Formulas are the foundation for determining benefits, never more so than when calculation what a retired or disabled worker is entitled to get. For Social Security benefits, the formula is based on your average indexed earnings over a lifetime. Year-to-year changes are based on the economy-wide growth of wages. According to the Congressional Budget Office, "Average initial benefits for Social Security recipients therefore tend to grow at the same rate as do average wages, and such benefits replace a roughly constant portion of wages."

To constrain the growth of Social Security benefits, CBO recommends that the initial benefits for Social Security recipients be based on price indexing rather than wage indexing as it is now. The immediate effect would be that increases in real wages would result in higher real Social Security payroll taxes but without a consequent increase in real benefits. To do this, the current formula, which is based on wage indexing, would need to be multiplied by the ratio of a price index to an average wage index.

Since the goal is to reduce federal spending, it’s important to know what the savings would be if this recommendation is adopted. In short, using pure price-indexing "would reduce federal outlays by about $13 billion over five years and by almost $137 billion over the next decade. By 2050, scheduled Social Security outlays would be reduced by 29 percent relative to what would occur under current law―from 5.9 percent to 4.2 percent of gross domestic product."

An alternative to this approach would be to adopt progressive price indexing. The current formula would be kept for workers who had lower earnings and pure price indexing would be applied to those with higher earnings. Since approximately 30 percent of workers fall into the lower lifetime earnings category, the savings would be reduced to $8 billion over 5 years and $85 billion over 10 years. By 2005, outlays for Social Security would be reduced by 18 percent instead of 29 percent and from 5.9 percent to 4.8 percent of gross domestic product.

Even with the more palatable alternative approach, "affected beneficiaries would no longer share in overall economic growth. As a result, benefits would replace a smaller portion of workers’ earnings than they do today." Further, the difference would be greatest during periods of high wage growth.

Next time Ill tell you about CBO’s proposal to raise the eligibility age for Social Security.