Changes in measuring the future finances of Social Security implemented in the latest Congressional Budget Office (CBO) figures provide clearer estimates of future finances. The new figures use a stochastic model to project the likelihood of a range of future outcomes, unlike the current Social Security Administration reports, which do not give likelihood measures. The new CBO estimates also assume that Social Security will remain unchanged over the entire horizon. Since Congress is likely to change Social Security policy in the future, this assumption must be taken with some caution.

Resident Scholar  Andrew G. Biggs

The Congressional Budget Office today released new projections of future Social Security financing, similar to those done in the annual Social Security Transferred Report. Also see Peter Orszag's blog post on the new report, plus the report's data in Excel format (something which endears CBO to the wonky set).

The headline deficit figure--1.06% of payroll over the next 75 years--is significantly lower than the Trustees 2008 projection of 1.70% of payroll, which was itself a big reduction from the 2007 projection of 1.95%. This post will focus on the source of changes in the CBO projections and as well as how they differ from the Trustees' Report.

There are three principal differences in assumptions between the CBO projections and those from the Social Security Trustees:

• Revenues from Income Taxation of Social Security Benefits. In a change versus prior practices, CBO assumes that "current law" will prevail with regard to income taxes over the next 75 years. This implies a very significant increase in both overall income tax revenues and income taxes levied on Social Security benefits. As I discussed in a somewhat different context here, current law on income taxes implies much higher future revenues in large part because the income tax brackets are not indexed for the growth of real incomes. As a result, individuals will find themselves pushed into higher and higher tax brackets over time. The Trustees assume that income tax revenues will remain roughly constant relative to GDP in the future. The new CBO assumption lowers their projection of the 75-year shortfall by around 0.24% of payroll, from 1.3% to 1.06%.
• • My comment: This is the most important change, in my opinion. It is hard to say which assumption is "right" in this area. Clearly CBO is correct about what current law entails; however, the Trustees' assumption of roughly steady ratios of tax revenues to GDP are almost certainly more realistic. The income tax code has always had a bias toward higher effective tax rates, but Congress has over time altered the law and kept revenues fairly constant relative to the economy. So there is no right or wrong here and either assumption is reasonable, but readers should bear in mind what each assumption means. "Current law" doesn't equal "likely law."
• Interest Rates. CBO assumes a real interest rate of 3.0 percent above inflation, versus 2.9 percent for the Trustees. This has two related effects: First, investments in the Trust Fund are assumed to earn a higher interest rate, which raises the balance and causes the Fund to last longer. Second, and more important, the interest rate is used to discount future surpluses or deficits to present values, which are used to calculated the system's overall balance. The difference between a 3.0% and 2.9% interest rate can be significant over the long term: a deficit of $100 million (in today's dollars) 75 years from now would have a present value about 7% lower under a 3.0% discount rate than a 2.9% rate.
• Real Wage Growth. CBO now assumes a 1.4% annual rate of real wage growth, versus 1.1% for the Social Security Trustees. This derives from their somewhat higher assumption for future productivity growth, of 1.9% vs. 1.7% for the Trustees. Higher real wage growth reduces the 75-year shortfall on a roughly 1-for-1 ratio. This means that a 0.3% difference in the assumed rate of wage growth would account for around 0.30 percentage points of the difference in projected 75-year deficits between CBO and the Trustees.

There are other differences in assumptions between CBO and the Trustees, plus CBO's model uses somewhat different methods than the SSA actuaries, but the above three factors account for most of the differences between the two reports.

Treatment of Uncertainty in New CBO Social Security Projections

There is a great deal of uncertainty in projecting Social Security's finances out over 75 years or more. We know the basic economic and demographic building blocks that determine Social Security's finances, but we can't know for sure the value of each over coming decades. In the Social Security Trustees Report, this uncertainty has traditionally been primarily addressed using "high cost" and "low cost" scenarios to complement the best-guess "intermediate cost" projections. For a number of reasons, I think these high/low cost scenarios aren't particularly helpful. (The recent Technical Panel agreed.)

CBO doesn't use high/low cost scenarios. Instead, they illustrate uncertainty using a "stochastic" or "Monte Carlo" simulation which assigns probability distributions to each of the main economic or demographic variables and then illustrates the range of outcomes we could expect. (The Trustees also use a stochastic model, but unfortunately it's not yet the primary descriptor of uncertainty in the Report.)

But even given a model that can calculate the range of possible outcomes, there's the important question of how you describe this range. You can't simply do a data dump, you need to find ways that are easily understandable. The new CBO report has a number of very effective ways of portraying uncertainty in Social Security financing. I'll run through them here.

CBO's Figure 1 shows the 80 percent probability range for Social Security's annual income and costs. The dark lines indicate the median outcomes for each, while the shaded areas denote the range of outcomes. Only 20 percent of outcomes would fall above or below these shaded ranges.

CBO's Figure 3 is similar, except that it focuses on uncertainty in the value of the trust fund ratio (the ratio of the trust fund's balance in a given year to the system's costs in that year). The dark line indicates the median outcome; it hits zero in the year in which the trust fund is projected to become insolvent. The advantage of Figure 3 over Figure 1 is that it also accounts for uncertainty in interest rates, which do not affect annual income and costs. However, many believe that annual cash flows have more substantive importance than the trust fund balance.

Figure 4 is a new chart that I believe is very helpful. It shows the probability that the trust fund will have been exhausted by a given year. Up through the mid-2020s there is almost a zero chance of the fund being exhausted. By the mid-2040s, the likelihood is around 50 percentg. This probability rises until by the 2070s there is only around a 15 percent chance of the trust fund not having been exhausted. One advantage of this chart is that allows an easy comparison of how much a reform plan might improve Social Security's finances. We could say, for instance, that under current law there is a 50 percent chance of the trust fund being exhausted by 2049, but under the reform plan this drops to 25 percent, etc.

Table 3 is also a new addition to the CBO report. It focuses on the probability of the program running deficits of a given size in a given year. For instance, the chart shows that in the year 2050 there is an 87 percent chance that Social Security will be running a cash deficit, a 53 percent chance that the deficit will exceed 1 percent of GDP, and a 16 percent chance it will exceed 2 percent of GDP.

These figures all derive from the same underlying model, but show different ways of describing different aspects of the model's output. I believe the two new figures constitute a significant improvement to how uncertainty is described and should be considered for inclusion in the Socail Security Trustees Report.

Andrew G. Biggs is a resident scholar at AEI.