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Social Security: Drifting Off Course (Fortune, 1967)

November 20, 2011, 8:00 PM UTC

Editor’s note: Every week, publishes a favorite story from our magazine archives. This week, as the bi-partisan super committee faces a deadline to find ways to cut the deficit by $1.2 trillion, we take a look back at one of the programs that’s on the table: Social security. As this 1967 Fortune story shows, the “swollen system” has been a political hot-button issue for decades.

The benefits are rising but so is the tax burden, and there’s a question whether the swollen system is relevant to a modern America’s needs.

By Dan Cordtz

FORTUNE — Very few politicians have cared to challenge the assertion of Dr. Paul A. Samuelson, the M.LT. economist, that “social security is, by all odds, the most successful program of the modern welfare state.” And small wonder. No other program has given so much to so many. Every month the Treasury mails out some 15,600,000 checks ranging from $16.50 to $368–a total of $20 billion a year in benefit payments. Nearly one American in eight receives some financial support from the system; it provides half the income received by those over the age of sixty-five. The system’s political invulnerability is demonstrated repeatedly. Just recently, members of both the House of Representatives and the Senate have overwhelmingly supported legislation to liberalize benefits.

And yet in the last year or two a new current has emerged in public discussion of social security. The almost reverent tone once adopted ritualistically in such discussion is heard less often. One reason for the change seems to be demographic: recently, about 2,200,000 Americans have been entering the labor force in a typical year, while only 675,000 have been retiring under social security annually. As those millions of young workers reduce the average age of the labor force, they also reduce the numbers of Americans who view social security mainly in relation to its benefits. A young man in his twenties is more likely to think of the program as a tax than as a benefit. Meanwhile, the natural tendency of younger people to be more concerned about taxes than about benefits they may receive far in the future has been fortified by the series of steep increases in social security taxes–and the future steep increases now projected.

When collections began in 1937, no worker paid more than $30 a year into the Old-Age and Survivors Insurance trust fund. Now the maximum tax has reached $257 and Congress has been working on legislation to increase this figure to $540 a year. Since no exemptions are allowed, a middle-income family with several children and a substantial home mortgage might find its social security deductions as formidable as its federal income tax. Most legislators are confident that voters will accept a high level of social security taxes, because everyone can hope for a direct return on his money someday. But members of Congress admit that they are starting to hear grumbles.

Taking a closer look

Until recently, few Americans had really paid much attention to the social security tax. They have been largely unaware of the fact that, overall, 18 percent of all federal taxes are raised through the social security system. But as they begin to focus on it, they may well conclude that social security taxes–and the system itself—have become less equitable as they have grown over the years. There are, in fact, a number of reasons for concern:

–In a country that is firmly committed to the principle of progressive taxation, these taxes are highly regressive–i.e., the poor pay a higher proportion of their incomes than the well-to-do. And the taxes are likely to become still more regressive. Income levels probably will continue to rise faster than the ceiling on taxable earnings, so that relatively fewer Americans will be taxed on all their wages.

–The trust funds from which benefits are paid are expected to play a large fiscal role–a deflationary one–over the next decade. Under the present tax benefit schedule, receipts might exceed benefits by some $100 billion in this period, with the surplus to be squirreled away in special government bonds. Thus the program will create a “fiscal drag,” as, indeed, it has at various times in the past. To be sure, Congress may elect to eliminate this drag by redistributing the surplus in the form of higher benefits. But that would exacerbate another problem associated with the system.

–The problem is that social security is a very inefficient and unfair way to redistribute income. Instead of redistributing income from the prosperous to the needy, the system now gives to the aged poor and the aged rich alike, principally at the expense of younger, middle-income families. And social security of course, does nothing at all for some of the poor–those who, because of one handicap or another, have not been employed most of their working years and cannot qualify for benefits even under the liberalized eligibility rules.

–Finally, some proposals for raising benefits pose a threat to the private pension schemes on which a growing number of Americans now depend for retirement at more than a subsistence level. The proposed heavy taxes, on employers as well as workers, could preempt the resources available to purchase more flexible and individually satisfactory pensions.

Some reasons for strain

These considerations are leading a growing number of economists and welfare experts, some of them inside the U.S. Government, to propose changes in the system. Late last month the Joint Economic Committee of Congress published the first three volumes of a compendium of more than sixty scholarly papers written in response to its 1966 staff study, “Old Age Income Assurance: An Outline of Issues and Alternatives.” Although the proposals range across the spectrum, in one way or another most of them suggest that new methods be found to pay for some of social security’s costs. The Brookings Institution next year will publish a book that also argues for changes in the way the system’s benefits are financed.

From one point of view, there is no reason to be surprised that the system is showing signs of strain. It wasn’t really very sophisticated in the first place–especially in comparison with some social-insurance schemes that had existed for years in European industrial countries. (Germany launched the first contributory, wage-related old-age pension system under Bismarck in 1889.) The U.S. program was an ad hoc response to the worst depression in the nation’s history. The major concern of most of the planners that President Franklin D. Roosevelt brought to Washington was to find a way to provide an immediate source of income for those temporarily unemployed–not a permanent source of income for retirees.

Their efforts to aid the unemployed resulted initially in a nationwide, state-administered system of unemployment compensation. But the political threat of the Townsend Plan (which proclaimed a goal of $200 a month for every citizen over sixty) was hanging overhead, and so one small group of New Dealers was asked to come up with something for the old folks. They were given no detailed instructions, and carried out their work almost ignored by higher government officials, recalls Dr. J. Douglas Brown, now economics dean emeritus at Princeton and then one of the three members of the advisory committee that framed the legislation. The program they devised, later enacted almost without change by Congress–it became law in August, 1935–was a wage-related old-age pension for retired industrial and commercial workers to be supported by a specially earmarked payroll tax levied equally on workers and their employers.

From the start, Brown says, the scheme was jerrybuilt. He and his colleagues gauged what they could hope to get enacted and planned to improve and broaden it later. In fact, the politicians began tinkering with the benefit structure even before the first payments were made four years later. The original program, anything but a comprehensive and completely worked-out system of social insurance, was filled with compromises. For the architects were faced with a difficult problem of national attitude. Not even the trauma of the depression had overcome the Puritan strain in the American ethos, which held to the precept that hard work and thrift would always be rewarded and that turning to public charity–even in times of general economic disaster–was a disgrace. Even those who most needed help were unwilling to accept a permanent pension system that smacked of a government dole. And so the plan was packaged as one whose chief aim was, not relief for needy older Americans, but “insurance” for all. It was designed to provide only limited retirement protection and assumed that each beneficiary, by paying for his own pension over his working years, could accept his payments in old age with head held high.

How social is social insurance?

The New Deal social planners were shrewd judges of national psychology and political reality. But in emphasizing “insurance,” they immediately encountered a large practical difficulty. Any rigid adherence to the usual rules of the insurance business–in which size of pensions is related strictly to size of contributions–would make it impossible to carry out the immediate social requirements, i.e., help for the elderly poor. And only if the date for beginning pensions was put off far into the future could early retirees possibly contribute enough money to justify even a minimal benefit level.

Thus the insurance concept was compromised to attain social objectives. A large share of the employers’ contributions was assigned to subsidizing the near-term benefits. For the longer run, moreover, a minimum benefit with any economic meaning could never truly be “paid for” by the taxes on a worker with low wages. His contributions would be small, yet precisely because his wages were low his pension could not be much lower if he was to have enough to live on. Accordingly, the benefit scale was weighted heavily in favor of low-wage workers and, from the outset, they got back much more in relation to their tax contributions than did better-paid employees.

Such an arrangement was quite defensible, of course. Supporters of the system point out that, even in private pension plans, heavy company contributions are frequently made to finance benefits for workers who retire soon after the programs are established. They also argue that in social insurance the “social” aspect is just as important as the “insurance.” But with every upward shift of the benefit level, the connection between contributions and benefits has become more tenuous; indeed, one can fairly describe the continued official emphasis on social security’s wage-related character as little more than a politically useful fiction.

Of all the hard facts about social security nowadays, probably the most difficult to justify is the fact that the taxes soak those of moderate means more heavily than they do the rich. A married man with four children earning $5,000 a year now pays a tax equivalent to 3.9 percent of his gross income. A bachelor earning $50,000, on the other hand, is charged only 0.5 percent of his income. When the social security tax was first collected thirty years ago, its regressive character was much less pronounced. Although the levy applied to only the first $3,000 of income, that figure took in the entire earnings of 97 percent of those covered. Today, with the taxable wage base set at $6,600, only 75 percent of American workers pay social security taxes on their entire income. Even under the Administration’s recent proposal to raise the base to $10,800 by 1974, just 87 percent of all workers would be taxed on all their wages.

There is no longer much argument about the proposition that social security may have significant fiscal effects. These effects were, of course, quite unforeseen by the system’s designers. But given the size of the system today, and given the public’s manifest uneasiness when the trust funds pay out more than they take in, they tend to run surpluses arid so tend to restrain the economy in most years. This year, for example, the system will extract about $25.3 billion in taxes and pay out about $21.5 billion in benefits, which means that Americans will have had about $3.8 billion less to spend this year than they otherwise would have had. Since this has been an inflationary year, it might be argued that the restraint was desirable. In fact, during last month’s Senate debate on social security, it was argued–by those wishing to raise benefits–that the government should continue this fiscal restraint early in 1968 by raising taxes even more sharply than it raised benefits; some Senators contended that the higher social security taxes could serve as a substitute for the proposed 10 percent income-tax surcharge.

Aside from the rather special current situation, those who support the system claim that in general it has a desirable countercyclical tendency, helping the economy when it is weak and dampening it when it seems too explosive. The argument is that in a weak economy taxes decline because payrolls fall, while benefits rise because marginal workers retire and begin to collect pensions; in a strong economy, both tendencies are reversed.

But some economists who have studied the system feel that it is too rigid and cumbersome to be used directly as an effective tool in fiscal policy. In a 1966 study, “Some Fiscal Implications of Expansion of the Social Security System,” Nancy H. Teeters (then of the Federal Reserve Board staff) describes social security taxes as “the least responsive to changes in aggregate income” and warns that by increasing them “we will be limiting the built-in flexibility of the federal revenue system.” From the fiscal point of view, she wrote, it would be desirable to make the tax “more responsive to changes in economic conditions.” (Mrs. Teeters also wanted to make the tax less regressive.) While there is some countercyclical effect, it seems clear that on balance the tax has a strong deflationary tendency. According to current contribution-benefit schedules, the system is expected to remove $100 billion from the economy over the next decade; the sum would pile up in the O.A.S.I. trust fund. In its 1965 report, the government’s Advisory Council on Social Security expressed concern over “the deflationary effect of the present contribution schedule in the years just ahead” and urged “a large reduction in the size of these accumulations.” In short, those fiscal effects are not so desirable.

[caption id=”attachment_7558″ align=”alignnone” width=”612″ caption=”From the beginning, social security has given the low-income worker considerably greater retirement benefits in proportion to his contributions than it has the higher-paid worker. Initially, the disparity in the proportions wa