Grubbs, Donald S., Jr. ............................................................................................. 191

National Center for Policy Analysis ....................................................................... 203

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SOCIAL SECURITY: ACHIEVING

SUSTAINABLE SOLVENCY

WEDNESDAY, MAY 25, 2005

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:05 a.m., in

room G–50, Dirksen Senate Office Building, Hon. Charles E. Grassley (chairman of the committee) presiding.

Also present: Senators Lott, Santorum, Crapo, Baucus, Conrad,

Lincoln, Wyden, and Schumer.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. Today’s hearing is the third of a series that we

are having on Social Security. Just for a little bit of history, our

first hearing focused on the long-term outlook of Social Security,

and the second focused on plans to achieve sustainable solvency,

and to do that with or without individual accounts, as the President has suggested individual accounts.

Today’s hearing will focus on a menu of options, of which I suppose you could tell me that there are 100 or more out there. But

we obviously cannot deal with 100 or more, but we have a menu

of options to achieve sustainable solvency and to address the potential payroll tax gap.

The menu of options was developed by the Congressional Budget

Office. However, I want it very clear that I did request the Congressional Budget Office to score each of the menus to reflect economic and Democratic—demographic assumptions. [Laughter.]

Senator BAUCUS. We appreciate that, Mr. Chairman.

Senator CONRAD. That is good. That is progress.

Senator BAUCUS. All in the spirit of bipartisanship. We appreciate that.

The CHAIRMAN. You know, when you have friends like these

folks, you do not really need any enemies. [Laughter.]

Demographic assumptions in the latest Social Security trustee

report.

Now, I made this request to the CBO for two reasons. First, the

Social Security trustees are required by law to report each year on

the actuarial status of Social Security.

I do not believe that we want to adopt a reform plan based on

more optimistic CBO assumptions only to have the trustees tell us

in their next report that we did not accomplish our intended goals,

2

a` la the debate between the Chief Actuary of CMS and CBO of the

last 3 or 4 years.

The second reason that I asked is, when it comes to Social Security, I believe that we should always err on the side of caution.

Using overly optimistic assumptions is exactly what brings us here

today.

I say that only because of what I believe and the caution I have,

not because I have any argument with CBO or the trustees on how

they arrived at their figures, because who are we? We are dealing

with professionals, and these are the best honest figures that they

can give us.

Now, we know Social Security was enacted a long time ago, in

1935. It was paying benefits in 1940. Over the next 31⁄2 decades beyond the 1930s and 1940s, Congress expanded coverage and increased benefits on an ad hoc basis.

By the late-1960s, there was growing interest in adopting automatic cost-of-living adjustments, but there was a significant impediment to doing so, because, since the beginning, the actuaries

who prepared long-range cost estimates for Social Security had utilized an actuarial technique known as—and these are their

words—level earnings assumptions.

Basically, the actuaries assumed wages would remain fixed at

their current level forever into the future. In 1935, that was not an

unreasonable assumption because, in 1935, wages were still below

the level that had prevailed in the decades of the 1920s.

The actuaries believed this assumption imposed a major fiscal

discipline and provided a cushion against unanticipated events.

Congress was willing to go along, because, as time passed and

wages grew, it was able to periodically dispense then a windfall in

the form of higher benefits voted by Congress.

Despite the availability of such windfalls, critics began to suggest

a new approach being needed. They pointed out that rising inflation imposed an undue burden on Social Security beneficiaries who

were forced to wait on Congress to enact a benefit increase. The

proposed solution was what we have today, the automatic cost-ofliving raise.

The idea of indexing benefits to prices, or even wages, had been

contemplated for several years, but the implementation of an automatic benefit increase was incompatible with the level earnings assumption used since 1935. Long-range projections based on rising

benefits and level wages would show large and growing deficits.

So, critics began a campaign to discredit the level earnings assumption and adopt something we call ‘‘dynamic assumptions.’’

This campaign led to the 1969–1971 Advisory Council recommendations that Social Security projections be based on assumptions that earnings would rise in the future.

By adopting dynamic assumptions, Social Security suddenly appeared to have a significant surplus. But unlike the windfall that

resulted from an actual wage increase, the surplus under dynamic

assumptions was merely assumed.

Nevertheless, several members of Congress seized on the Advisory Council’s recommendations of 1969–1971 and urged an immediate 20 percent across-the-board increase, accompanied by automatic benefit increases thereafter.

3

Bypassing the normal committee process, an indexing amendment was offered on the Senate floor to a must-pass bill increasing

the statutory debt limit. It passed overwhelmingly in June of 1972.

The Congressional debate that preceded passage of the indexing

amendment focused on keeping benefits up with inflation. For

those who were already collecting benefits, the amendment delivered as promised.

But for those who were not yet receiving benefits, the amendment had an entirely different effect: depending on the relative

change in wages or prices, initial benefits for newly eligible recipients would rise faster than prices, or even faster than wages.

This critical distinction between initial benefits and subsequent

benefits might have gone unnoticed for years, but economic and demographic forces soon intervened to reveal that the formula was

flawed and the goal of wage-indexing was no longer affordable at

the scheduled payroll tax rate.

The 1972 amendment was based on two assumptions: that wages

would rise nearly twice as fast as inflation, and that the number

of births would remain near the baby-boom level. Under these two

conditions, the initial benefits would rise in line with wages and

there would be plenty of workers to support each beneficiary without raising the payroll tax beyond the 12.5 percent.

However, the decades of the 1970s saw rising inflation and the

end of the baby boom. The flawed formula caused benefits to rise

faster than wages and the declining birth rate resulted in projected

decline in the ratio of workers to beneficiaries. As a result, Social

Security trustees began to report ever-rising deficits.

In response to these trustees’ reports, the Senate Finance Committee and Ways and Means Committee of the House requested appointment of an independent consultant panel to examine the problem and develop alternatives.

The panel issued its report in 1976 and recommended that Congress index the initial benefits to prices instead of wages. But advocates of higher benefits sought to replace the flawed 1972 formula

with another wage-indexing formula that was less erratic and unpredictable.

Ironically, the flaw of the 1972 formula became its biggest asset,

since between 1972 and 1977 the projected costs more than doubled, from 12 percent to 24 percent of taxable wages.

Advocates of wage-indexing sought to portray their version of

wage-indexing as significant savings because it costs only 18 percent of taxable wages, which is probably where it is today.

Advocates of wage-indexing persuaded Congress to adopt their

plan in 1977 by simultaneously arguing that it was cheaper than

current law and more generous than price-indexing.

The fact that changing demographics had rendered the promised

level of wage index benefits unaffordable at the scheduled payroll

tax rate of 12.5 percent did not seem to make any difference.

Advocates dismissed the projections of future deficits by suggesting that economic and demographic changes might solve the

problem. If not, then Congress would have plenty of time to think

of something.

4

Well, here we are today, still trying to think of something to do

about what we know is the issue out there, that was still an issue

predicted by some people in 1977.

Members of this committee will no doubt find the menu of options presented by our witnesses today less than appetizing. And,

of course, everybody is welcome to put their own options on the

table, and we should consider all options, but the time has come

to address the issue.

So let me conclude by sharing with you the admonition given to

this committee by that consultant panel already referred to back in

1976: ‘‘This panel gravely doubts the fairness and the wisdom of

now promising benefits at such a level that we must commit our

sons and daughters to a higher tax rate than we ourselves are willing to pay.’’

Senator Baucus, I know I took a long time. You take as long as

you want.

OPENING STATEMENT OF HON. MAX BAUCUS,

A U.S. SENATOR FROM MONTANA

Senator BAUCUS. Thank you. Thank you very much, Mr. Chairman. I very much thank you for calling this hearing focused on extending the life of Social Security without private accounts.

As you know, Mr. Chairman, in the view of many of us, that last

part is key. If we are to have any hope of enacting legislation in

this Congress to strengthen Social Security, then the President

needs to leave his effort to privatize Social Security behind.

Once the President disavows private accounts in Social Security,

he will find Democrats willing and able to join him in an effort to

strengthen Social Security for centuries to come.

Social Security is America’s most important domestic program. If

Social Security did not exist, most of our seniors would live in poverty. With Social Security, just 1 in 10 seniors do.

Under the current law, the Congressional Budget Office projects

that Social Security can pay full benefits to 2052. The year after

that, Social Security will be able to pay about 80 percent of benefits.

We clearly need to improve Social Security’s finances so that it

will be able to pay full benefits after 2052, but we do not need to

make drastic changes.

Unfortunately, we are going to be hearing about drastic changes

today. The testimony of the Director of the Congressional Budget

Office will provide data on three options, options to achieve sustainability and to sustain solvency of the Social Security trust fund.

Unfortunately, each option results in deep benefit cuts for both

middle-class and low-income Social Security beneficiaries. I do not

think that these deep cuts would be acceptable to most of the

American people.

Let me be more specific. The first option put forward is price-indexing, just as in Model 2 of the President’s Social Security Commission. The President’s advisors suggested in January that the

President liked this option, although they have backtracked since

then.

CBO’s testimony indicates that this option reduces all benefits by

about 50 percent after 63 years. These are huge benefit cuts. MoreVerDate 11-MAY-2000 15:46 Jun 07, 2006 Jkt 095484 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 27402.000 SFIN1 PsN: SFIN1
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over, these big cuts would also apply to disability benefits and to

survivors’ benefits when workers die during their working years.

The second option being put forward is similar to the President’s

partial price-indexing plan. He endorsed this plan in his press conference a few weeks ago. Like the President’s proposal, this proposal has deep benefit cuts for the middle class and deep benefit

cuts for survivors.

For example, workers with average earnings who are born today

and retire at age 65 would have their benefits cut by 31 percent.

But this option also cuts benefits for some low-income workers who

were protected under the President’s plan.

For example, all low-income workers with average career earn- ings as low as $15,000 in today’s dollars would receive benefit cuts

under this newest option. Moreover, the new option would also

make deep cuts in benefits for the disabled, as would the President’s.

The third option put forward today would raise the retirement

age to about 70 years for all workers who are born 10 years from

now. Currently, the retirement age will rise to 67. This is a big increase. If that were not enough, the option would also cut benefits

by changing the way benefits are indexed.

This would reduce benefits by 27 percent for earners in the middle of the income distribution who were born this year and retire

at age 65. Even worse, it would cut benefits for workers in the lowest fifth of the income distribution by 33 percent, and these deep

benefit cuts would apply to survivors of deceased workers and to

disabled workers as well.

Once you look at the details, I think it becomes clear that these

three new options cut benefits for Social Security beneficiaries far

too deeply. We need to scour all other ideas for improving Social

Security’s long-run finances. Regrettably, the President’s Social Security plan would also cut benefits far too deeply. It would also add

massively to our Federal debt.

The President’s plan has two basic parts. The first proposal is to

privatize Social Security. The President wants to allow workers to

divert some of their payroll taxes out of the Social Security trust

fund and into private savings accounts.

He proposes that when these workers retire, they must pay back

to the Federal Government all of the money that had been diverted, plus interest, compounded at a rate of 3 percent above the

inflation rate. The President would dock retirees’ Social Security

checks to collect that repayment.

This privatization proposal is a bad idea, for several reasons.

First, this makes Social Security’s solvency worse—not better, but

worse. Suppose we consider Social Security’s health over the next

75 years, as has been traditional.

The diversion of funds from the Social Security trust fund takes

place during the working years of the individual, but the repayment of the funds first begins after the worker retires. So for some

workers, their payment occurs outside the 75-year window. This

timing gap worsens Social Security’s 75-year solvency.

Coping with this increase in solvency would cause pain. To make

up for this added solvency with benefit reductions for retirees,

while protecting benefits of survivors and the disabled, the Federal

6

Government would need to cut retirement benefits across the board

by more than 9 percent. That is according to the Congressional

Budget Office.

I would further note that the average benefit for a retiree today is about $11,000. A benefit cut of 9 percent would mean a loss of

about $1,000 a year to that average retiree. So, privatization is a

self-inflicted wound to solvency. It does not make sense.

The second problem with privatization is that it would cause a

massive increase in the Federal debt. The debt would go up by

about $5 trillion during the first 20 years.

That is because the Federal Government would have to borrow

money to buy the stocks and the bonds it would need to put into

each worker’s private account. The $5 trillion of new debt would

more than double the size of the Federal debt held by the public

today.

At some point, all this extra debt would drive up long-term interest rates. This would slow economic growth and reduce our standard of living. This added debt would result in foreigners owning a

lot more of our financial assets.

This means that the earnings on these assets would benefit foreigners, not United States residents. Foreigners already own about

$2 trillion of our debt. Privatization would probably double that

amount.

Moreover, much of our debt is currently owned by the central

banks of foreign countries such as China, Japan, and South Korea.

If the dollar were to start dropping even more in value than it already has, these banks might fear that the U.S. debt they owned

would start plunging in value. They might feel compelled to sell

that debt. This would cause interest rates here to spike, certainly

causing a recession.

The third problem with privatization is that it could cause many

workers to lose money. Under the President’s proposal, if your

earnings do not average at least 3 percent above inflation for your

working years, you will lose money. But the CBO projects just that,

3 percent, which means if you make even slightly less than that

rate of return, you will suffer a loss.

Unfortunately, the President also has endorsed a second bad

idea, and that is cutting benefits by changing the indexing of initial

benefits. The President’s plan would severely cut Social Security

benefits for middle-income retirees, as I discussed, and these cuts

would occur regardless of whether the worker opts for private accounts—regardless.

That is not the end of it. The President’s Chief Economic Advisor,

Alan Hubbard, said last week that the President’s plan would cut

Social Security survivors’ benefits as well. He also admitted that,

under the President’s proposal, disability benefits for workers and

their families would not be fully protected.

As bad as privatization is by itself, and as bad as the middleclass benefit cuts are standing alone, they are even worse when

they are combined together. Yet, that is what the President is proposing.

As noted earlier, workers who opt for private accounts will have

their Social Security benefits reduced when they retire. As noted

earlier, the President’s plan would cut benefits of middle-class

7

beneficiaries regardless of whether they had opted for private accounts.

The combination of these two benefit cuts, for a worker born 5

years from now with career average earnings of $59,000 who retires at age 65, would be a cut of 97 percent. For a worker with

career average earnings of $90,000, the benefit cut would be 100

percent.

Even with these cuts, the President’s plan would not come close

to eliminating Social Security’s insolvency. Under the projections of

the Social Security actuaries, which the President is using, this

combination would eliminate only about 30 percent of Social Security’s financing shortfall over 75 years. The President would have

to propose a lot more savings, and probably huge benefit cuts beyond those he has already proposed.

The disadvantages of the President’s two proposals, in combination or separate, greatly outweigh any advantages. We need to

leave the President’s plan behind. Rather, we must scour all the

options available to eliminate Social Security’s 75-year insolvency

shortfall. For example, we need to look at tax compliance with Social Security’s employment taxes.

The Joint Committee on Taxation and the Treasury Inspector

General for Tax Administration each have made recommendations

for improving compliance with employment tax law. The changes

that they are recommending would increase income to the Social

Security trust fund.

We should not cut the benefits of any law-abiding retiree by 1

dime or raise the taxes of any law-abiding worker by 1 dime until

we have done our best to ensure that all taxpayers are complying

with current tax law. The same holds true with respect to any improper payments that are being received on the benefit side for the

program.

So I look forward, Mr. Chairman, to the testimony and discussion

from our very, very fine panel of witnesses. The sooner we get the

President’s plan behind us, the sooner we can return to the real

business of improving Social Security’s finances for the long term.

The CHAIRMAN. Thank you very much, Senator Baucus.

We now have a panel, and we will go in the order in which they

are seated.

Dr. Douglas Holtz-Eakin, Director of CBO; Dr. Eugene Steuerle,

senior fellow, Urban Institute; Mr. Stanford G. Ross, former Commissioner of Social Security; Mr. George Yin, Chief of Staff, Joint

Committee on Taxation; and the Honorable Russell George, Office

of the Treasury Inspector General for Tax Administration, Treasury Department.

Dr. Holtz-Eakin?

STATEMENT OF DR. DOUGLAS HOLTZ-EAKIN, DIRECTOR,

CONGRESSIONAL BUDGET OFFICE, WASHINGTON, DC

Dr. HOLTZ-EAKIN. Mr. Chairman, Senator Baucus, and members

of the committee, the CBO is pleased to have a chance to be here

today to discuss this important topic of solvency for Social Security.

You have our written testimony. I could not possibly do justice

to the attachment, which is a menu of options within the context

8

of the current system which would affect the future solvency of the

system.

I probably could not do justice either to the three particular

pieces which we pulled out as stylized components of changes to

Social Security in my oral remarks, so I will instead attempt to

provide you a road map to that written testimony and look forward

to your questions at the end.

I will divide the road map into three pieces. First, implications

for aggregate finances for Social Security; second, distributional implications of changes, as I illustrated them in the testimony; and

third, the nature of the benefit adjustments which are underneath

both the aggregates and the distributional implications.

To begin, Figure 1 in the testimony, and the figure I have put

up on the screen, is the current outlook for Social Security, both

in terms of current law and also scheduled benefits. As the Chairman noted at the outset, this projection is done using the trustees’

assumptions, so it is CBO’s mimic of the 2005 trustees baseline.

To review the basics of what I believe is by now a very familiar

story, under current law, Social Security at the moment will run

a cash-flow surplus. That cash-flow surplus will peak in the near

future and then diminish, turning to a cash-flow deficit. In the

background, during that period the trust funds will be building up

and providing financing for the future.

Within the program itself, going forward until 2044, the cash

flow deficits will be financed by transfers from the remainder of the

budget to honor the Social Security trust funds, and then in this

projection, trust funds will exhaust and benefits will be cut down

to match receipts coming in, and there will be a gap between the

top dotted line, which is scheduled outlays, and benefits under the

program and those which the Secretary of the Treasury will have

the legal ability to pay.

So that is the current-law outlook, that is the aggregate finances,

and the target for the options that we showed in the written testimony was to transform that outlook into one which had sustainable

solvency.

The tactic is to focus on benefit changes which would permit a

greater accumulation of trust funds and a slower decumulation out

in the cash-flow negative years so that the trust funds do not exhaust under the reform and there are sufficient funds to pay benefits as scheduled in the reformed system out to 2100.

In each case, we have scheduled these to begin in 2012, and thus

they would not affect anyone who is currently 55 or older. In each

case, we have focused on reducing benefits through a variety of tactics. As noted in the menu in the attachment, there are other ways

one could do this. Benefit changes are easy to compare and

straightforward. All of the benefit changes will lead to sustainable

solvency. They are designed to do that.

All, in fact, will be of sufficient magnitude that, out around 2100,

there will be a cash-flow surplus in Social Security. The cost and

income lines would not only come together, they will cross.

All share the same Achilles heel of such changes in the current

budgetary context, which is that they rely up front on the accumulation of trust fund surpluses and the presumption that those will

not be spent elsewhere in an economic sense by the rest of the

9

budget, and all rely on the future transfers from the unified budget

to honor the trust fund in a world where, I will remind you, the

current-law promises for Medicare and Medicaid are ramping up

much more rapidly and becoming much larger, so they all will

evolve in the same budgetary context that has been discussed in

the past.

Now, moving to the distributional analysis. Under current law,

one can measure the implications in a variety of ways. The measures that we focus on in the testimony are replacement rates: the

primary insurance amount (the basic retirement benefit) as a fraction of your average indexed monthly earnings.

We also discuss to a lesser degree some lifetime benefit measures. These are measures that we have produced in the past, and

in our outlook for Social Security there is greater detail.

These are not the only measures of benefits. One could look at

first-year benefits awarded to retirees. One could look at disability/

survivors, and one could certainly look at taxes paid over a lifetime. But given the wide variety of benefit measures, these are the

focus of the written testimony.

There is also an issue always in distributional analysis of how

you would classify workers. The figure on the screen, which is Figure 3 in the written testimony, shows the implications of different

classifications for your measure of distribution under current law.

One possibility is to measure someone by their place in their

ability to purchase, and so the top line shows a worker at the middle of the earnings level for 2005, which is averaged indexed

monthly earnings of $2,500, and looks at the replacement rate for

a person like that with the same purchasing power and the same

lifetime real earnings going forward. You can see that, under

scheduled promises, the replacement rate would rise for such an individual going forward.

The insurance amount as a fraction of their earnings would be

increasing over time up until, under current law, the dotted line at

the bottom, which showed the drop-off when trust funds exhaust

and there was a benefit cut.

Alternatively, you could look at the individual and classify them

on their relative rank, where do they fit in the income distribution.

As the economy gets richer, that same middle-earnings person now

would have higher than $2,500 in purchasing power in the future.

The bottom line in that figure shows you the relatively flat replacement rate that one would depict if you focused on an earner

at the middle of the distribution at every point in time in the future as opposed to an earner with exactly the same purchasing

power.

So there are alternative measures. We tried to lay them out

clearly in the testimony so that the committee can understand

them. And in looking at changes in both the distribution and the

aggregate finances, the focus of the testimony is on alterations of

the current benefit formula. The figure on the screen is the computation of the primary insurance amount for those workers who

turn 65 this year.

The key features from the point of view of the computation are

that, step one, you calculate average indexed monthly earnings,

10

typical earnings over a lifetime, where ‘‘indexed’’ in this case is a

wage index.

One variation we will show in the reforms is to change that indexing to prices. Having computed that, the formula then consists

of three segments with bend points, as we refer to them, and replacement factors. The replacement factors are 90 percent, 32 percent, and 15 percent. The bend points are, at the moment, indexed

to go up with wages.

The basic tactic in all of the options that we show you is to alter

the pieces that go into this computation, alter the average indexed

monthly earnings computation, change the location of the bend

points, or alter the replacement factors.

These, again, are not the only options one could choose. As the

attachment shows, you could alter retirement ages; you could alter

the cost-of-living adjustments during retirement.

So the options that one sees in the written testimony are really

three, four if you count current law as essentially a wait-and-reform option where you just let the trust funds exhaust and cut benefits across the board. So, we show that as well in the interest of

comparability.

The three we show are, as the Chairman or Mr. Baucus mentioned, price-indexing as outlined by the President’s Commission on

Social Security. In the context of this diagram, that amounts to

lowering the replacement factors going forward to offset real wage

growth. So, the 90, 32, and 15 percent become smaller numbers

going forward, and this affects individuals and lowers aggregate

benefits as well.

Number two is progressive price-indexing. In the implementation

that you have in the written testimony, this is the same for people

at the top end as the first option. It is pure price-indexing for the

very highest earners.

It is current-law for those who are at the 25th percentile or

below, so they are insulated. It is a combination of those two for

everyone in between. That has a differential effect across the income distribution, but also serves for lower aggregate benefits.

Then, finally, we show an option in which we alter the computation of the average indexed monthly earnings by moving the index

from wage- to price-indexing. We then also change the bend points

by indexing those to prices instead of wages, and we alter the entire benefit award for longevity.

Having once made the first two changes, the third longevity

change is meant to provide the same lifetime benefits for those living longer in the future as those people would get in the present.

The upshot of these changes is a set of formulas which in each

case affects different parts of the income distribution differentially.

You can see that in the stylized pictures that we have here. In each

case, the formulas lie below the current formula and, thus, reduce

the growth rate of benefits and allow sustainable solvency for the

system as a whole.

I thank you for the chance to be here today to talk about this

important question, where about the only option that we know is

not on the table is doing nothing. I look forward to explaining the

ones that we have outlined in the written testimony, both from the

11

implications of the aggregate finances and their distribution consequences for beneficiaries. Thank you.

[The prepared statement of Dr. Holtz-Eakin appears in the appendix.]

The CHAIRMAN. Dr. Steuerle?

STATEMENT OF DR. C. EUGENE STEUERLE, SENIOR FELLOW,

URBAN INSTITUTE, WASHINGTON, DC

Dr. STEUERLE. Thank you, Mr. Chairman, Mr. Baucus, and members of the committee. I have had the privilege over a number of

years to serve members on both sides of the aisle in addressing Social Security and tax issues, and am indeed honored to be here

again to try to help you today.

I should indicate right up front that my testimony is largely driven by one major concern: the legacy that our government is about

to leave our children is really a government whose almost sole purpose is to finance our consumption in retirement.

There is little left in the budget for other items if we continue

the pressure of Social Security and the other programs for the elderly as to the share of the budget that they are going to take.

At the same time, I believe it is possible to build a Social Security system that would do a better job than even current law at removing poverty among the elderly—measured by relative living

standards, I should indicate—and serving the majority of the population when they are truly old.

Now, much of my testimony, as requested, deals with our increasing inability to protect the young, the very old, and the vulnerable when Social Security essentially morphs into a middle-aged

retirement system, which is what it has become.

Let us begin by defining lifetime benefits as the value at age 65

of Social Security and Medicare benefits as if they were in a 401(k)

account. In today’s dollars, lifetime Social Security benefits for an

average income couple—that is a couple making about $50,000

combined—is about $400,000. That figure is up from about

$195,000 in 1960, and it rises to over a half a million another 25

years from now.

If you add in lifetime Medicare benefits, a couple retiring in

about 25 years is scheduled to get total lifetime benefits—in constant dollars, discounted (I am not cheating with inflation)—of over

$1 million. We cannot provide benefit packages of this size and encourage people to retire for the last third of their adult lives without significantly affecting—in fact, dramatically affecting—the

services that could be provided by government to children and to

working families. We simply cannot.

Let me try another lens on these numbers. Close to one-third of

the adult population is scheduled in another 21⁄2 decades to be on

Social Security. That does not count people on other welfare systems or other people that need support by government. People,

today, already retire for about the last third of their adult lives.

Now, this issue is not just one related to the benefits under Social Security, but of the amount of years people retire and the extent to which they drop out of the workforce, reduce national income, and reduce revenues available to government.

12

If people retired today for the same number of years as they did

when Social Security was young—that is, in 1940—they would be

retiring about age 74 today. Go out another 40 or 50 years in the

future, they would be retiring at about age 78.

What that means is that, by constantly increasing benefits to

people who are essentially middle-aged retirees, we reduce the

share of benefits that can be doled out to the truly elderly, as

measured by life expectancy. I show this in some graphs in my testimony.

Meanwhile, because people retire for so long, the revenues for

the rest of the government decline, affecting everything else. I will

come back to this revenue picture because it affects the reform options.

Now, believe it or not, I feel there is tremendous opportunity in

all of this. People in their late 50s, 60s, and even 70s have now become the largest under-utilized pool of human resources in the U.S.

economy. They represent for the labor force, in the first half of the

21st century, largely what women did for the last half of the 20th

century.

It is a tremendous pool of human resources if we can figure out

how to make use of it. I again point out, if they work, they increase

national income, they increase the revenues not just for Social Security, but for everything else.

Now, restoring Social Security to an old-age, and not a middleaged retirement program can be done partly by increasing retirement ages.

But I also point out some related moves that we can make. For

instance, we could adjust benefits so they go more to those who are

truly older. That is, we could ratchet benefits to give more in old

age and a little less to those who retire when they still have 15,

20, or more years of life expectancy.

These changes progressively move benefits to later ages when

people have less ability to work. When they have lower income.

And what is very important, when they are less likely to have a

spouse around to help them when they have impairments.

By the way, these types of changes put the labor force incentives

at the right level, that is, up front when people could adjust, as opposed to other benefit adjustments that affect people when they are

older and cannot make adjustments easily. And, I point out again,

they can increase revenues.

Now, admittedly, some groups have shorter-than-average life

expectancies. But attempting to address their needs by granting

many of us—and I am including the people in this room in the audience and myself—a 20th, a 21st, and 22nd year of benefits because of our life expectancy—if we are healthy, that is what we are

granted—that is, in many ways, the ultimate form of trickle-down

theory.

In effect, I do not think I am protecting the poor by making sure

that I get this 22nd year of benefit. But to make an adjustment for

those who are poor and have shorter life expectancies, I do favor

a good minimum benefit.

If we are going to increase retirement ages, let us back it up with

a good minimum benefit so those who have shorter-than-expected

life expectancies actually get an improvement in benefits as well.

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That is, they do not need to bear the brunt of an increase in retirement age.

Now, one question that often arises when I raise these issues

about retirement age—when I talk about Social Security becoming

a middle-age retirement system, and Social Security providing an

increasing share of benefits every year to those further and further

from date of death—is whether people can actually work longer.

In my testimony, I provide three pieces of evidence which I will

quickly summarize. First, older Americans over age 55 have been

reporting—this is their own reporting—improved health over time.

Today, among those even 65 to 74, less than a quarter report that

they are in either poor or fair health.

Second, there is strong empirical evidence that the physical demands of jobs have been declining over time. Finally, until recently, the labor force participation of those with similar life

expectancies has fallen dramatically over time.

For instance, those age 65, when Social Security was young, had

about 16 years of life expectancy. When Social Security was first

established, over 85 percent of people with that type of life expectancy worked. Today, it is less than 40 percent. It is hard to believe

that, as physical demands have been declining, people have become

less capable of working.

Now, in my testimony, I also suggest, as a measure of budget reform and not just Social Security reform, that some rules should

be adopted to back up whatever reform we do so that the system

would remain in balance over the long run. For instance, persistent

projected deficits could automatically lead to a gradual increase in

the retirement age or to a reduction in the rate of benefits for

middle- and higher-earning workers.

In conclusion, our current Social Security system increasingly favors middle-aged retirement. As a consequence, it reduces the

share of Social Security resources for those who are truly elderly.

That is an arithmetic fact. There is no doubt that if you provide

more and more benefits further and further from death, then

smaller shares go to those who are closer to death.

Because of the way our budget is working, the share of revenues

remaining for programs for children and working families will decline, as I say, and they will be left with almost nothing if we

project our budgets out into the near future.

A reformed system, I believe, can reduce poverty rates, adjusted

for living standards over time, while providing many others among

the truly old a lifetime benefit that is as good or better than most

generations have received in the past.

Thank you.

The CHAIRMAN. Thank you, Dr. Steuerle.

[The prepared statement of Dr. Steuerle appears in the appendix.]

The CHAIRMAN. Now, Mr. Ross?

STATEMENT OF STANFORD G. ROSS, FORMER COMMISSIONER

OF THE SOCIAL SECURITY ADMINISTRATION, WASHINGTON,

DC

Mr. ROSS. Thank you. Mr. Chairman, Senator Baucus, members

of the committee, I am very pleased to have the opportunity to be

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here today and to give my views on how to handle the Social Security solvency problem.

I am going to address this based on the charter that this hearing

has, which is, how do you achieve financial solvency? This is obviously a challenge, but I do not think it is a crisis.

We have handled problems like this before, and in some ways it

is less of a crisis than it was in 1983 when there was a real threat

that the checks would not go out. We have time, so we can measure

the response and phase it in in a way that does not involve abrupt

changes.

The most important thing in approaching Social Security is that

it has to be done on a broadly bipartisan basis. Nobody wants to

be advocating revenue enhancements or benefit adjustments. Indeed, the less you have to do, the better.

That is why, historically, the way to go about this is to try to develop a package of incremental changes with relatively small effects. That is what I would urge on the committee today. I have

attached to my testimony an illustrative package of incremental

changes that I think could get us there.

Now, the first thing you have to do is to get your hands around

the size of the problem. Here, I do not think the committee is well

served by having a very broad range for its target. The SSA Office

of the Actuary, based on the 2005 Trustee Reports, has that deficit

at 1.92 percent of payroll.

As I understand the CBO numbers—I have not had time to really get into the ones presented today, but I have looked at the ones

that were presented previously—a comparable figure is about 1.05

percent of payroll. That is quite a big discrepancy.

I think it is necessary for these two offices to get together and

to help policy makers by presenting a common projection, or at

least a clear explanation of what the differences are. Then people

can make a decision and you can establish a target for the changes

you are obviously going to have to make.

In this regard, for the rest of my statement today and my testimony, I have assumed we will use the SSA Office of the Actuary’s

1.92 percent, and I have assumed we will use their test for solvency, which is to achieve a balance over a 75-year projection period, plus make sure that at the end there is stable or rising balances so that you do not drop off the cliff and have to have this

discussion rapidly again.

I think their test works. I think some of the other things that

have been mentioned, such as doing projections on an infinite horizon, which would raise that deficit target to 3.6 percent of payroll,

are not helpful. They may be helpful for some purposes, but for this

purpose we have a tradition on how you go about this, and I think

that is the way to go at it.

Now, just to get something out of the way, adding an individual

account system in would make it more difficult to solve this problem. We do not have a comprehensive actuarial study of the President’s plan, but it appears that it would increase that 1.92 percent

deficit by about 0.6 percent. That is a big hurdle.

I am going to assume for the balance of my testimony that we

can focus on achieving financial solvency and we can do it by an

incremental package of changes.

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Now, traditionally, this package has had roughly an equal measure of revenue enhancements and benefit adjustments. I think if

people, on a bipartisan basis, get together and talk about it, that

is ultimately where they will get.

That is where they have gotten every other time that this problem has been approached in the 70-year history of the program,

and I do not think you need to reinvent the wheel. I think you just

need to do it currently; adjust to current circumstances.

On the revenue enhancement side, there are two fairly obvious

changes. One is to restore the covered earnings to 90 percent. It

has drifted down to 83 percent because of the greater dispersion of

earnings in the society, the rich getting richer and the poor getting

poorer, and also because there are more non-cash benefits.

I think the 90-percent standard that was used in 1983 is a good

one. I think you can get back there incrementally. It produces 0.75

percent of payroll, which is almost 40 percent of the deficit target

that you need to cover.

I similarly think that you can subject Social Security benefits to

tax in a manner similar to private pensions. I think if you do this,

it is sound because the tax revenues recycle through the trust

funds to pay more benefits. It is a very good device, far better than

approaching it through changing the indexing.

The indexing, as Senator Grassley well articulated, evolved after

a great deal of study and turmoil. We finally got to a system that

is stable. Economists and others can argue the pros and cons of indexing, but we have a system where you basically rely on wages

until you set the initial benefit, and then prices, once you are in

retirement status, to keep up the purchasing power. I think that

system basically works.

As I will indicate below, a possible benefit adjustment is to make

the CPI formula more accurate. There has been more study and

you can make better assumptions about consumer behavior, and

that actually would improve the deficit by 0.35 percent.

But before I leave the revenue enhancements, I also think what

Senator Baucus said is very important. We ought to collect all the

payroll taxes that are legally required to be paid. This is a huge

item.

We have a $350 billion annual tax gap, and at least $50 to $60

billion of that is in payroll taxes. We can collect some of that. In

fact, the country used to do a better job of that.

There are no miracles about how you do it. You give the IRS

more money for enforcement, and they conduct more examinations.

You give taxpayers a better indication of what they are required

to do, and better taxpayer service to help them. I am sure these

last two witnesses will be very articulate about it.

I feel strongly about that, because I started my career in Washington in 1961 under President Kennedy. I came here as a young

person to work on the first modern tax reform, and I really believe

in the need to have a tax system with integrity, and I think we can

get there.

Now, on the benefit adjustment side, besides making the CPI

more accurate, I would increase the number of years to calculate

benefits from 35 to 40. That is entirely in line with having an initial benefit formula that takes account of an entire lifetime of work.

16

I would hope we would not need to make other changes in the

initial benefit formula, but, if we do, that is a far better way to go

at it than other ways.

I would also, on the retirement age, begin with what I think is

fairly obvious. We now have legislated a normal retirement age of

67. I think we ought to eliminate the hiatus in reaching it and we

ought to phase it in more promptly, not wait 11 years before we

ratchet it up again. We can then see where we are at.

It may well be that we need to increase the retirement age in the

future to deal with some of these longer-term issues that Dr.

Steuerle and others are talking about, and that should certainly be

studied. But this is an obvious change to get to the 1.92 percent.

Similarly, there are other things about benefits that could be improved. The spousal benefit, which gives an automatic 50 percent

based on the higher earner’s wage history, can be seen as discriminating against lower-earner spouses and working spouses.

I think we can revamp that. I think we can work on adding a

better minimum benefit and make other changes in the benefit

structure that would improve the efficiency and effectiveness of the

system and get the balance of what we would need to have a 50/

50 package.

Finally, I would say that it is important to give the Social Security Administration, like the IRS, some additional resources to do

a better job. There are long lines in Social Security offices. The 800

telephone number service is not adequate. Applicants for disability

benefits can wait years to get a determination.

Short-changing the administrators of what is a very good system

does not serve the American people well. They deserve better, and

that should be part of any package of legislative changes to improve solvency.

Finally, I would close by saying, because we all read the newspapers, if in the present political climate it is difficult to directly

achieve the broad bipartisanship that is needed, I would recommend you consider a commission along the lines of the 1983

commission that included members of Congress, or the recent 9/11

Commission that took another approach.

I have to say that I do not think the President’s commission was

helpful. It did not have the right mandate. The mandate required

an inclusion of individual accounts.

I think a clear mandate that says, achieve solvency, give us an

agreed state of facts and a good set of options, would help the Congress get on with it. These matters we are talking about, even

small or incremental changes, much less larger changes such as

Dr. Steuerle has talked about, are quite complicated.

You need an expert staff to do work in a dispassionate atmosphere, and the Congress could then be presented, if it had about

a year to work and it got appointed quickly, by next summer, with

a good report that might allow Congress to reach agreement.

At any rate, I welcome the opportunity to be here. I have appeared before this committee many times. I respect the bipartisanship that this committee has always reflected. If there is any way

I can be helpful to you to get to that consensus, I am prepared to

do it.

Thank you, Senators.

17

The CHAIRMAN. Thank you for your thoughtful comments.

[The prepared statement of Mr. Ross appears in the appendix.]

The CHAIRMAN. Mr. Yin?

STATEMENT OF GEORGE K. YIN, CHIEF OF STAFF,

JOINT COMMITTEE ON TAXATION, WASHINGTON, DC

Mr. YIN. Thank you, Mr. Chairman, Senator Baucus, members of

the committee. Thank you for inviting me to testify today.

I have been asked to present to the committee various tax legislative changes that could be adopted to improve the solvency of the

Social Security system.

I set forth in my written testimony possible expansions to the

employment tax base, as well as certain options relating to the employment tax rate and cap, and have included very preliminary revenue estimates of most of the options presented.

I encourage the committee to consider changes that would make

the employment tax base more comprehensive before contemplating

possible employment tax rate changes or an increase in the employment tax cap.

Most of the tax base options were described in the recent Joint

Committee staff report on options to improve tax compliance and

reform tax expenditures, and are worthwhile changes apart from

any effort to improve Social Security solvency.

Moreover, distortions created by existing exceptions to the tax

base, such as growth in the use of non-cash compensation and certain forms of business entities, may be exacerbated if the exceptions are permitted to continue with an increase in tax rates and/

or the tax cap.

Let me briefly describe for you four possible employment tax base

changes. First, the employment tax treatment of partners, S corporation shareholders, and owners of limited liability companies

needs to be clarified and reformed.

Under current law, each of those taxpayers may face different

employment tax liabilities, even though the services they provide

on behalf of their businesses are the same. As a result, the choice

of business form may be motivated more by a desire to avoid or reduce employment tax liabilities rather than by non-tax considerations.

The conceptual problem is that the income of these taxpayers

may represent a mix of economic returns for labor and capital. If

employment taxes are to apply only to their labor income, then

labor income must be properly segregated from capital income.

Under the proposal of the Joint Committee staff report, the distributive share of income of these taxpayers is generally made subject to SECA tax. Exceptions, however, are provided for certain

types of capital income and in situations where the taxpayer does

not materially participate in the underlying business.

The staff option thus attempts to measure the labor income and

the resulting employment tax liabilities of these taxpayers in the

same way, and similarly to that of sole proprietors.

This more uniform treatment improves the fairness of the tax

law and increases tax neutrality by reducing the importance of employment tax differences in a taxpayer’s choice of business form.

18

A second option is to address the problem of under-reporting of

compensation income by sole proprietors and others not subject to

wage withholding. IRS studies have consistently shown this problem to be the single largest contributor to the tax gap.

The staff report includes a proposal to impose withholding on

certain government payments for goods and services that are not

currently subject to withholding. Because such payments represent

a significant part of the economy, the proposal can be expected to

improve compliance to a significant extent without burdening any

private-sector payors.

The proposal thus attempts to balance the goals of improving

compliance and not creating undue administrative burdens. This

proposal could be expected to increase income tax and employment

tax revenues, both by collecting some tax from the transaction and

by stimulating voluntary reporting and payment of tax apart from

any amounts actually withheld.

A third option is to provide consistent FICA treatment of salaryreduction amounts. Under current law, contributions made to taxfavored retirement plans by salary reduction, such as contributions

to 401(k) plans, including the Federal Thrift Savings plan, are

wages for FICA purposes.

However, salary-reduction amounts used to provide other non-retirement benefits, such as health and dependent care benefits, are

excluded from wages for FICA purposes. The staff report includes

a proposal to treat all salary-reduction amounts as wages for FICA

purposes.

Legislative history indicates that salary-reduction retirement

contributions are included in the FICA tax base in order to avoid

undermining that base and making the Social Security system partially elective. This rationale for the FICA treatment of retirement

plan contributions applies equally to salary-reduction amounts

used to provide other benefits.

One effect of this staff proposal is to provide more consistent

FICA treatment of amounts paid by employees to purchase non-retirement benefits, regardless of whether the benefits are provided

through or outside an employer-sponsored plan.

Finally, the proposal to impose FICA taxes on all benefits provided through salary reduction could be expanded to apply to all

non-retirement employee benefits. Such a proposal would also provide consistent FICA tax treatment with respect to employer-provided and non-employer-provided benefits.

A variety of issues would need to be addressed under such a proposal that do not arise under the staff option. For example, valuation issues do not arise under the staff option because the amount

of salary reduction is known, but valuation issues may arise with

respect to benefits not provided on a salary-reduction basis.

I have set forth in my written testimony a number of other possible employment tax base changes, and have also included for discussion purposes several options that would change the employment tax cap or rates.

I would be pleased to answer any questions about any of the options outlined. The staff looks forward to working with the committee in developing proposals for you, and we appreciate very

much the opportunity to testify.

19

The CHAIRMAN. Thank you, Mr. Yin.

[The prepared statement of Mr. Yin appears in the appendix.]

The CHAIRMAN. Now, Mr. George?

STATEMENT OF HON. RUSSELL GEORGE, OFFICE OF THE

TREASURY, INSPECTOR GENERAL FOR TAX ADMINISTRATION, U.S. DEPARTMENT OF THE TREASURY, WASHINGTON,

DC

Mr. GEORGE. Thank you. Chairman Grassley, Senator Baucus,

members of the committee, thank you for the opportunity to discuss a report that my office is releasing today that has implications

for achieving sustainable solvency for Social Security. Mr. Yin’s testimony briefly addressed the topic.

The objective of our report was to determine whether the existing

laws, tax regulations, and IRS policies and practices ensure fairness in the administration of self-employment tax laws for similarly situated taxpayers. We compared the employment tax liabilities of sole proprietors to the employment tax liabilities of singleshareholder S corporations. Our report found that employment tax

inequities exist between sole proprietorships and single-shareholder S corporations.

These inequities have historical underpinnings. In 1958, Congress established Subchapter S of the Internal Revenue Code,

which enabled small businesses, including sole proprietorships, to

form corporations owned by 10 or fewer shareholders.

Electing S corporation status exempts profits from corporation

taxation and allows profits to pass through to the shareholders.

Shareholders are then responsible for paying individual income

taxes on the profits received. In addition, shareholders who actively

operate the businesses are subject to employment taxes on the compensation received for their services.

The IRS developed its methodology for dealing with the employment taxes of S corporations in 1959. This methodology does not

properly address how today’s S corporations are structured because

the 1959 methodology is based on the assumption that S corporations will have multiple shareholders or owners. In a multipleshareholder environment, a consensus of shareholders typically set

the salary of the business operator at a level reflecting the market

value of the operator’s services.

However, in Tax Year 2000, 78.9 percent of all S corporations

were either fully owned by a single shareholder, or more than 50-

percent owned by a single shareholder. Therefore, in nearly 80 percent of S corporations, the individual who owns the business determines the amount of the salary paid to the shareholder operating

the business.

The decision by the single shareholder of an S corporation of

what amount to pay himself or herself in salary has tax consequences. A lower salary results in lower employment taxes and

higher profits. In comparison, sole proprietorships are treated

much differently for the purposes of employment taxes.

Employment taxes are authorized by the Federal Insurance Contributions Act, or FICA, and the Self-Employment Contributions

Act, or SECA. FICA applies to S corporations and SECA applies to

sole proprietors. Under FICA, S corporations are required to withVerDate 11-MAY-2000 15:46 Jun 07, 2006 Jkt 095484 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 27402.000 SFIN1 PsN: SFIN1
20

hold taxes from the wages of employees with matching amounts

paid by the employers. In comparison, under SECA, sole proprietors must pay taxes on profits from the operation of their businesses.

The self-employment tax law treats all profits, except for an

amount equal to the employer portion of FICA, as if they were

wages. As a result, the sole proprietor pays the equivalent of both

the employer and employee portion of FICA on business profits.

The different tax treatment has caused the S corporation form of

ownership to become a multibillion-dollar employment tax loophole

for single-shareholder businesses. For example, as shown in this

first chart, in Tax Year 2000, the owners of 36,000 single-shareholder S corporations received no salaries at all from their corporations, even though the operating profits of each of these corporations exceeded $100,000. This resulted in employment taxes not

being paid on $13.2 billion in profits.

A 2001 Tax Court case provides a textbook example of the type

of S corporation shareholder I am referring to. A veterinarian was

conducting business as, and was the sole shareholder in, his S corporation. His corporation produced over $400,000 in total profits

over 3 years, yet during these 3 years he declared no salary for

himself, despite the fact that his corporation’s sole source of income

was from his services. In court, the IRS prevailed. The Tax Court

agreed that the corporation’s profits should be subject to employment taxes.

Now, determining what is reasonable compensation to pay a

business officer is complex and subjective. The IRS must sometimes

engage in litigation. Since the IRS is forced to address the issue of

reasonable officer compensation on a case-by-case basis, many owners of S corporations have apparently determined that saving employment taxes by minimizing salaries is worth the risk of an IRS

examination.

As shown in the next chart, owners of single-shareholder S corporations vary widely in the amount of salary they give themselves.

As you can see, at the top of the chart, many are willing to set

their salaries at zero dollars to maximize their employment tax

savings.

Furthermore, the owners of single-shareholder S corporations

have been setting their salaries at a decreasing percentage of corporate profits in the past several years.

As shown in this third chart, in Tax Year 1994, these shareholders paid themselves salaries subject to employment taxes equal

to 47.1 percent of their profits. This percentage fell to 41.5 percent

by Tax Year 2001. In comparison, sole proprietors pay employment

taxes on all of their operating profits.

The employment tax consequences of these single-shareholder S

corporations paying themselves little or no salaries are in the billions of dollars. My final chart compares the actual FICA taxation

of single-owner S corporations to the theoretical SECA taxation

that would have been paid if these profits were taxed as a sole proprietorship. In Tax Year 2000 alone, S corporations paid $5.7 billion less in employment taxes than would have been paid if the

taxpayers were sole proprietorships.

21

Billions of dollars in Social Security and Medicare taxes are

being avoided by single-shareholder and majority-owned S corporations. Trends indicate that the employment tax base is eroding. In

fact, advising small businesses to save on employment taxes by

forming S corporations has become a cottage industry. A search of

the Internet yields many sites that advises entrepreneurs that they

can save thousands of dollars a year in employment taxes simply

by incorporating.

The Joint Committee on Taxation shares my concern about the

employment tax treatment of pass-through entities such as S corporations, and has, as you heard, recommended changes to their

taxation. Additionally, the Joint Committee outlined five general

principles for improving compliance and reducing the tax gap in

testimony before this committee last month. The employment tax

treatment of owners of pass-through entities was included as one

example of how compliance is hampered when tax outcomes are dependent on difficult factual determinations.

Mr. Chairman, members of the committee, I appreciate the opportunity to discuss this important issue. I look forward to working

with the IRS to identify and recommend solutions to the problem,

and would be happy to answer any questions you have at the appropriate time.

[The prepared statement of Mr. George appears in the appendix.]

The CHAIRMAN. Thank you.

We will take 5-minute turns. One of my colleagues is concerned

about everybody sticking with 5 minutes, so I will try to set a good

example.

Senator LOTT. The witnesses did not.

The CHAIRMAN. But I thought I was very lenient and liberal with

the witnesses because we have a big problem of understanding

these issues, and these folks have studied it for a long period of

time for us, and I thought they needed that time.

Dr. Holtz-Eakin, when people compare Social Security benefits

over time, they often compare them in terms of replacement rates,

that is, a person’s benefit relative to his or her own wages.

As you point out in your testimony, relative to any given level

of income, replacement rates are rising under current law. In other

words, someone who makes $1,500 a month in the future will collect a higher benefit than someone who makes $1,500 today.

Do you believe that the American public is aware of the fact that,

under current law, people who earn the same income and pay the

same taxes will receive higher benefits in the future than they do

today?

Dr. HOLTZ-EAKIN. Well, Senator, I have no idea what the American public is aware of, but I do not think that there has been a

full depiction of the distributional consequences of even the current

system, and that is one aspect of it.

The CHAIRMAN. All right.

And given the fact that we are unwilling to raise our own taxes

to pay for higher benefits today, do you believe it is reasonable to

expect future workers to pay higher taxes to support higher benefits in the future?

Dr. HOLTZ-EAKIN. I think that the broad lesson of the various

studies, not just the CBO’s, but others’, is that it is appropriate to

22

restructure the system now to give people time to anticipate what

changes they will have, and what the system will look like in the

future, and that the current structure is unsustainable. Just waiting and adding a piecemeal fix in the future is probably not desirable.

The CHAIRMAN. Also to you, it is often suggested that switching

from wage-indexing to price-indexing would reduce replacement

rates. However, as you pointed out in your testimony, there are two

different ways to implement price-indexing. So, I would like to have

you give us further explanation of the two different approaches and

how they affect replacement rates over time.

Dr. HOLTZ-EAKIN. I believe you are referring to just the pure

price-indexing versus the progressive price-indexing?

The CHAIRMAN. Yes.

Dr. HOLTZ-EAKIN. I wanted to make sure. There are, in fact,

more than two. There are an infinite number of ways to do this.

But the pure price-indexing is the simplest to explain because it is

just an across-the-board change in the way the initial benefits are

indexed over time. They make sure that, in the future, the initial

benefit gets the same purchasing power that the benefit has right

now, and that is preserved through the pure price-indexing.

The progressive price-indexing provides that same real benefit at

the top end of the income distribution, it provides a rising real benefit at the bottom end of the income distribution, and it provides

a mixture in between. One could provide that mixture in any number of ways. It would depend on the details of any particular proposal.

The CHAIRMAN. All right.

Also to you. It has been suggested that switching from wage-indexing to price-indexing would reduce benefits for future retirees.

In Figure 9 of your testimony, you compared lifetime benefits

under each of the options to the benefits that are scheduled under

current law.

However, Social Security cannot pay the benefits scheduled

under current law. If you compare all future retirees to the cohort

born in the years 1940 to 1949, is it not true that all future cohorts

would receive as much or more on a lifetime basis?

Dr. HOLTZ-EAKIN. Under current law, to give you a flavor of

this—that includes the exhaustion of the trust funds going forward—it will be the case that lifetime benefits will rise.

The highest household earnings quintile in the 1940 cohort will

get, on average, $243,000, the 1970 cohort, $303,000 in lifetime

benefits, all in the same inflation-adjusted dollars, and the 2000 cohort, even facing the trust fund exhaustion, would get $363,000 in

lifetime benefits.

The CHAIRMAN. All right.

Dr. Steuerle, some people say that Congress should not raise the

retirement age. You referred to this, about whether or not people,

particularly doing manual labor throughout their career, are too

worn out to keep working.

But in your testimony, you point out that in the 1940s and

1950s, the average worker did not start collecting Social Security

until they were 68. Is there any reason to believe that people were

23

healthier and jobs were easier in the 1940s and 1950s than they

are today?

Dr. STEUERLE. Mr. Grassley, in my testimony I provide several

pieces of evidence on this point. People report that they are

healthier. The studies we have done on physical demands of jobs

show that they have declined.

If you look closely at the decline in labor force participation of

workers having a similar life expectancy, what you find is a great

deal of it occurred during that very time period when early retirement benefits were made available in Social Security, and Medicare was made available. Once that point was hit, all of a sudden

you had this very rapid fall-off in labor force participation rates of,

say, workers with 16 years of life expectancy.

Before that, it remained relatively constant, even from about

1940 to 1960. All of these pieces of evidence—and this is empirical

evidence, done in a nonpartisan way—indicate to me that there is

no evidence at all that people are less capable of work today than

in the past. In fact, they are probably more capable.

Can I just add one additional item on this replacement rate

issue? The replacement rate has, for a long time, been based on the

notion of what the elderly get versus the non-elderly. That is sort

of the purpose behind it.

Even if we use replacement rates—and I am not sure that they

are the best measures—if we take into account that people are living longer, their lifetime replacement rates have been going up. If

you go far enough in the future, they are still going up, even with

the increase in the retirement age.

The reason is, if you think about a lifetime benefit package providing more and more years of benefits relative to lifetime earnings, it has gone up significantly over time. If you go far enough

into the future, it will start going back up again.

The CHAIRMAN. All right.

Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

I was struck by what I regard as Mr. Ross’s very thoughtful approach. That is, this is not a crisis. We do have some time, but we

should not procrastinate. We should start now, but we do have

some time. This means that we have the opportunity to come up

with some thought-through, thoughtful solutions here.

Almost by definition, it has to be bipartisan, as was the case in

1983. That was solved because, finally, at the end, when that commission could not reach agreement, a very high official of the White

House called a couple of Democrats in the commission and said,

hey, let us make a deal here.

We Republicans will agree with tax increases if you Democrats

agree to benefit cuts. They said, you bet. Therefore, the President

and the Congress, Republicans and Democrats, shook hands and

joined together to find a thoughtful, incremental, bipartisan solution.

I also think it does not make sense to propose fairly drastic

changes in the current Social Security system, as would be the case

with some of the proposals that we have heard about lately, and

one is private accounts. That is drastic, and it makes the problem

worse, not better. Worse.

24

If we are to solve the solvency problem of Social Security, we

should certainly not take actions which make the problem worse,

not better. We are here to solve it, not make it worse.

Second, I am a little concerned about some of the proposals on

the table today, and some of the testimony today, which is focused

so much on benefit cuts only or to some degree on some revenue

rise.

But the thrust of the President’s proposals, and Mr. Pozen’s proposals, which are basically the President’s proposals, as has been

suggested here with these various new options asked of the CBO

to provide, are essentially benefit cuts, and pretty drastic. Very

drastic.

We all know Social Security is in trouble. We all know that lifetime earnings is increasing. We all know the demographics. That

is a given. The real question is, what is the solution here?

So I just want to get a couple of points out here, and would like

some of the witnesses to tell us, just for the record, the facts. Forget the politics, just the facts. Is it true, or is it not true, that the

addition of carve-out private accounts makes the solvency problem

more difficult to solve?

Dr. Holtz-Eakin?

Dr. HOLTZ-EAKIN. Viewed in isolation, with no other change to

the account, taking——

Senator BAUCUS. The answer is yes?

Dr. HOLTZ-EAKIN. Yes.

Senator BAUCUS. Thank you.

Dr. Steuerle?

Dr. STEUERLE. That is correct.

Senator BAUCUS. You agree, it makes it worse?

Dr. STEUERLE. I agree.

Senator BAUCUS. All right.

Mr. Ross?

Mr. ROSS. Yes, it makes it far worse, because the package that

you will need to get it in balance just has to be hugely greater.

Senator BAUCUS. Mr. Yin?

Mr. YIN. I do not have a view on that.

Senator BAUCUS. Whoa. Whoa. I am not going to let you off that

way. Mr. Yin, your analytic, Joint Tax, honest answer. I mean, you

are a very smart man. You are particularly smart with figures. You

have looked at Social Security solvency.

Mr. YIN. Senator, I read the papers and so forth, but I have not

analyzed it from a professional standpoint the way the other three

gentlemen who have just responded have, so I would be reluctant

to give you a professional judgment on that.

Senator BAUCUS. What is your personal judgment? Your personal

judgment. Your honest, personal opinion.

Mr. YIN. I really do not think that would be appropriate to share

with the committee.

Senator BAUCUS. Does it help solve the problem?

Mr. YIN. Well, I do not know. I just have not examined it from

a professional standpoint.

Senator BAUCUS. I am astounded, Mr. Yin, at that response.

Mr. George?

25

Mr. GEORGE. Thank you. Senator, my report was limited especially to the employment tax issue. I am an attorney, not an economist. I really do not have an answer.

Senator BAUCUS. You are also a good soldier.

I would like also to ask some of you, why do we not look at some

of these other options that have been suggested here? For example,

let me ask Dr. Holtz-Eakin about those that Mr. George is applying, namely, SECA and FICA treatment.

Well, let us go back to proprietorships versus S corporations. It

looks like many S corporations, particularly controlled by one

shareholder, or two, are avoiding salaries to avoid employment

taxes. Why not correct that as part of the solution?

Dr. HOLTZ-EAKIN. I do not see any reason why one could not analyze all the options.

Senator BAUCUS. But on the face of it, in your mind, is that

something worth exploring?

Dr. HOLTZ-EAKIN. I think, certainly, from what I have heard—

and I have heard only what I have heard sitting at the table—it

is important to remember that if one were to bring those into the

earnings base, there would be benefits paid on them as well, unless

some change was made.

Senator BAUCUS. Right.

Dr. HOLTZ-EAKIN. So, do both sides of the equation. Do not just

look at the tax side, look at the earnings side and make sure the

benefits are included in that calculation.

Also, think about the tax policy objectives. You do not want to

bring too much capital income into the base, because then you will

make the same mistake in the other direction and drive people to

reorganize on the basis of tax consideration.

So, certainly it merits consideration, it merits thoughtful consideration, and we would be happy to work with you, and especially

the Joint Committee, if that is someplace you would like to go.

We did include some tax options in our menu. The menu, I really

want to emphasize, is a work in progress. It is not comprehensive.

It was meant to provide stylized components of the kinds of things

that are important to consider. If this is something like that, I

would be happy to work with you on that.

Senator BAUCUS. What is your reaction to some of the thoughts

that Mr. Yin suggested?

Dr. HOLTZ-EAKIN. In terms of equalizing the treatment of S corporations and sole proprietorships?

Senator BAUCUS. Yes. Right.

Dr. HOLTZ-EAKIN. That was the heart of my comments. I think

you do have to calculate the benefits as well. It is not just taxes.

The timing will be different, but both will be on the table. I think

that it is important for the committee to remember that there are

both financial considerations and tax policy considerations. If you

have a hard time drawing the line——

Senator BAUCUS. What about salary reductions?

Dr. HOLTZ-EAKIN. I am sorry?

Senator BAUCUS. Salary reductions.

Dr. HOLTZ-EAKIN. I have not looked at that. I would be happy

to work with you.

26

Senator BAUCUS. All right. Well, my time has expired. But I

would just urge us to look at a much broader range of options and

not just as this panel is primarily suggesting, at least your end of

the panel, benefit cuts only.

Thank you.

The CHAIRMAN. Senator Crapo?

Senator CRAPO. Thank you very much, Mr. Chairman.

I would like to ask any member of the panel who would like to

respond to this to discuss with me for a minute just what exactly

does happen at the time when the trust fund runs out of money,

whether it is 2042, or 2052, or wherever that happens.

Let us take the 2042 projection, which I think then has a 26 percent cut. How is that cut administered? Does every person receiving Social Security at that time get a 26 percent cut in whatever

benefit level they are receiving? Maybe, Mr. Ross.

Mr. ROSS. Yes. I am a lawyer and I have served as a public trustee. My understanding of the law is that the benefits cannot be paid

unless there is money in the trust fund at the beginning of the

month to pay full benefits. You cannot make a partial benefit payment.

Some of the notion that there is an automatic cut to pay whatever you have, 80 percent, I do not think is in accord with the law.

In the 70-year history of the program, the Congress has never allowed that Armageddon to arise, that you get to the beginning of

the month and there is not enough money to pay the benefits. I do

not think Congress will ever allow that to happen. There has to be

legislation in advance that tells the Treasury what to do.

Senator CRAPO. Well, but assuming that Congress does not do

that, assuming the current law, are you saying that at the time

when there is not enough money in the fund to pay the benefits

due that month, that you pay zero?

Mr. ROSS. You pay zero.

Senator CRAPO. So everyone’s benefits are reduced to zero?

Mr. ROSS. Then the benefit does not go out. That is why, in 1983,

it was that gun to the head that got people to agreement. The Congress has to act. This is not a matter of administrative discretion.

There is nothing in the law that says anything but pay the full

benefit, and if you do not have the money to do it, then you pay

zero.

Senator CRAPO. Does anybody else on the panel have a different

perspective on what the law says?

Dr. STEUERLE. I do not disagree with Mr. Ross. The month you

do not have the money, you would not pay. It may be the next

month you do.

Senator CRAPO. So you might be paying in alternative months.

Dr. STEUERLE. So over the course of the year you might end up

paying 75 or 80 percent. Stan, do you agree with that?

Mr. ROSS. We have never encountered that. I think the lawyers

who are advising the Secretary of the Treasury would have to stay

up quite a few nights to come up with this kind of alternating payment approach.

I think they would probably be up here pleading with the Congress to give them clear direction, because as far as the public is

concerned, if you think of some poor beneficiary out there who is

27

waiting for that check, they would much rather know that if they

are not going to get it, what they are going to get. They get it every

month as their——

Senator CRAPO. I certainly agree with that, Mr. Ross. In fact,

that is what we are here trying to do, trying to forestall that occurrence.

Mr. ROSS. That is why I do not think it is possible to realistically

think that Congress will not act eventually to give a clear answer

to what you pay when Armageddon is approaching.

Senator CRAPO. I certainly hope you are right, and I hope we act

sooner than later.

Dr. Holtz-Eakin, I would like to talk to you for a minute, because

in his testimony Mr. Ross made a very good point, I thought, as

I took it. He said we have two very different sets of projections

about what is going to happen, and when.

Frankly, the fact that we have two such different projections is

making it much more difficult for us to analyze and determine how

to address this issue on a policy basis.

Why? I mean, I understand the fact that they are different because of the assumptions that are being made. But why do we have

such vastly different assumptions?

Dr. HOLTZ-EAKIN. This is a really important question, so let me

respond in two different areas. First is substance and process with

the two different projections.

First, on the substance, these are, in my view, two very highquality projections about the future of the finances of the Social Security that make different choices, in some cases, depending on the

objectives.

In our case, the CBO’s are intended to build up the 10-year projections, which provide the baseline for budget projections, so they

must marry up well with those.

They are intended to be cohesive in providing the ability to analyze Social Security from the perspective of not just program finances, but the budgetary implications and all the interactions

there, as well as economic impacts at the level of beneficiaries and

at the level of aggregate economic performance. We grow faster or

slower under different circumstances. So, our choices are driven by

that. The Social Security Administration makes different choices.

My own view is that, given the standards of science in this area,

these are essentially the same policy projections. I know numerically they differ, but there are uncertainties that prevail in the future. Both projections tell the same story to the Congress.

Importantly, with a few notable exceptions, most of the reforms

that have been considered look the same regardless of which baseline you start with, so the changes you make come out about the

same.

As a matter of process, I can speak only for CBO. We will continue to provide both. We will do the CBO projections for those interested. We can provide our mimic of the SSA, and are happy to.

It is up to Congress. There is statutory guidance on what to do in

the 10-year baseline, but there is not beyond that. So, we are going

to work with you.

What you are going to have to worry about is what the Chairman

mentioned at the outset, which is making sure that an analysis

28

provided by us or the Social Security Administration marries up

well with an evaluation of the financial condition at the end of

that. If the CBO baseline is used and the trustees agree that that

constitutes a fix, that is fine. If you use the trustees’, you have an

automatic guarantee that marries up well with theirs.

Now, I know that is a longer answer than anyone deserves on

this, but it comes up again and again and again. I think it is an

important issue to be resolved so that, going forward, the discussion is about the issues and not about the numbers.

Senator CRAPO. Well, thank you.

The CHAIRMAN. Senator Conrad?

Senator CONRAD. Well, that is a good segue into my questions because I have the same kinds of questions. I thank Senator Crapo

for asking that, because I think that is going to be increasingly

part of this debate.

Let me just say, I have grave doubts—very serious doubts—about

the underlying assumptions made by everybody here. Let me show

why.

Under the assumptions by the Social Security actuaries and by

CBO, they are saying economic growth over the next 75 years is

going to be 1.9 percent a year. That is an incredibly pessimistic

forecast. Looking at the past 75 years, economic growth has been

3.4 percent.

What happens if future economic growth was the same as past

economic growth? Well, here is what happens. Eighty percent of

this problem goes away. Eighty percent of the shortfall disappears

if we just have the same economic growth in the next 75 years that

we have had in the past 75 years.

Now, this is more than an academic question about projections,

because I have gone back now and looked at what the actuaries

told us in 1994. My colleagues, in 1994, told us there was 36 years

of solvency left. That is what their report says.

In 2005, guess what? They tell us there are 36 years of solvency

left. How can it be? Eleven years ago, there were 36 years of solvency left. Eleven years later, there are 36 years of solvency left.

It is because they completely underestimated economic growth.

Now, does this mean we do not have a problem? No. I wish it

did. But we do have a problem. We have a big problem. I just think

we have been asking, frankly, the wrong questions.

The problem we have, to me, is a budget problem. The budget

problem we have is, first of all, that the shortfall in Medicare is

7 times the shortfall in Social Security. This is much less prone to

these kinds of missed assumptions than is Social Security, at least

as I look at it, because it is driven by two things that are very likely to continue.

One is the fact the baby boomers are going to retire. They have

been born, they are out there. Also, medical inflation is running far

ahead of other inflation, and technical changes make that likely to

continue.

Second, we have record budget deficits now before the baby

boomers retire. Third, the President is proposing a tax policy that

has the cost of the tax cuts explode at the very time the baby

boomers retire. This is totally disconnected from any reality.

29

In addition, Social Security, those bonds that we talk about

which are backed by the full faith and credit of the United States,

they are real assets, but they have to be redeemed out of current

income. This is missing from this discussion.

Yes, it is true Social Security is solvent long into the future. It

is also true that it is solvent because of assets that are held in the

trust fund, and those assets are a call on the general revenues of

the United States.

When those bonds come due, they must be paid for out of current

income, so you connect the dots for the American people: massive

shortfall in Medicare; record budget deficits now; baby boomers retiring; Social Security has to be redeemed out of current income,

and we are headed for a train wreck. We are headed for a train

wreck.

But I must say, I think the assumptions on Social Security are

extremely pessimistic, and very likely to be just wrong. I would

hope that we would go back to a much more fundamental question

of the problems and challenges facing us, which are, to my way of

thinking, a budget crisis. All of these elements contribute to it.

I would ask, Mr. Ross, when I look back on this message from

the trustees, you are one of the signatories of this message to us

back in 1994, saying we had 36 years of solvency left at the time.

Do you recall that?

Mr. ROSS. Yes.

Senator CONRAD. And now they are telling us that there are 36

years of solvency left. Why do you think there was this significant

variance from what actually occurred?

Mr. ROSS. Because the projections are made on the basis of assumptions and methodologies. The assumptions change as experience changes. There are trends, there are fads in the climate of

opinion among economists, demographers, and others who are

called on. That is why we have safeguards in the system to do this

annually. Periodically, we do technical panels to check these assumptions.

One of the last ones, I was chairman of the bipartisan, independent Social Security Advisory Board, and my colleague here, Dr.

Steuerle, was the chairman of the technical panel. We had a broad

range of people in, and we looked at it. But you cannot lock it up

for all time. You have to look at it freshly.

Senator CONRAD. I agree with you. I think, given what the Congress is trying to do now because of where the President has placed

this solvency issue on the agenda, I think it should be looked at

fresh and made sure that the assumptions and methods are as

good as we can get, and that the policymakers have the best information possible to make decisions.

Let me just say, given the variance between what is projected

and what has happened, the idea of trying to do this over an infinite time horizon leaves me cold. It just strikes me as so utterly

unrealistic.

The CHAIRMAN. Senator Wyden?

Senator WYDEN. Thank you, Mr. Chairman.

Mr. George, I am very troubled by the fact that a substantial

number of extremely wealthy people are not contributing their

share on the Social Security matter. They are what I call the Social

30

Security scofflaws. That is what they are, Social Security scofflaws.

I think Senator Baucus was dead right, that you ought to go after

them first.

My question to you with respect to this substantial under-reporting is, do you believe that enforcement is all that needs to be done

in order to get this revenue, or is it also a matter of changes in

the statute to provide new tools? Let us start there.

Mr. GEORGE. Let me preface my response, Senator, by saying

when you call them ‘‘scofflaws,’’ you must remember that the law

currently allows people to make this election.

Senator WYDEN. There is no question about that, and I understand that. I still think, when you talk about this, we are talking

about a substantial number of very wealthy people. I want to know

whether you need a statutory change or whether you can do this

by enforcement.

Mr. GEORGE. Well, the basis of this is an Internal Revenue Service revenue ruling dating back to the 1950s. We believe that statutory change is required to make the changes that would allow for

the elimination of this problem, sir.

Senator WYDEN. Good.

Mr. Yin? Yes.

Mr. YIN. If I could just comment. There is an enforcement issue

because, under current law, the requirement is based on reasonable

compensation. So, it is a question of, to what extent is that being

well enforced? But that is a very difficult line to enforce.

So, I would concur with Mr. George that, as our testimony suggested, that statutory changes are needed not just in the subchapter S area, but in all of the other areas, the limited liability

companies and partnerships as well.

Senator WYDEN. That is what I mean. I think this is a very

broad kind of area, and we are going to want to follow this up with

you.

A question for you, Dr. Holtz-Eakin. Thank you for your cooperation. You have always assisted me and been very responsive. When

you brought up the question of surpluses essentially now and into

the future, you did not talk about how the continued use of the Social Security surplus for other programs in government contributes

to this problem.

Can you tell us what your judgment would be on this? Because

this is what I think most bothers the American people. I mean,

they understand the demographics. We are going to have more

older people retiring, and fewer younger people.

Yet, I think when they look back at the history from 1983, they

see that the Social Security surplus then was continually used for

other matters. So, I would like you to lay out for us just what, in

effect, the abuse of the surplus has done with respect to solvency.

Dr. HOLTZ-EAKIN. Well, I think it is central to examine this issue

in the broader budgetary context. CBO has always tried to present

that so it is clear that you can see the interactions where current

surpluses in payroll taxes and excessive benefits are showing up in

the unified budget.

In the future, any 75-year balance plan requires that they be delivered back, with interest, in the presence of these other budgetary

31

demands, Medicare and Medicaid, in particular. So I think that

perspective is central.

Number two, the economic question is whether we have, in the

process of the past 20 years, with payroll taxes and excessive benefits, managed to take that surplus and, in an economic sense, save

it by raising national saving, accumulating more in the way of

technologies and physical capital so the pie is bigger, so we can pay

for everything in the future, public and private. That is the question. I would say, on balance, the answer is no.

The government budget, with focus on current consumption and

borrowing to finance current consumption at the moment, mitigates

against that. So going forward, we have to raise national saving.

That is part of Social Security. It is also part of everything else.

We have not done that in the past.

Senator WYDEN. And you have to level with the American people.

That is what happened in 1983. The American people were told

that this was going to pre-fund the baby boomers, and it did not

happen. Yes, sir?

Dr. STEUERLE. Senator Wyden, when I give talks to the public—

and I agree with you, the public has to be engaged in this issue—

I often make an analogy to a household.

Suppose as a household I spent $100,000 and made $80,000.

Then on the side, I decided to borrow not just $20,000 to finance

my consumption, but $30,000, and put that extra $10,000 into an

account.

Then suppose I pass those debts and that account on to my children, and I tell my children, you owe me a great deal of money because of the amount that I have in the account. That is sort of the

equivalent.

The amount we have put in these Social Security trust fund accounts, which is relatively modest relative to the liabilities, is being

passed along to our children, along with a huge amount of liabilities, not just from the current deficits we are running, but from

all the promises that we have made to ourselves.

Senator WYDEN. Mr. Chairman, thank you.

The CHAIRMAN. You bet.

Senator Lott?

Senator LOTT. Thank you very much, Mr. Chairman. Thank you

to all the panel members for being here. I wish we had more time

to ask questions, but all of your testimony has been quite interesting.

Dr. Holtz-Eakin, first of all, is it accurate that the numbers do

not add up when you factor in the fact that we are living longer,

the fact that we have the baby boomers—my generation—coming,

and the fact we have huge benefit increases? We are just not going

to be able to continue on this path without there being a tremendous shortfall, right?

Dr. HOLTZ-EAKIN. Benefits, paid and promised, exceed dedicated

revenues as far as the eye can see.

Senator LOTT. It is real simple. And you know the American people have that figured out. They understand it, really. They are not

sure what we should do about it and they are not quite sure exactly when it is essential that action be taken, but they understand

that the numbers do not add up.

32

And by the way, I think most elderly people like my mother, at

92 years old, almost, is more worried about what is going to be

there for her children and grandchildren than she is about the fact

that her situation is going to be protected and she is not going to

have her benefits cut.

Is it also not just very clear, Dr. Holtz-Eakin, that the sooner we

begin to address this problem, the easier it really will be? Not that

it will be easy, but you have a longer time to lead into it. You can

take your actions where they have gradual effects rather than,

boom, a shock, and with each passing year, we get about another,

what, half a trillion dollar hit in solving the problem. Are those

statements accurate?

Dr. HOLTZ-EAKIN. Moving sooner is better from the point of view

of beneficiaries, certainly. Simply resolving the uncertainty would

be a good thing. Being able to make plans for the new system

would be a good thing.

Moving sooner is better from the government budget perspective

under the assumption that any additional surpluses you accumulate actually turn out to be economic surpluses. If they are dissipated, then you have not really gained by moving.

Senator LOTT. Right.

Let me ask you this, too. We have this Washington-speak, which

is so disingenuous, in my opinion. And I say ‘‘we’’ because we all

are guilty of it. But only in Washington, if you control the rate of

growth of benefits, is that considered a cut, even though your benefits are still going up.

So the fact of the matter is, if we go with an honest CPI—because what we have now is not honest—or if we convert to using

prices instead of wages, that benefits will not go up as fast, but will

still go up. Is that accurate?

Dr. HOLTZ-EAKIN. You can certainly run the system with different price indexes that will provide higher real benefits than people receive today.

Senator LOTT. Yes. Yes.

Dr. Steuerle, I thank you for having the courage, at least, to address this question of, thank goodness, we are living longer and we

are living better, but it is creating a huge problem for Social Security. So what do we do? You have been over it, but let me get it

real simple.

Do we go automatically to a straight age increase? Or what about

this idea, that you index it to longevity? If we wind up living now,

where the average age becomes 80, that it would automatically go

up, giving us political cover, because we can say we did not have

any hands on the steering wheel, it just automatically happened.

What about that concept?

Dr. STEUERLE. Well, Senator, if the system had been indexed for

longevity from the beginning and we had the current tax rate, we

would not be sitting here. We would be in substantial surplus and

we would not have an issue.

Senator LOTT. No question about it.

Dr. STEUERLE. The complication with starting indexing right

now, is that, by itself, it is not enough to restore solvency. The

main reason is we delayed so long. It was not just the baby

boomers coming along, which actually gave us a reprieve.

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It is the decline in the birth rate that started in the 1920s—that

temporarily stopped when the baby boomers came along, and then

came along again—that forces us, in some sense, in one generation,

to make changes we would normally make over three generations.

So to some extent, items like the increase in the normal retirement age from 65 to 67, and adjustments like that, have to take

place in addition. Just indexing, by itself, is not enough.

Senator LOTT. But if we indexed and went back to prices instead

of wages—and I was in Congress when these changes were made.

In fact, I voted against them. But I understood why we converted

to wages, because we thought it would be better for the system at

the time. Then things flipped and now it has created the problem.

But if we just did those two things, all other things being considered equal—and I know it is saying too much—we would have the

problem resolved and money left over, right?

Dr. STEUERLE. I am not sure how those two add up. I would have

to check with Doug here. But I want to say, even if we had no solvency problem, the fact that we retire people—and I tried to make

this very clear—for longer and longer still gives us an argument for

increasing the retirement age.

Senator LOTT. No question about it.

Dr. STEUERLE. The reason is that smaller and smaller shares of

benefits are going to the people who are truly old and in need.

Senator LOTT. I have been stunned that my classmates, some of

them, have been retired since they were 58.

Dr. STEUERLE. If you give the benefits back to the old, I am

saying——

Senator LOTT. Why? I think you ought to work until you cannot

work any longer, personally. But the thing about it here is, we can

solve this problem, I believe, by addressing the age question and

controlling the rate of growth of the benefits. We do not need tax

increases. I think one of the cruelest taxes of all is the payroll tax,

because it hits that working man and woman so hard.

But let me just address my last question to you, Mr. George. Is

it not a fact that the people that get hit the hardest by Social Security taxes are small business men and women? No wonder they try

to get over subchapter S. They are trying to get out of being hit

twice as hard as the average worker. Is that not true?

Mr. GEORGE. I agree, sir.

Senator LOTT. All right.

Well, I just think that my colleagues on the other side of the

aisle think the solution is just raising taxes. I think that, as the

only solution, is not acceptable, so I hope we can work with that

viewpoint in mind.

Thank you, Mr. Chairman.

The CHAIRMAN. The Senator from Arkansas.

Senator LINCOLN. Thank you, Mr. Chairman.

I do not know where that last one came from, Senator Lott,

about raising taxes, but we are all looking for some plausible solutions of how we maintain a program that has meant so much to

so many.

So, Mr. Chairman, we thank you for bringing us together once

again to discuss this really important issue.

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I want to thank all of our panelists. Our great Nation is faced

with a number of economic challenges, including, but definitely not

limited to, Social Security. I think you all have made some inferences in some of your comments, but I strongly believe that this

debate is about more than Social Security.

It is certainly about the budget and the economy. It is about

Medicare and Medicaid. Certainly, the issue that the President and

others want to continue to borrow from the Social Security trust

fund for things other than Social Security, we have all been guilty

of that.

Some of the most recent have been very large tax cuts. It is

wrong, and the people of this country know it. The debate is really

about setting priorities. My priorities are to ensure that Arkansas

and its people, and other people across this country, have the retirement security that they need to live their lives with dignity,

and certainly minimize the burden to future generations.

So, we applaud you all for being here and working with us, and

I applaud the Chairman and Senator Baucus. I certainly look forward to working with him towards the end of finding those answers.

Dr. Holtz-Eakin, the Congressional Budget Office has put many

options on the table to address Social Security solvency, and these

options would generate a large amount of money for Social Security, certainly a program that will be able to pay 75 to 80 percent

of its promised benefits beyond 2041 or 2052, wherever you want

to choose.

On the other hand, the Medicare trust fund is predicted to be exhausted by 2020, over 20 years earlier than Social Security, which

is, I think, clearly a more imminent concern for us, is this financial

crisis for Medicare.

Has CBO put any options on the table to address Medicare?

Dr. HOLTZ-EAKIN. We do not have a comparable menu for the

Medicare program——

Senator LINCOLN. Do you intend to get one together?

Dr. HOLTZ-EAKIN. [Continuing]. That reflects both our focus on

Social Security at the moment, Senator. But also, there is a big difference between the two programs in the research community. Social Security is a program that is, by and large, well understood.

The menu that has been provided by the research community is

much deeper and broader. The program is simpler in the sense that

it is just money. I do not mean that in a cynical fashion.

Senator LINCOLN. I think you are right, though. It is much easier.

Dr. HOLTZ-EAKIN. The source of the problem in Medicare is rising health care costs in excess of the growth of the economy as a

whole, and that is less well understood.

The diagnosis is not as clear. Is it higher quality, in some cases?

Administrative costs? Over-utilization? All those aspects. As a result, the menu of solutions is thinner. We do not have the same

consensus. We certainly look forward to working with you on it, but

it is a harder problem.

Senator LINCOLN. Good. Well, I hope we will, because I do think

that, because it is a harder problem and the solutions are not as

easy to come up with, and the problem that exists with Medicare

35

comes sooner than Social Security, that we will focus some time on

that. Because, clearly, if those solutions are harder to find and it

is a much more intricate problem, we are going to have to devote

some serious time to it. I hope that we will.

I guess I would like to address this to Dr. Holtz-Eakin as well,

but any of you others can answer. I think some of you already

have. It, a little bit, has to do with the assumptions that Senator

Conrad brought up.

But there was a recent article in Business Week that asserts that

Social Security’s problems are economic and not demographic. As

we know, in 1983 the Social Security Commission knew that the

Nation was going to be faced with some big demographic changes,

but the article says that there were two things that the commission

could not anticipate: the growth of average U.S. wages slowing

down and the income inequality rising very sharply.

I guess, Dr. Holtz-Eakin, you did not really answer that question

in terms of these assumptions on economic growth that we are assuming in much of what is being talked about in Social Security

being much larger than what they have historically been.

Dr. HOLTZ-EAKIN. Let me say a couple of words about that. The

pieces that you need to do a projection of this sort are numbers of

bodies and how much income you get per body, the productivity of

those workers. The dominant difference between the past and the

future is simply the growth in the number of bodies.

Over the past 30 years, there has been a growth of 60 percent

in the covered workers in the system. Going forward, there is going

to be a growth of 15 percent, and that is due to the demographics.

So, the total growth rate of the economy is driven, to a great extent, by demographics. Much of that is baked in the cake. The piece

that is not, is immigration, the source of real population growth

going forward, which will depend, in many cases, on policy and economic development. So, first, is bodies.

The second is productivity of those workers and what they will

earn in wages as a result. Part of that is just pure technology. I

do not think anyone is projecting a diminishment of the U.S. technological prowess going forward, so that part I would expect to remain quite strong. We have that in our projections.

The next piece is national saving and the accumulation of the resources to train people, buy factories, give them better equipment.

That is a wild card, the degree to which we save as a Nation and

equip those workers.

Given that none of this is for sure, what we have tried to do is

display the range of uncertainty in our projections, to be quite honest about it. The hope is to give that to you, not as an acknowledgement of our broad incompetence as a profession, but instead to indicate those situations where solutions are robust to the way things

actually pan out versus those where they are very knife-edge, and

steer away from those that rely heavily on particular assumptions.

Senator LINCOLN. Absolutely.

Dr. STEUERLE. Senator Lincoln, as Stan Ross mentioned, I

chaired a technical panel where we examined these issues. And one

of the points that was hard to make, but we tried to make very

strongly, was that when policy makers address Social Security,

36

they do not just need to target some very long-run average benefit

or average actuarial balance. They can also target the uncertainty.

The reason Social Security and Medicare, as you mention, are

very different from other programs we have as a Federal Government is that these are the primary ones where we promise increased levels of benefits for 75, 100, 200 years in the future.

It is not that we could not also project educational spending for

200 years in the future. But you do not as a Congress index teachers’ salaries for wages, and you do not have them automatically

grow. So what happens is, we put only a select group of programs

on automatic pilot.

With automatic growth, we do not give other programs a level

playing field. We put other programs at a severe disadvantage in

the budget process. Then we force our estimators to estimate the

cost of our promises.

Well, they will not estimate educational spending 20 years from

now because it is not in the budget. But we do have promises for

Social Security 20 years from now.

The point I am trying to make is that we can reduce that uncertainty. For instance, if we are not certain about how long people

are going to live, we can index for life expectancy.

If we are not certain about the economy, we can index so that

the system does certain things as the economy changes. If economic

growth provides additional reprieve to the system, then we can increase the rate of benefit growth. In effect, we can actually target

uncertainties in designing policy.

That is what we have not done in Social Security, and to a larger

extent, Medicare. I just want you to remember that you can actually target reducing the uncertainty so that future economic and

demographic changes do not constantly force you back to the table.

Senator LINCOLN. I want to make sure I am clear on what I am

hearing you say. You are indicating that it is less economics and

more demographics.

Dr. STEUERLE. Well, it is more demographics, as Doug HoltzEakin just mentioned, because the drop in workers-to-retirees from

3 for 1 to 2 for 1 is a demographic push, it is not economics.

Economics can help you a little bit in terms of economic growth.

The problem is, economic growth increases benefits in a wage-indexed system, so when you get more economic growth, you also get

more benefits.

Senator LINCOLN. Is that same demographic, though, not very

prevalent in the fact that you are seeing a sharp increase or a rise

in income inequality? That kind of highlights that demographic

that you are talking about.

Dr. STEUERLE. You could target the income inequality as well by

saying that you are going to have the wage base adjust over time

so it covers 90 percent of the wages; if the income becomes more

unequal, then you are going to have the wage base still grow. You

can also target the issues that the two gentlemen at the end of the

table mentioned in terms of the wage base.

There are two reasons why the wage base in Social Security has

become worse over time. One is increasing inequality, and one is

because we have a constant increase in the share of compensations

37

not subject to tax. We could change those laws so those things did

not occur.

What I am indicating is that, in almost all these areas of uncertainty, we can actually target them. It would leave the system

more in balance over time. Even if you left it at the current level

of 1 percent or 2 percent of taxable payroll, 75-year actuarial imbalance, we could reduce the uncertainty around that. If you want

a target of zero percent, we can reduce the uncertainty by dealing

with all these issues.

Senator LINCOLN. It just seems like there is more involved there

than what we have actually been targeting as it is.

A couple of last questions.

The CHAIRMAN. Your time is up.

Senator LINCOLN. Oh. Are we going to have another round?

The CHAIRMAN. Yes.

Senator LINCOLN. All right.

The CHAIRMAN. Sure. We will give you all the time you want.

Senator Baucus will give you all the time you want. [Laughter.]

I want to focus on an argument that I sometimes hear, and we

have heard it this morning, about solving the Social Security financial problems by closing the tax gap and dedicating those revenues

to Social Security.

I am very interested in closing the tax gap. Senator Baucus and

I have worked together on the tax gap. Last year, Mr. Yin, we

wrote you a letter asking you to report to this committee on ways

to reduce the tax gap. You reported back to us with a variety of

proposals.

Some of those proposals were aimed at improving tax compliance,

some really were aimed more at what I call tax reform rather than

the tax gap, in the truest sense of the word. Many of the proposals

could be very, very controversial with members, even on both sides

of the aisle.

But in any event, let us just assume that all of those proposals

were enacted in law. How much revenue would that bring into the

Federal Government? You can use the 10-year figure, but an average annual figure, I think, is a good basis, too.

Mr. YIN. Mr. Chairman, I do not remember the figure offhand.

Bear in mind that we did not estimate the package of proposals together, so that we did not measure the potential interaction. We estimated each of the independent items in isolation from all of the

others, so it would not necessarily be the sum total.

The CHAIRMAN. It would not be the $300 billion over 10 years?

Mr. YIN. I believe the sum total was somewhere in the range of

$400 billion over 10 years, but that is correct, sir.

The CHAIRMAN. So $30 billion a year, which would go a long

ways from closing this problem we have with Social Security. I

mean, it would fall way short of the problem we have identified

here today.

Mr. YIN. Well, of course, it depends on what your target is. I

mean, from where I come from, that is still not chump change. But

I understand what you are saying, sir.

The CHAIRMAN. All right.

I would like to follow up with you, and to expand a little bit on

this question and drill down some of the specific proposals, because

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too many members seem to think the tax gap is like ripe fruit on

the ground waiting to be just picked up.

You mentioned one of these would be repealing the mortgage interest deduction on home interest loans. Another one would be subjecting State and local workers to the Medicare tax. One would be

subjecting workers to use cafeteria and other fringe benefits to pay

the payroll tax on those, or allowing offshore activities of U.S. companies to be exempt from tax.

I know that members on both sides of the aisle, Republicans and

Democrats, who would have serious concerns with those proposals.

I am sure that many here would not endorse them. Most of the

other proposals in the Joint Committee report generate similar controversy.

Just focusing on these four proposals, however, how much of the

number—well, you could not remember, but I thought it was in the

neighborhood of $300 billion—is reflected in these four proposals,

which would be the total revenue impact of all the proposals in

your report, minus these four?

Mr. YIN. Again, Senator, I do not have that number. And probably just to clarify, the proposal on mortgage interest only related

to home equity loans. It did not affect your mortgage on your principal residence, but it did involve a curtailment of the deduction on

home equity borrowing.

The CHAIRMAN. I did not realize that we have a vote right now.

Senator BAUCUS. Mr. Chairman, I will just defer to our colleague

from Arkansas, if she wants to ask some questions. I have no more

questions.

Senator LINCOLN. I just had two quick questions.

The CHAIRMAN. Do not forget to go vote.

Senator LINCOLN. No, no. I will not. I will not.

The CHAIRMAN. Because I am not going to be here to remind you.

Senator LINCOLN. All right. Well, thank you. Thank you, Mr.

Chairman. I will be very brief.

The CHAIRMAN. Thank you all very much on the panel.

Senator BAUCUS. This was a thoughtful discussion. Mr. Chairman, I thank you for allowing the witnesses to go beyond the customary 5-minute rule, because I think it helped us think this

through a little more thoughtfully, and I thank you very much. You

all have been very good, and I appreciate it.

Senator LINCOLN. I agree with those two gentlemen.

Dr. Steuerle, you mentioned about allowing people in the workforce longer, allowing them to continue their productivity. We had

a great hearing on that in the Aging Committee, a lot of good testimony about that. But has anybody studied what that does to unemployment?

Dr. STEUERLE. Most economists do not accept the notion that if

an elderly person works longer, he or she in some sense is taking

away a job from a younger person. The reason is fairly simple. If

I work longer and I make $50,000, it means I am producing

$50,000 for the economy and I am $50,000 richer. If I go out and

I buy other goods and services, then I create a demand for $50,000

of goods and services that somebody else must produce.

Senator LINCOLN. So there has been a universal understanding

or something that this is not going to have an impact?

39

Dr. STEUERLE. In the Depression, there was an argument that

Social Security needed to retire people early so they could create

jobs for young people. I should say, by the way, we did not get out

of the Depression until we got into World War II.

Senator LINCOLN. All right.

I think, Mr. Yin and Mr. George, I just have to believe that increasing enforcement can happen without increasing taxpayer education. So, only focusing on the enforcement, I feel like, is somewhat short-sighted and can result really in our taxpayers not getting the services and the information that they need.

Do you agree that if in fact what we need to do is to crack down

and make sure that we are doing a better job in the collection of

that, that we also need to do a better job in educating, getting

them the tools that they need to comply with increased enforcement?

Mr. YIN. Senator Lincoln, I think that better taxpayer information is always useful, but I think the laws do have something to

do with it. If the laws are written in a way that does not require

a lot of taxpayer information or a lot of taxpayer compliance obligations, that facilitates the collection task for everybody. It facilitates

for the taxpayer, it facilitates for the enforcement agency.

So I think that the design of the law is a critical piece of the puzzle. That said, obviously, given the laws that we have, taxpayer information is certainly an important issue.

Senator LINCOLN. Thanks, Mr. Yin.

Mr. GEORGE. Senator, I agree with what Mr. Yin stated. Once

again, what the report that we issued today deals with is a legal

loophole in the tax law. So whether or not education is the issue

here, I am not sure, but overall, of course, an informed populace

is a better populace in terms of making decisions.

Senator LINCOLN. That is the largest complaint we usually get

up here, is that we just willy-nilly enact laws and then we forget

they have to be implemented on a local level. Without an educational component, oftentimes there is a lot that is not there.

There are a couple of minutes left, and I want to make sure the

Chairman knows I do not miss the vote.

Thank you all very much for participating. We are grateful for

your expertise and sharing that with us. Thank you.

I will adjourn the committee.

[Whereupon, at 12:12 p.m., the hearing was concluded.]

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