Today, the Social Security program does not face an immediate crisis, but it does face a long-range financing problem driven primarily by known demographic trends that is growing rapidly. While the crisis is not immediate, the challenge is more urgent than it may appear. Acting soon to address these problems reduces the likelihood that the Congress will have to choose between imposing severe benefit cuts and unfairly burdening future generations with the program’s rising costs. Acting soon would also allow changes to be phased in so that the individuals who are most likely to be affected, namely younger and future workers, will have time to adjust their retirement planning while helping to avoid related “expectation gaps.” On the other hand, failure to take remedial action will, in combination with other entitlement spending, lead to a situation unsustainable for both the federal government and, ultimately, the economy. The Social Security system has required changes in the past to ensure future solvency. Indeed, the Congress has always taken the actions necessary to do this when faced with an immediate solvency crisis. I would like to spend some time describing the nature, timing, and extent of Social Security’s financing problem. As you all know, Social Security has always been a largely pay-as-you-go system. This means that the system’s financial condition is directly affected by the relative size of the populations of covered workers and beneficiaries. Historically, this relationship has been favorable. Now, however, people are living longer, and spending more time in retirement. As shown in figure 1, the U.S. elderly dependency ratio is expected to continue to increase. The proportion of the elderly population relative to the working-age population in the U.S. rose from 13 percent in 1950 to 19 percent in 2000. By 2050, there is projected to be almost 1 elderly dependent for every 3 people of working age—a ratio of 32 percent. Additionally, the average life expectancy of males at birth has increased from 66.6 in 1960 to 74.3 in 2000, with females at birth experiencing a rise of 6.6 years from 73.1 to 79.7 over the same period. As general life expectancy has increased in the United States, there has also been an increase in the number of years spent in retirement. Improvements in life expectancy have extended the average amount of time spent by workers in retirement from 11.5 years in 1950 to 18 years for the average male worker as of 2003. A falling fertility rate is the other principal factor underlying the growth in the elderly’s share of the population. In the 1960s, the fertility rate was an average of 3 children per woman. Today it is a little over 2, and by 2030 it is expected to fall to 1.95—a rate that is below what it takes to maintain a stable population. Taken together, these trends threaten the financial solvency and sustainability of this important program. The result of these trends is that labor force growth will continue to decline in 2006 and by 2025 is expected to be less than a fifth of what it is today, as shown in figure 2. Relatively fewer U.S. workers will be available to produce goods and services. Without a major increase in productivity or increases in immigration, low labor force growth will lead to slower growth in the economy and to slower growth of federal revenues. This in turn will only accentuate the overall pressure on the federal budget. This slowing labor force growth has important implications for the Social Security system. Social Security’s retirement eligibility dates are often the subject of discussion and debate and can have a direct effect on both labor force growth and the condition of the Social Security retirement program. It is also appropriate to consider whether and how changes in pension and/or other government policies could encourage longer workforce participation. To the extent that people choose to work longer as they live longer, the increase in the amount of time spent in retirement could be diminished. This could improve the finances of Social Security and mitigate the expected slowdown in labor force growth. The Social Security program’s situation is one symptom of this larger demographic trend that will have broad and profound effects on our nation’s future in other ways as well. The aging of the labor force and the reduced growth in the number of workers will have important implications for the size and composition of the labor force, as well as the characteristics of many jobs in our increasingly knowledge-based economy, throughout the 21st century. The U.S. workforce of the 21st century will be facing very different opportunities and challenges than those of previous generations. Today, the Social Security Trust Funds take in more in taxes than they spend. Largely because of the demographic trends I have described, this situation will change. Although the trustees’ 2004 intermediate estimates project that the combined Social Security Trust Funds will be solvent until 2042, program spending will constitute a rapidly growing share of the budget and the economy well before that date. Under the trustees’ 2004 intermediate estimates, Social Security’s cash surplus—the difference between program tax income and the costs of paying scheduled benefits— will begin to decline in 2008. By 2018, the program’s cash flow is projected to turn negative—its tax income will fall below benefit payments. At that time, the program will begin to experience a negative cash flow, which will accelerate over time. Social Security will join Medicare’s Hospital Insurance Trust Fund, whose outlays exceeded cash income in 2004, as a net claimant on the rest of the federal budget. (See figure 3.) In 2018, the combined OASDI Trust Funds will begin drawing on its Treasury securities to cover the cash shortfall. At this point, Treasury will need to obtain cash for these redeemed securities either through increased taxes, spending cuts, and/or more borrowing from the public than would have been the case had Social Security’s cash flow remained positive. Whatever the means of financing, the shift from positive to negative cash flow will place increased pressure on the federal budget to raise the resources necessary to meet the program’s ongoing costs. There are different ways to describe the magnitude of the problem. A case can be made for a range of different measures, as well as different time horizons. For instance, the actuarial deficit can be measured in present value, as a percentage of GDP, or as a percentage of taxable payroll in the future. The Social Security Administration (SSA) and CBO have both made projections of Social Security’s future actuarial deficit using different horizons. (See table 1.) CBO uses a 100-year horizon to project Social Security’s future actuarial deficit, while the Social Security Administration utilizes both 75-year and infinite horizon projections to estimate the future deficit. In addition, both the Social Security Administration and CBO have different economic assumptions for variables such as real earnings, real interest rates, inflation, and unemployment. While their estimates vary due to different horizons and economic assumptions, each identifies the same long-term challenge: The Social Security system is unsustainable in its present form over the long run. Taking action soon on Social Security would not only make the necessary action less dramatic than if we wait but would also promote increased budgetary flexibility in the future and stronger economic growth. Some of the benefits of early action—and the costs of delay—can be seen in figure 4. This figure compares what it would take to keep Social Security solvent through 2078, if action were taken at three different points in time, by either raising payroll taxes or reducing benefits. If we did nothing until 2042—the year SSA estimates the Trust Funds will be exhausted— achieving actuarial balance would require changes in benefits of 30 percent or changes in taxes of 43 percent. As figure 4 shows, earlier action shrinks the size of the necessary adjustment. As I have already discussed, reducing the relative future burdens of Social Security and health programs is essential to a sustainable budget policy for the longer term. It is also critical if we are to avoid putting unsupportable financial pressures on Americans in the future. Reforming Social Security and health programs is essential to reclaiming our future fiscal flexibility to address other national priorities. Changes in the composition of federal spending over the past several decades have reduced budgetary flexibility, and our current fiscal path will reduce it even further. During this time, spending on mandatory programs has consumed an ever-increasing share of the federal budget. In 1964, prior to the creation of the Medicare and Medicaid programs, spending for mandatory programs plus net interest accounted for about 33 percent of total federal spending. By 2004, this share had almost doubled to approximately 61 percent of the budget. If you look ahead in the federal budget, the Social Security programs (Old- Age and Survivors Insurance and Disability Insurance), together with the rapidly growing health programs (Medicare and Medicaid), will dominate the federal government’s future fiscal outlook. Absent reform, the nation will ultimately have to choose among persistent, escalating federal deficits and debt, huge tax increases and/or dramatic budget cuts. GAO’s long-term budget simulations show that to move into the future with no changes in federal retirement and health programs is to envision a very different role for the federal government. Assuming that discretionary spending grows with inflation and all existing tax cuts are allowed to expire when scheduled under current law, spending for Social Security and health care programs would grow to consume over three-quarters of federal revenue by 2040. Moreover, if all expiring tax provisions are extended and discretionary spending keeps pace with the economy, by 2040 total federal revenues may be adequate to pay little more than interest on the federal debt. (See figure 5.) Alternatively, taking action soon on Social Security would not only promote increased budgetary flexibility in the future and stronger economic growth but would also make the necessary action less dramatic than if we wait. Indeed, long-term budget flexibility is about more than Social Security and Medicare. While these programs dominate the long- term outlook, they are not the only federal programs or activities that bind the future.