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Social Security Windfall Elimination Provision: unpopular, but not unfair

Half the readers will find this column of only passing interest at best, while interested parties may find themselves in intense disagreement with my conclusions.

Many government employees, who have worked outside the social security system most of their careers, find that their federal social security benefits are reduced, seemingly arbitrarily, when they retire because of the Windfall Elimination Provision (WEP). This can result in a maximum of a $340 per month reduction in social security benefits in 2007.

Note that there is a separate, but related provision known as the Government Pension Offset (GPO), which deals with survivor benefits. Many of the same same arguments that apply to the WEP also apply to the GPO.

The Windfall Elimination Provision of the social security law appears to be grossly unfair and is the subject of hostility and bitterness on the part of many Illinois government employees. Public employee unions and teachers organizations lead continuing efforts for the provision's repeal. Each year, the Illinois' State Universities Retirement System Board includes a provision in its legislative platform calling for its repeal. The WEP affects University of Illinois and Parkland College employees as well as public school teachers. Both of Illinois' senators and 12 Illinois U. S. representatives of both parties are co-sponsoring legislation to repeal of both the WEP and the GPO.

Why should a retiree's social security benefits earned in private employment be reduced simply because the worker happened to be employed in a government job? I seldom defend the logic of government policies, but surprisingly, there actually is a reasonable rationale for the WEP.

It is not well known, but social security differentially rewards low wage earners. Retirees with a history of low incomes receive a higher return on their social security contributions compared to higher income workers. In essence, there is both a pension and a welfare component of social security benefits. This was built into to the benefit structure to address the high rates of poverty among low-wage retirees.

Historically, some state and local government employees have never been fully a part of the social security system. Approximately 230,000 Illinois government employees in public schools, public universities and community colleges are not covered by social security. This is a relic of the early days of social security when the federal government gave state and local governments the option to join social security or operate independently. Private employers were given no such choice.

Employees of government organizations opting out of social security do not have to pay the retirement portion of social security taxes, (currently a 12.4 percent combined employer-employee rate on wages up to $97,500) although most do pay Medicare taxes. These employees also do not receive credit for their government earnings in calculating social security benefits. Since they are outside of social security, their retirement benefits are expected to come from state and local pension systems. This is a substantial benefit for most government employees, because the return per dollar invested is typically much greater in state and local pension systems compared to social security.

A problem arises in that many employees working in social security-exempt employment also earn additional small amounts from organizations covered by social security. Their earnings are usually modest since their main source of income is derived from exempt government employment. In such a situation, even well paid government employees often appear to be poor based on their covered social security earnings. Without the WEP adjustment, these government workers would receive disproportionally large social security benefits that include both the pension and welfare components. The WEP attempts in an imperfect way to rectify this by reducing the so-called windfall portion of social security benefits, but not state and local pension benefits.

The WEP penalty diminishes for workers who split their careers between the public and private sector and have substantial earnings in the private sector. It is completely eliminated for those with 30 or more years of substantial earnings covered by social security. More detail is available at www.ssa.gov/pubs/10045.html#exceptions.

The elimination of the WEP would not be hugely expensive (an estimated cost of $20 billion over 10 years), but it would increase the cost of social security at a time when there are efforts to rein in program growth.

Aside from the cost and fairness issues, there is another problem that would probably result if the WEP were eliminated. Its elimination would most likely only occur in the context of a broader reform of social security. In particular, most observers believe that the elimination of the WEP would be accompanied by the eventual end of the ability of state and local governments to operate outside the social security system. This would be a huge cost to pay. Most workers, who will eventually be impacted by the WEP, would lose much more by being forced into social security than they stand to lose from the WEP.

Even from the standpoint of self-interest, most government employees would be better off with the current arrangement as compared to the results of social security reform that might include the elimination of the WEP.

- J. Fred Giertz is a professor of economics within the University of Illinois' Institute of Government and Public Affairs. He can be reached at (217) 244-4822 or jgiertz@ad.uiuc.edu.

CAPITAL EXPANSION, DIVIDENDS COMPETE FOR SHRINKING CASH

Morris Beschloss
CIBM Contributor

For years, investors generally took a two-pronged approach to the financial markets. If they were primarily looking for income, they would buy various types of bonds government, tax-free municipals, corporatesand even convertibles, which were a stock/bond hybrid.

Preferred stocks were also included in this category. Convertible bonds were particularly attractive because of higher dividends, and mandated exchange opportunities into common stock.

In effect, these offerings are a superior vehicle for investors who are willing to give up some capital gain possibilities for substantial income opportunities. However, like all stock and bond offerings, the risk factor lies in the underlying safety of the basic investment.

For capital gains, investors would choose value equities or growth stocks. The former were more conservative and represented such traditional brand names as DuPont, Dow Chemical, General Motors, Minnesota Mining & Manufacturing and Coca Cola. These international brand names promised a long-term capital enhancement at a limited risk over an extended period of time.

Growth stocks were more speculative and reflective of Microsoft, Oracle, Cisco, Intel and other emerging high tech stocks that started proliferating in the 1990s. The former generated an average annual dividend of 2 percent, while the latter go-go stocks would return their capital for growth and pay little or no dividends. Most recently, the growth stocks attracted investors into even more exciting opportunities, such as Google, Amazon, Red Hat and Apple.

But lately, that's changed. After the Bush administration lowered qualified dividend rates to 15 percent in 2005, many corporations became more dividend conscious and actively catered to potential as well as long standing investors. This proved immensely successful as the investing public viewed an opportunity to gain the benefit of substantial dividends and capital gains simultaneously.

Although corporate profits have had an amazing run during the recent economic expansion, businesses have become more reluctant to resurrect this accumulated cache into capital investments. Instead, these companies have bowed to the demand of their executives and stockholders alike, as dividends have become an increasing choice of capital yields. But this trend could have long-term consequences as total domestic profits retreat from their recently established peaks. Early returns from third quarter results seem to confirm this probability.

Although reaching a record high in the second quarter, capital spending fell 0.7 percent from a year ago, according to the Federal Reserve Board's latest figures. Decreasing productivity, higher costs of raw materials, and the falling dollar all play a part in this decline.

Instead of businesses investing in the expansion of computers and other labor-saving devices, like cost-saving machinery, dividends are up are up more than 21 percent from a year ago. Smaller companies are joining the party, while sub-chapter S corporations accounted for 40 percent of all non-financial dividend payments in 2004, up from 20 percent in 1991, according to Internal Revenue Service data. This is due to the fact that S-Corporations are primarily interested in optimizing the income benefits of the owners.

But such fatter payouts are creating a financial gap at a time when available cash is shrinking. This means that capital spending exceeds internally generated funds, increasing the need to borrow. It puts many companies into a cash squeeze from which they had escaped during the recent multi-year income surge.

In 2005, after tax and depreciation, profits more than covered cash left after dividend distributions. Currently, capital expenditures are 30 percent greater than internal funds. This widening gap is coming at a time when credit is tighter, which makes it tough for corporations to maintain investment spending while retaining dividend outlays. Such a credit crunch couldn't come at a worse time for companies hoping to expand their market positions.

Long-term, this means that companies previously flush with cash will have to decide whether to reduce dividends or slow capital spending.

It's a decision that may impact the future growth of thousands of companies, at a time when expanded development, inflation and lower productivity will combine to reduce the expansion necessary to be competitive domestically and with imports.

Editor's note: This article was previously published in the Desert Sun in Palm Springs, Calif.

- Morris R. Beschloss graduated from the University of Illinois' College of Communications in 1952.
He is a columnist for the Desert Sun and publishes two newsletters for the pipe, valve and fittings industry. He can be reached at flem6609@bellsouth.net or (760) 324-8166.

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