Wednesday, December 19, 2012

Thoughts on the Fiscal Cliff and the Social Security COLA.

Thoughts on the fiscal cliff and the Social Security COLA

The Obama Administration has agreed to change the Social Security COLA as part of a fiscal cliff deal.  Specifically, the Obama Administration proposal will link future inflation-related adjustments to Social Security benefits to the chained CPI rather than the traditional CPI.  The growth in the chained CPI is smaller than the growth in the traditional CPI because the chained CPI more quickly incorporates information on substitution between goods.   

This is a really complex and important decision with implications for the long term fiscal outlook, the future of the Social Security system, and the financial status of elderly Americans.

Here are my thoughts:

1.       Tax rates are often revisited. The fiscal cliff negotiations are the result of the scheduled expiration of the Bush Tax rates.  The tax rate on top earners could be revisited in 2014 if the Republicans win the Senate.  I do not anticipate an event leading to the reconsideration of a change in the Social Security COLA.  The change in the Social Security COLA formula is likely to impact all future cohorts of Social Security beneficiaries. 

2.       The impact of changes in the COLA on benefits is cumulative.  The one-year reduction in benefits from the new formula is trivial, the cumulative effect large.  There would be a 7% reduction in benefits from the new formula assuming a 2.0% annual growth rate in the traditional CPI and a 1.7% annual growth rate in the chained CPI for 23 years.  The long-term dollar impact of the COLA change on benefits could be larger if the differential between the growth of the traditional and chained CPI grow.

3.       It will take four decades before the impact of the new rule fully determines the adjustment in Social Security benefits for all beneficiaries.  The annual budget savings from this policy change will grow throughout this time period.

4.       The final rule may allow some lower income, disabled, or older household to receive a larger COLA based on the traditional CPI rather than the chained CPI.  The effectiveness of the exceptions in protecting future cohorts from financial hardship depends on the details of the new rule.  However, many elderly households have large medical bills at some point in their life.  The income and wealth of these households will be lower because of the lower benefits received prior to the exigent circumstance.  The proposed change in the COLA formula will increase the poverty rate for elderly Americans.  It would be useful to have unbiased estimates of the proposed rule change on poverty.

5.       The change in the COLA formula provides a slow but sustained reduction in government debt.   It moves the nation towards a more sensible fiscal structure in the long term without imposing a large contraction on an economy where GNP growth is fairly weak. This proposal would be highly desirable if achieving a balanced pro-growth fiscal policy was the only consideration.  

6.       Under current law, absent changes in Social Security funding or benefits there will be an automatic reduction in benefits once the trust fund has insufficient funds to pay full benefits.  This change to the COLA will delay, but not eliminate, the need to reduce Social Security payments in the future.  A more complete assessment of the merits of the proposed change in the COLA requires more information about the proposed impact of the change in the COLA on future solvency.

7.       The change in the COLA does little to insulate the Social Security system from political pressure from future reductions in benefits.  Critics of the current Social Security system will still favor reductions in benefits and privatization even though the replacement rate of the current Social Security benefit is very low and Social Security is the only defined benefit plan and source of disability income for most workers. 

8.       Many, but certainly not all, economists believe that changes in the CPI overstate the cost of living.  I am in the camp of economists who believes that changes in the CPI do NOT overstate inflation.  There is in fact substantial evidence indicating that inflation is higher than official numbers. Future blogs consider some of the studies on the CPI bias.

Concluding Thoughts:  The decision by the Obama Administration to include a permanent change to the Social Security COLA as part of an annual budget exercise is a really large concession.  The change in the COLA is sensible fiscal policy but it will increase poverty among elderly Americans and will not protect the Social Security system from demands for future cuts.

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