Expert: Social Security needs more reform than just higher COLAs

Nathan Abse interviews Laurence Kotlikoff, an economist at Boston University and longtime expert on Social Security. Kotlikoff offers insight on several problems with the government-administered retirement program, and how to fix them.

Inflation is a dreaded word to current retirees and anyone getting ready to retire—and to all who face living on a fixed income of any kind. Unfortunately, it’s also a word and a fact we all must deal with daily now. After decades of very modest inflation, the ratcheting down of the COVID pandemic brought a massive wave of people returning to commuting, in-person education, consumer activities—and with those economic demand and sharply rising prices. By July, the most commonly referenced Consumer Price Index rose at an annual rate of 8.5%. In August, thankfully inflation slowed slightly to a CPI hike of 8.3%. Still, at least for a time, we can expect inflation to remain stubbornly high. For many retiring feds this problem tops their list of worries—as they try to budget a good life on a combination of TSP, FERS or CSRS and Social Security. And, regarding the last piece, this week Nathan Abse interviews Laurence Kotlikoff, an economist at Boston University and longtime expert on Social Security, well known for his strong views on reforming not just the way that COLAs are calculated but many other aspects of the biggest public retirement insurance program—as well as the country’s system of taxation.

Q&A with Laurence Kotlikoff:

Like many economists—and advocates for seniors—for years you have said Social Security COLAs do not keep up with the real costs of inflation. Is that still true, and if so by how much?

Kotlikoff: So, the question you’re asking is, is Social Security in need of fixes? Especially to deal with inflation? The answer is yes, because Social Security is absolutely not fully indexed for inflation. Nor does the program take into inflation in setting the limits—beyond which first 30% and then 85% of your Social Security benefits are subject to taxation. This federal tax element has not been adjusted to take into account decades of inflation. Instead, we have fixed nominal-dollar limits, set in stone in nominal dollars in 1983, ultimately by [President Ronald Reagan’s OMB Director] David Stockman. It all ended up in a bill passed by Congress way back then.  

OK, so your criticism is that Social Security’s federal tax-free limits remain stuck at a level—$32,000 for a couple—set in the ‘80s, when that number represented a much higher income. But after decades of inflation and COLAs, that non-indexed number means people of even modest incomes get hit with tax on Social Security?

Kotlikoff: Yes, that’s right. Because every year since 1983 we’ve had some inflation—even if most years it was modest—over time, more and more people (I mean, a higher percentage of Social Security recipients) have gone over those limits and got sucked into having their Social Security benefits subject to taxation. That’s what happened, as the benefits were increased over time by the COLA—you see? Your modified adjusted gross income—on your tax forms—was going up. But meanwhile the limits themselves have been fixed, stuck. And therefore more and more people were pushed beyond those limits. And they’re having to pay taxes on those benefits. For Social Security to be progressive or fair at all, this problem has to be fixed.

In short, then—and in contrast to the Social Security payments themselves, which are indexed and grow (if not enough) based on COLAs—the taxation threshold affecting taxing those payments is not indexed, impacting especially people of modest income?

Kotlikoff: Right.

You criticize another key piece of Social Security that is not indexed for inflation: income earned late in a person’s work history, and how that affects calculating Social Security payments—right?

Kotlikoff: Yes. In addition to the problem of having no inflation indexing on those income limits that trigger taxation on Social Security benefits, there’s a big problem with the fundamental benefit calculation itself. That calculation is done using something called the Primary Insurance Amount or "PIA formula." The PIA formula is not fully inflation-indexed. What I mean here is that earnings on labor income up to age 60 is indexed for inflation, but beyond a certain age—beyond 60—it is entered “nominally,” and is not inflation-adjusted. So, if you keep working and your salary goes up—and most of that increase is simply just your pay going up with inflation and inflated dollars, then if you stay at work a few years after 60 it can very significantly raise your Social Security benefit, well beyond what a fair calculation would. In other words, your benefit will go up a a lot—not because you actually earned a lot more in real terms over a long work history, but because you earned more, in nominal terms, after age 60—during which years the income you earn is no longer indexed to inflation in Social Security’s formula.

In short, you’re saying earnings after 60 are unfairly over-weighted—especially since for many workers their lines of work are not practical after age 60 and so they don’t have this option. But can you give an example to illustrate your point?

Kotlikoff. Sure. So, let’s do a hypothetical. Let’s say over most or all your work history you earned whatever—an average salary for your line of work. But then after you are 60—pretty late in your work history—you experience some sizable salary bumps, mainly due to inflation. Those nominal rises in pay after 60 will significantly impact—raise—your Social Security benefit. Your higher nominal salary after age 60 will greatly pull up the highest of your 35-year highest-year earnings. And that will result in a significantly bigger Social Security payment. But only because those income numbers after 60 were not indexed to inflation—those high nominal income years at the very end of your career are over-emphasized in their formula. When you start taking it, your benefit would have risen from being pretty low—right up to the last few years—and suddenly now at retirement it’s calculated at much higher or maybe even the highest possible value. That’s because your nominal dollar earnings has risen so much due to inflation in those years after 60, but Social Security’s PIA did not adjust for that inflation at the end.

Wow. So again, as with the tax situation, Social Security doesn’t accurately take account of inflation. But in this example of people who earn inflated salaries after 60, that nominal dollar pay boost can help—even if it’s from a flawed formula and unfair to many other retirees, right?

Kotlikoff: That’s right. But even if it helps some, this [excessive] effect of late-career earnings is another problem, as you can see. The PIA formula needs to be adjusted, for the system to be more fair and more accurate. But you’re right. This particular ‘problem’ does favor some people. In fact, I could have put it that way: That where Social Security is concerned this moment in time is an especially good one to be a high earner late in your working life. All the more if you’ve had a low earnings history most of your working life and you’re over 60, it’s an especially good time to be trying to earn more money. Because even if each added dollar you get now is worth significantly less than just a few years ago or even last year, your nominal earnings after 60 can boost your Social Security benefit significantly, when you retire. And it’s an effect greater than the annual COLA you’ll get after you start receiving Social Security.

Some readers who have not researched this much will want to know: How? How does the formula skew things in this potentially extreme way—can you break it down?

Kotlikoff: I can. Social Security looks at your earnings every year up to age 60, and they index them to the average wage growth in the economy up to that time. But, with respect to your earnings after age 60, they just enter those in nominal terms into their formula. Think about this as an Excel file listing of all your top earnings. So, let’s say after you’re age 60 your earnings are increase 5% or 10%—or 50%. Whatever it is. But that boost is largely just because of inflation in our economy. So you were earning, say, $70,000. Then a few years later you are earning $100,000 That is going to show up on that list, however many years of that much higher salary at the end, in inflated dollars. But it is going to then be averaged along with the other 32, 33, 34 numbers of the years of your working life, to give you what's called the ‘average indexed monthly earnings,’ OK? Then, that average indexed monthly earnings is going to be plugged into a formula to generate your basic what, again, is called your ‘PIA’—the primary insurance amount. Your real benefit will go up, dramatically, right? Because those last years at that nominal $100,000 or whatever inflation helped drive your salary up to. I used a high jump in salary just to illustrate.

So, in addition to inadequate COLAs, you’ve outlined two more flaws in Social Security—failure to index the earnings limits re taxes and failure to index late-career earnings, right?

Kotlikoff: Right. Two problems here: One is taxation—that income tax benefit that Congress originally laid down in the 80s, needs to be indexed to inflation. And second the benefit formula itself is not fully indexed, and it needs to be. Most people still don't know this.

You have said that certain seemingly random consumer items sometimes seem to gauge or track inflation pretty well. One of your favorites was the price of an ice cream cone, right?

Kotlikoff: I have said that. You really can kind of track inflation that way—the “ice cream cone” price test is one I’ve often used. I’ve gone to one place where a year ago it was six bucks for a cone. I went to another where it was four bucks. Then, this year at each of those, it will have come up a certain amount. You can use these as a kind of indicator. But the bigger point is that everybody is buying different baskets of goods. In other words, officially over the last 12 months inflation might have risen about 8%, but for your own purchases—where you live and what you buy—it might be up more, say 15%. Right? If you go out to restaurants a lot, for example—those prices I’ve found have gone up a lot more. Cars—used cars especially—have come up in price a great deal. 

You’ve mentioned also the rising costs of mortgages as another item that needs to be taken into account, right?

Kotlikoff: Yes, I have. Look, real things—things that are real, and solid and people need are protections against deflation. Let me explain. One of the reasons that mortgage rates are going up is really because it's, it's a form of insurance—against inflation. In other words, the rate of interest is versus what is expected to be inflation in the future. People should understand this. And at some point, as mortgage interest goes up, the price of that ‘insurance’ gets so expensive that people probably aren't going to take it. We’ve seen that in previous housing industry crashes. My conclusion around this is that, policy-wise, we should be thinking about whether we should issue mortgages that are adjusted for inflation—not to interest rates which are set by the fed and banks. I think perhaps it would work better if they would float based on inflation rates or wages.

Getting away from the issue of Social Security law and policy even further then: What do you think government should do to try to slow inflation, or control inflation longer-term?

Kotlikoff: I don’t think the Fed should raise interest rates so high as to try to kill the economy to slow inflation. I don't think we should be killing the economy. People need to realize that prices can go back down, and they will go back down. We need to try to help make that happen. But there are many ways to do that. Government should be trying to get employers to limit their price increases—do some “jawboning,” you know, talk and lobby and meet more with business on this.

Well, President Gerald Ford’s administration tried some of that: lapel pins and a publicity campaign to ‘whip inflation’—both public and quiet negotiation campaign on this, right?

Kotlikoff: Look, the government needs to be operating, trying on many levels to slow inflation—like that. Doing much more than just jacking interest rates and ending in crashing the economy to slow inflation, as they did in the early Reagan administration. There is a lot about inflation that is psychological. If I’m in business, I raise prices because I think other people are going to raise their prices. I fire some of my employees because I think others are going to do the same. As a country, we can end up in this self-fulfilling prophecy of inflation. These are important aspects of inflation, how it gets going and sticks. You have to work against it on many levels. Talking to industry can be part of improving things.

You have said, and you post on your website, legislative and policy ideas that you say would create a better and more humane system of retirement. Can you share a few?

Kotlikoff: Your readers can look at www.kotlikoff.net and my book You’re Hired, which outline my platform for change. One central thing I’m concerned about—with respect to all of us, rich, poor or middle class—is that we need to stop putting people into marginal tax brackets where many have no or low incentive to work. That’s where we are now. Instead, we need to replace the current federal income tax and the corporate income tax systems. We need to go instead to a more progressive system—one with a value added tax, a low-rate retail sales tax, and a high and progressive cash-flow consumption tax. Such a system would be much more progressive on the ground, and it would be fairer and tax bigger consumers. It would make sure the rich pay their share. This system would better things through a range of mechanism, changing how we deal with benefits, clawbacks of benefits, everything affecting marginal taxes. We need to reform taxes comprehensively. To get results, we can't be like, “well, let’s just play with the payroll tax,” or “let’s reform the income tax.” People must learn that in our current system of taxes, every tax interacts with the others—and marginal taxes add up. To see this, go to my website and search on “marginal taxation,” for a complete picture of marginal taxes in the U.S.–including every single federal and state fiscal program. When you look at our country’s tax system comprehensively, it’s terrible: About one-quarter of poor people are stuck in what turns out to be very high marginal tax brackets, above 70%! Think about that! This needs to change.

Back to Social Security, for feds, WEP (Windfall Elimination Provision)—and for some pensioned people elsewhere in the economy, GPO—how would you fix those, WEP and GPO?

Kotlikoff: There are current proposals for reform to make the WEP work better. Myself, as I said I think everybody should be included in a new and better national pension system. It should be each person’s own personal security account. Over time we would retire Social Security and switch to that. In this way the WEP goes away, the GPO goes away—the entire mess. We continue to operate and pay off accrued benefits under Social Security, but we phase it out.

Are you heartened that—although not the comprehensive reforms of taxes that you propose—more people are pressing for reforms, such as free IRS filing and more processors at IRS?

Kotlikoff: Well, helping people to file for free is a good thing to push for, true. And making the IRS more efficient and able to answer more telephone calls, that could be good too. But that’s not going to give people incentives to work, not like the reforms we really need. In our country we are still locking the poor into poverty through our fiscal systems. Thousands of tax rules and hundreds of thousands of rules on top of those. The whole thing, taken together, is a mess. Honestly, it makes some progressives go Republican, and then some of them even go Q-Anon—what I mean is, our tax and retirement systems are not progressive and it drives people crazy. I am not saying we need to get rid of it all. I’m saying let’s take IRS and change it and do it right. Same with Social Security—freeze the current system, meaning those who’ve paid into it get paid out of it. But let’s create a new system for the future and fund it and do it right this time.

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