To finance the U.S. government until after the 2012 elections, Congress must raise the U.S. debt ceiling by roughly $2.4 trillion. Many members of Congress will not support such an increase in the debt ceiling without a similar decrease in long-term federal spending.
There are only three potential sources for trillion-dollar reductions in federal spending: Defense, Medicare and Social Security. The Obama administration has proposed a $400-billion reduction in Defense, making it hard to squeeze anything further from the DoD.
Medicare is the largest potential source of federal savings, but it presents the most difficult political challenge. Because Republicans and Democrats cannot agree on whether Medicare should be a public or private insurance program, a trillion-dollar agreement on Medicare cuts seems unlikely.
Thus, Social Security reform is the best candidate for a significant decrease in long-term federal spending. Recently, President Obama has put Social Security reform on the table, even if it alienates the left wing of his party. AARP has also recognized that benefit reductions may be needed in order to prevent insolvency of the system in 2037 -- which would force automatic benefit cuts of roughly 25 percent.
To make Social Security reform politically viable, Congress needs to package it with measures that attract middle-class voters by helping them save for retirement. Most proposals for reforming Social Security preserve the current benefit schedule for low-wage earners and limit the growth of benefits for high-wage earners. While these two aspects of reform seem to be politically acceptable, the challenge is replacing any benefit reductions for middle-class workers with average annual wages (not income) between $30,000 and $85,000.
To deal with this political challenge, Congress should offer a government match to retirement contributions by workers in this middle-wage range. Specifically, Congress should adopt the Obama administration's 2010 proposal for an enhanced Saver's Credit, which would match the first $500 in contributions to a retirement plan at a rate of 50 percent for eligible workers. Workers eligible for the full match would include couples with adjusted gross incomes of $65,000 per year or less ($32,500 for singles), with lower matches available to couples with adjusted gross incomes up to $85,000 per year ($42,500 for singles).
The value of this federal match, conservatively invested over a long career, would partially offset the proposed reductions in scheduled Social Security benefits for the median worker. Suppose a married worker at age 30 receives the median U.S. wage of $37,000 per year and contributes $500 each year to an IRA until he retires at age 66. His contribution attracts a federal match of $250 each year.
If this $250 annual match were invested in a balanced fund -- half in long-term government bonds and half in an S&P 500 index -- with a real return averaging 5.8 percent per year, the total value of this match would be $30,150 at his retirement. With that sum at a 5.8-percent interest rate, he could buy a fixed annuity with monthly payments of $255 for the rest of his life.
These annuity payments from the Savers' Credit would make up most of the modest benefit reductions for middle-class retires in the future -- reductions likely needed to make Social Security solvent. For example, actuaries estimate that the scheduled monthly benefits of the median worker retiring in 2045 would be reduced by approximately 16 percent, or $290, under my progressive indexing plan. That $290 reduction would be largely offset by the $255 supplemental retirement benefit from the lifetime annuity funded entirely by the federal match. As a result, the total monthly payments of this median worker would be roughly the same as the current benefit schedule. If you consider that the credit may have induced this worker to save on his own, he is likely doing just as well, or better, than without these policies.
It bears emphasis that this federal match would come entirely from the Congressional appropriations process and would not divert any monies from the Social Security Trust Fund. If this federal match is the political "sweetener" to help enact Social Security reform, Congress should estimate the cost of the match over the next 75 years -- the standard period for measuring Social Security's deficit. Assuming that the cost of federal match grows at a rate of 3 percent per year, its 75-year cost would be approximately $850 billion.
But this is a small price to pay to facilitate the passage of Social Security reform. Without such reform, Congress would have to appropriate more than $13 trillion over the next 75 years to make up the shortfall between the estimated revenues and annual obligations of Social Security.
In short, Congress should combine a generous Savers Credit with a progressive plan to eliminate the long-term deficit of Social Security. That combination would mitigate the political perils of adopting such a plan by making up a significant portion of any middle-class benefit reduction involved with restoring Social Security to solvency. Of the many tough choices facing Mr. Obama and both parties in Congress, this combination of policies may be the most politically feasible way to make a big dent in the long-term federal deficit.