Aspen Gorry is a research fellow at the American Enterprise Institute and an assistant professor at the University of California, Santa Cruz, and Sita Nataraj Slavov is a resident scholar at AEI.
With graduation season nearly finished, another cohort of young workers is set to enter the labor force. Members of this cohort confront an immense challenge in planning for retirement: There is a great deal of uncertainty about the Social Security taxes and benefits they will face.
With the trust fund projected to be exhausted in the next two decades, either payroll taxes must be increased or benefits cut. But uncertainty about the timing and scope of reform makes it difficult for young workers to make smart choices about work and retirement. This uncertainty can be reduced by tackling Social Security reform now rather than later.
Most people dislike uncertainty. Consider a gamble that pays $10,000 if a coin comes up heads and $0 if it comes up tails. Offered a choice between this gamble and $5,000 for sure, most people would choose the sure thing even though the gamble can be expected to pay, on average, the same. The presence of uncertainty diminishes the monetary value of the gamble. Indeed, most people are willing to pay to reduce uncertainty – that's why there are markets for various kinds of insurance.
The same principle applies to uncertainty about future policy. Consider Jane, a 25-year-old worker who is just now starting her first job and hopes to retire at age 67. Since she wants to retire in 2055, long after the Social Security trust fund is projected to be depleted, Jane cannot be sure what level of retirement benefits she will receive from Social Security. She also faces uncertainty about the payroll tax she will face on her future earnings.
This uncertainty affects Jane's choices. For example, when Jane is deciding how much to work, she weighs the benefits from work (the extra pay) against the personal cost (the value of the time she must give up). Under the current Social Security retirement system her take-home pay is diminished by a 10.6 percent payroll tax, which discourages her from working. On the other hand, because retirement benefits are based on Jane's earnings, the effect of the tax is partially offset by an increase in the benefit that she will receive in retirement.
But, just as in the gamble described above, Jane values her uncertain retirement benefit less than she would if it were certain. The benefit is therefore less effective than it could be in offsetting the effect of the payroll tax. This means that uncertainty about Social Security may cause Jane to work less, hurting both Jane and the economy as a whole. In addition to changing the payoffs from work, uncertainty about Social Security reform can distort Jane's decisions about saving, education and spending too.
While this example is hypothetical, uncertainty about Social Security reform causes substantial harm to individuals trying to plan their lives. In a recent research paper, economists Erzo F. P. Luttmer and Andrew A. Samwick conducted a survey and found that, on average, individuals between the age of 25 and 59 expect to receive only 60 percent of the Social Security benefits that they have been promised. But there's a great deal of uncertainty, as respondents differed in their assessments of how much their benefits would be cut. The researchers estimated that people would be willing to tolerate an additional 4-6 percent cut in benefits in exchange for certainty about the level of benefits.
In a separate study, Francisco J. Gomes, Laurence J. Kotlikoff, and Luis M. Viceira estimated that individuals would be willing to give up 0.6 percent of their lifetime earnings in exchange for learning about their benefit cut at age 28 instead of age 65.
Some will argue that because the deficit for 2013 is now projected to be much smaller than previously expected – only $642 billion, or 4 percent of GDP – Congress has time to wait to reform entitlement programs. Such a conclusion would be mistaken.
Changes to entitlements are unavoidable. Benefits will have to be cut or taxes increased. But uncertainty about these changes can be avoided by making them now rather than later. Acting now not only reduces the burden of adjustment on future generations, it also reduces the uncertainty these generations face in planning for retirement.