In his 1998 State of the Union Address, President Clinton explained that "if we balance the budget for next year, it is projected that we'll then have a sizeable surplus in the years that immediately follow." Clinton then asked, "what should we do with this projected surplus?" In January of this year, the Congressional Budget Office (CBO) supported Clinton's statement by projecting that federal surpluses will total nearly $2.6 trillion between 2000 and 2009~, which further inspired the already intense debate between policymakers over the best answer to Clinton and the country's pressing question.

Before evaluating the potential policies concerning the surplus, it is first necessary to understand the nature and source of the surplus. Tax increases in Bush and Clinton's deficit reduction packages in 1990 and 1993 respectively, enhanced the government's fiscal status. As Alan Auerbach and William Gale explain in their article. "The Case Against Tax Cuts:"

This robust economic growth led to reduced spending and increased revenues (from 1992 to 1998 spending decreased by 2.9 percent of GDP while revenues increased by 2.8 percent) which has led us to the current surplus of $71 billion. The surplus is calculated from the difference between the $99 billion in the Social Security Trust Fund and the $28 billion current budget deficit. By the year 2008, the Trust Fund component of the surplus is projected to grow to $1.6 trillion while the on-budget surplus is expected to rise to $800 billion. There is a general consensus among policymakers, however, that the Trust Fund surplus should be preserved for future fund obligations. Thus, the question at hand is how do we best utilize the on-budget surplus. This paper will focus on Social Security and reformation of current policy.

In his aforementioned 1998 State of the Union Address, President Clinton answered his question concerning the allocation of the surplus by saying, "I have a simple four word answer: save Social Security first." It is not difficult to make a case for saving the most effective method of securing income for retired workers, especially considering two-thirds of retired workers currently receive 500/o or more of their income from Social Security. ii The question that naturally arises is why do we need to save a program that is bringing in more than enough money to pay current benefits. As discussed earlier, the Social Security Trust Fund, which receives the payroll taxes that are paid out as benefits, currently holds a surplus of $99 billion.

The answer is simple. The combination of baby boomers coming to retirement and increasing life expectancy promises to drive the ratio of workers to retirees down to approximately 2 to 1 by the year 2031 - the year all the baby boomers will have reached the age when unreduced social security benefits will be paid. This is half of what it was in 1970.m The growth of future beneficiaries is also a result of changes in the labor force, namely an influx of women working jobs covered by Social Security.

By 2040, Social Security is projected to cost 6.8 percent of GDP --2.2 percent more than it does today. This increase, however, is not astounding compared to previous increases in Social Security and other federal programs over even shorter time periods. However, as Henry Aaron and Robert Reischauer explain in their book Countdown to Reform: The Great Social Security Debate, " Social Security is far from the whole story when it comes to the burden that the retirement of the baby boomers will impose on society."iv Medicare spending, Medicaid spending and Supplementary Security Income is all projected to undergo a substantial increase in percentage of GDP.

In response to the future economic strain imposed by the retirement of the baby boomers, there has been a great deal of discussion on how Social Security should be administered in the future and the role of the surplus in this administration. However, effectively evaluating potential Social Security reforms and examining the economic and political circumstances surrounding the proposals first necessitates a brief overview of the current Social Security system.

The current Social Security system is basically a pay-as-you-go, tax and transfer system across generations. Essentially, each generation pays for the retirement of its parents' generation. A worker's benefits upon retirement are determined by a worker's lifetime earnings and adjusted to reflect average wages prevailing in the economy right before the worker's retirement. The benefits are progressive, which means that although high-income workers extract the largest benefit in sheer dollar amount, low-income workers receive a larger percentage return. The benefits also favor single earner families, because the spouse's, or "lesser earners", receive half the amount of the primary earner. In addition, replacement rates - the percentage of pre-retirement earnings that benefits replace - are relatively constant across time and income groups. For the most part, retirees have received more in benefits than they and their employers paid in.v

There is a general consensus among policymakers that Social Security needs to be reformed in some aspect. There are dozens of reforms that policymakers have introduced, each with their own unique twist on reforming social security, but for the most part, the proposals can be classified into three basic categories: privatization, means testing, and modifications to the current system.

While there are varying versions of the privatization plan, the basic concept of privatization is to split Social Security into two parts: individually managed savings and investment accounts and a basic payment. The first component's returns would vary with the individual selection of investments and market performance, while everyone would receive benefits of the latter. Under a fairly standard system, each beneficiary would have 5% of the current 12.4% Social Security tax rate devoted to a personal security account, which would be open to a wide range of investment vehicles. The rest of the tax would go toward the basic payment and the non-retirement benefits.vi

Advocates of privatization claim that it would result in a drastic increase in retirement incomes, because investment in common stocks produces a significantly higher return than Social Security.vii Advocates also contend that privatization will provide people with greater freedom and allow them to exercise a larger role in determining their retirement income. The chief benefit of privatization that proponents emphasize is that it would increase national saving. As Aaron and Reischauer explain, " Increased saving, and the higher rate of capital formation that this saving would generate, would boost the growth of output per worker and the nation shoulder the costs of a gradually increasing dependent population.llviii

While these benefits are enticing, the drawbacks of a privatization are far greater. Privatization threatens the fundamental goal of Social Security to provide retiree's with adequate reliable income. Under a privatization system, those who do not make shrewd investments, which would most likely be the people who rely on social security the most - the poorer and less educated sectors of the population - stand to lose a substantial portion of their retirement income. Furthermore, the privatization plan relies on a more rapid than current growth rate of the economy, which economists do not find feasible.ix

This reliance on economic growth is not the only risk inherent in the privatization system. The system is also politically risky, because the basic payment benefits could very easily take on the same sort of stigma associated with welfare, which could lead to politically volatile situations.x In addition, a large portion of the population stands to lose a great deal if the stock market experiences a major downturn. This downturn would also inevitably lead to great political conflict focused on how to provide for those whose retirement funds were severely depleted by the downturn. Overall, the risks associated with the privatization defy the fundamental principles of Social Security.

Another popular Social Security proposal is the means testing system. In this system, households with incomes at least $5,000 over the national median would have their benefits reduced 1 percent for each $1,000 by which their annual income exceeded the threshold. The maximum reduction would be set at 85%.xi

The obvious benefit of this system is that benefits are cut from those who need them least, and presumably redistributed to those who need them most. But as Aaron and Resichauer explain, "Unfortunately, this principle would have undesirable consequences if applied to Social Security benefits. It would increase penalties on working and saving, raise insurmountable administrative problems, and undermine the basic rationale of Social Security."

The final proposal that warrants evaluation is simply modifying the current Social Security plan. The two most common and direct methods for maintaining the current system and still accommodating the needs of future generations of retirees is increasing the payroll tax and cutting benefits. However, increasing the payroll tax is not politically amenable, and thus the focus should be on the best method of cutting benefits so as to create a more economically efficient program.

One area of reform is spousal benefits. The 50% benefit may have made sense in the program's early days, but with a record number of women currently in the work force, a good amount of couples already at high income levels are receiving relatively high retirement benefits. While an abrupt cut of spousal benefits would carry negative ramifications for many older couples and single worker families, a gradual cut in the spousal benefits will result in great savings.

Another modification that would provide modest savings to the program would be to raise the initial eligibility age. Raising the age from 62 to 64 would enlarge the labor force, boost national production, and reduce the burden of supporting the economically inactive.xii

There are also some simple changes in the way benefits are calculated that would help reduce the projected long-term deficit. Increasing the averaging period from which benefits are calculated from 35 to 38 years would result in earnings for formerly excluded years. Which according to Aaron and Reischauer "are necessarily lower than those of currently included years." In addition, simply improving the accuracy of the CPI to better measure inflation, and thus the true growth rate in benefits, will result is savings xiii

Another simple, yet effective improvement upon the current system would be to extend Social Security coverage to all state and local workers. As Aaron and Reischauer explain, "extending coverage to currently uncovered state and local government employees would eliminate certain gaps in disability insurance coverage, extend survivor benefits to their spouses, and provide more retirees inflation-proof pensions based on career earnings."

Perhaps the most simple and effective method of reducing the Social Security deficit is levying a tax on 100% of Social Security benefits. Taxes on Social Security do not enter into general revenue, but instead are earmarked directly toward the Social Security and Medicare Trust Funds. Aaron and Reischauer estimate that Social Security's share of the fund would have been $25.5 billion higher if tax rules for private pensions were applied to Social Security.xiv

Finally, the last modification to the current Social Security system intended to help reduce the deficit would be to establish a Social Security Reserve Board (SSRB) which would monitor the reserves in higher yielding investments, while at the same time reducing the risk of the investments.

The development of the SSRB, however, is not the final adjustment to the Social Security system. An important fault in the current system that needs to be addressed is the insufficient income allocated toward survivors, causing many elderly widows, widowers, and divorcees to endure severe financial struggles. Increasing survivors' retirement income to 75% of the couple's combined benefit is a critical policy change, which will help ease the financial strain on most survivors.

These aforementioned modifications to Social Security do result in cuts in benefits to a system that is already stingy in comparison to the rest of the world. At the same time, the modification provides a substantial benefit to those who need reliable income most - survivors. As Aaron and Reischauer explain:

While this plan lies to the left of the conservative partial privatization proposal that Congressional Republicans support, it is right of President Clinton's proposal. The president proposes strengthening Social Security's finances by transferring an additional $2.7 trillion of the expected on-budget surplus to the Social Security Trust Fund over the next 15 years.xvi The Social Security program will use these funds to purchase treasury bonds, and in addition, Clinton proposes that roughly 20% of the surplus will be transferred to the Trust Fund.

Without even discussing Clinton's proposal in detail, it becomes clear that the aforementioned modifications to Social Security, which cut the projected deficit without tapping into the on-budget surplus, are a superior policy.

First, it is more appealing to the entire political spectrum. It appeals to liberals because it maintains basically the current Social Security system and it appeals to conservatives because it does not earmark the surplus toward government spending. Furthermore, the plan establish a method for preserving Social Security, that does not rely on tenuous projections that many economist believe to be faulty.xvii Granted, the moderate concessions in benefits are not ideal, but if the surplus does materialize, and there are no more needy government programs, the cut benefits can be replaced in the future.

i Auerbach, Alan J. and Gale, William G. "The Case Against Tax Cuts" Policy Brief #46. www.brookings.edu. March 1999.

ii Rasell, Edith and Faux, Jeff. "Fixing Social Security: the Clinton Plan and its Alternatives." Economic Policy Institute Issue Brief. www.epinet.org. April 1999

iii Cadette, Walter "Safeguarding Social Security" Public Policy Brief. www.levy.org. September 1997.

iv Aaron, Henry J. and Reischauer, Robert D. Countdown to Reform. Centurv Foundation Press. New York. 1998.

v Cadette.

vi Ibid.

vii Aaron and Reischauer

viii Page 78

ix Wray, L. Randall, "Goldilocks and the Three Bears". Policy Notes. www.levy.org.

x Greenstein, Robert. "Should a Portion of Social Security Benefits be Invested in Equities?" Center on Budget and Policy Priorities. February 23, 1999.

xi Aaron and Reischauer.

xii Ibid.

xiii Ibid.

xiv Page 107.

xv page 115

xvi Rassell and Faux.

xvii Wray. L. Randall. "Surplus Mania: A Reality Check." Policy Notes. www.levy.org