As America moves into the 21st
century, two public policy issues are becoming increasingly
important: the need to reform Social Security and the need to
spur economic growth and raise real wages. Recent evidence
suggests that it may be possible to solve both problems
simultaneously.
Our current Social Security system is acting as a drag on
economic growth in two important ways. First, the payroll tax
distorts the supply of labor and the type of compensation
sought by workers. These losses are inevitable because of the
low return implied by the pay-as-you-go character of the
unfunded Social Security system. Second, the system reduces
national savings and investment.
Privatizing Social Security, transforming it from an
unfunded pay-as-you-go system to a system of mandatory
private savings accounts, would solve both of those problems and
increase economic growth.
Under the current Social Security system, each generation
now and in the future loses the difference between the return
to real capital that would be obtained in a funded system and
the much lower return in the existing unfunded program.
Shifting to a privatized system of individual mandatory
accounts that can be invested in a mix of stocks and bonds
would permit individuals to obtain the full real pretax rate
of return on capital. This would mean a larger capital stock
and a higher national income.
Conservative assumptions imply that Social Security
privatization would raise the well-being of future generations
by an amount equal to 5 percent of gross domestic product
(GDP) each year as long as the system lasts. Although the
transition to a funded system would involve economic as well
as political costs, the net present value of the gain would
be enormous—as much as $10-20 trillion.
Such a private savings program would solve Social
Security's long-run financial problems without the necessity
for either huge tax increases or draconian benefit cuts. At
the same time, it would yield enormous benefits to the
economy. In short, privatizing Social Security can increase
real incomes for everyone while ensuring a dignified
retirement for future retirees.
Introduction
Although reforming the Social Security retirement program
is an issue of enormous importance, elected officials are
still unwilling to confront this serious but politically dangerous
problem. Eventually, however, the system's deteriorating
financial condition will force major reforms.[1]
Whether those reforms are good or bad, whether they deal with
the basic economic problems of the system or merely protect
the solvency of existing institutional arrangements, is the
crucial policy issue. Simply protecting the solvency of the
unfunded system by tampering with taxes and benefits will
perpetuate existing adverse effects on labor markets and national saving.
Shifting to a system of funded individual accounts can
produce a major increase in national income and in the well-being
of the population.
Central to the analysis of Social Security's impact on the
economy is the concept of "Social Security wealth,"
defined as the present actuarial value of the Social Security benefits
to which the current adult population will be entitled at age
65 (or are already entitled to if they are older than 65)
minus the present actuarial value of the Social Security
taxes that they will pay before reaching that age. Social
Security wealth has now grown to about $9 trillion or more
than the total value of GDP, which is equivalent to more than $40,000
for every adult in the country.[2] Its value substantially
exceeds that of all other assets for the vast majority of
American households. In the aggregate, Social Security wealth
is equal to about half of all private financial wealth.
Social Security wealth is of course not real wealth but
only a claim on current and future taxpayers. Instead of
labeling this key magnitude Social Security wealth, it could
more accurately be called the nation's Social Security
liability. Like ordinary government debt, Social Security
wealth has the power to crowd out private capital accumulation.
And it will continue to grow as long as our current system
remains unchanged, displacing an ever larger stock of
capital.
The $9 trillion Social Security liability is more than
twice the official national debt. Even if the traditional deficit
is eliminated in the year 2002, so that the traditional national
debt is no longer increasing, the national debt in the form
of the Social Security liability is likely to increase that
year under current law by about $500 billion.
Looking further into the future, the aggregate Social
Security liability will grow as the population expands, as it
becomes relatively older, and as incomes rise. Government actuaries
predict that, under existing law, the tax rate required to
pay each year's Social Security benefit will rise over the
next 50 years from the present level of slightly less than 12
percent to more than 18 percent and perhaps to as much as 23
percent.[3]
The financial problems of the system are therefore serious
indeed. This essay, however, will not discuss the financial
insolvency of Social Security but will focus instead on the
more fundamental economic effects of continuing with an
unfunded system. Dealing appropriately with these economic
effects will also solve the financial problems.
Labor Market
Distortions
The Social Security payroll tax distorts the supply of
labor and the form of compensation. These losses are inevitable
because of the low return implied by the pay-as-you-go
character of the unfunded Social Security system.
Unlike private pensions and individual retirement
accounts, the Social Security system does not invest the money
that it collects in stocks and bonds but pays those funds out as
benefits in the same year that they are collected. (Although
the system has been accumulating a fund since 1983 to smooth
the path of tax rates, more than 90 percent of payroll tax
receipts are still paid out immediately as benefits, and the assets
in the Social Security trust fund are only about 5 percent of
the Social Security liabilities.)
The rate of return that individuals earn on their
mandatory Social Security contributions is therefore far less than
they could earn in a private pension or in a funded Social
Security system. An unfunded program with a constant tax rate provides a
positive rate of return that is roughly equal to the rate of
growth of the payroll tax base.
The average growth of real wages since 1960—2.6
percent—can serve as a reasonable estimate of what an
unfunded Social Security program can yield over the long-term future.
In contrast, the real pretax return on nonfinancial corporate
capital (i.e., profits before all taxes plus the net interest
paid) averaged 9.3 percent over the same period.[4] Although
individuals do not earn the full 9.3 percent pretax return even
in Individual Retirement Accounts (IRAs) and 401(k) accounts
because of federal and state corporate taxes, a funded
retirement system could deliver the full 9.3 percent pretax return
to each individual saver if the government credited back the
corporate tax collections.[5]
A simplified example will indicate the magnitude of the
tax wedge implied by the Social Security program. Consider an
employee who contributes $1,000 to Social Security at age 50
to buy benefits to be paid at age 75. With a 2.6 percent
yield, the $1,000 grows to $1,900 after the 25 years. In
contrast, a yield of 9.3 percent would allow the individual
to buy the same $1,900 retirement income for only $206. Thus, forcing individuals
to use the unfunded system dramatically increases their cost of buying
retirement income. In the example, a funded plan would permit
the individual to buy the same retirement income with a 2.5
percent contribution instead of the 12 percent payroll tax.
The 9.5 percent difference is a pure real tax for which the individual
gets nothing in return.
The distorting effect of this tax is much larger than one
might at first think. The net Social Security tax rate is imposed
on top of federal and state income taxes. The federal
marginal tax rate is 28 percent (for single individuals with
taxable incomes over $23,000 and married couples with
combined incomes over $38,000), and the typical state income
tax rate is 5 percent. The Social Security tax therefore
raises the total marginal tax rate to more than 40 percent
and substantially exacerbates the distortions and waste
caused by the income tax.[6]
The combination of the income tax and the payroll tax
distorts not only the number of hours that individuals work
but also other dimensions of labor supply like occupational choice,
location, and effort. It also distorts the form in which compensation
is taken, shifting taxable cash into untaxed fringe benefits,
nicer working conditions, etc. These distortions in the form
of compensation are in effect distortions in the individual's pattern
of consumption. They cause individuals to spend their
potential income on things that they value less than those
things that they could buy for cash. These distortions are
dollar for dollar as important as the distortion in labor
supply.[7]
In practice, these distortions are exacerbated by the
haphazard relations between benefits and taxes that result
from existing Social Security rules. For example, because benefits
are based on the 35 years of highest earnings, most employees under
age 25 receive no additional benefit for their payroll taxes.
Because many married women and widows claim benefits based on
their husbands' earnings, they also often receive no benefit
in return for their payroll taxes. Because there is no extra
reward for taxes paid at an early date, the effective tax
rate for younger taxpayers can be a substantial multiple of
the tax rate for older employees. The Social Security rules
are so complex and so opaque that many individuals may simply
disregard the benefits that they earn from additional work
and act as if the entire payroll tax is a net tax no
different in kind from the personal income tax.
The extra distortion that results from these very unequal
links between incremental taxes and incremental benefits
would automatically be eliminated in a privatized funded
system with individual retirement accounts. Although it could
also be eliminated within the existing unfunded system by
creating individual Social Security accounts for each
taxpayer, the larger labor market distortions that result
from the low rate of return in an unfunded system cannot be
eliminated without shifting to either a funded public system
or a privatized system of individual retirement accounts.
Reduced National
Saving
The loss that results from labor market distortions is not
the only adverse effect of an unfunded Social Security system
or even the largest one. Current and future generations lose
by being forced to participate in a low-yielding, unfunded program—i.e.,
by being forced to accept a pay-as-you-go implicit return of
2.6 percent when the real marginal product of capital is 9.3
percent. Even though capital income taxes now prevent
individuals from receiving that 9.3 percent on their personal savings,
the public as a whole does receive that full return; what
individuals do not receive directly, they receive in the form
of reductions in other taxes or increases in government
services.
The extent to which an unfunded Social Security system
causes a decline in national capital income and economic
welfare depends on how individual saving responds to Social
Security taxes and benefits and on how the government acts to
offset the reductions in private saving. Let's look at some
facts.
An individual who has average earnings during his entire
working life and who retires at age 65 with a "dependent
spouse" now receives benefits equal to 63 percent of his earnings
during the full year before retirement. Because the Social
Security benefits of such an individual are not taxed, those
benefits replace more than 80 percent of peak preretirement
after-tax income. Common sense and casual observation suggest
that individuals who can expect such a high replacement rate will
do little saving for their retirement. Such saving as they do
during their preretirement years is more likely to be done as
a precautionary balance to deal with unexpected changes in
income or consumption. Not surprisingly, the median financial
assets of households with a head of household aged 55 to 64
were only $8,300 in 1991, substantially less than six months'
income. Even if we look beyond financial wealth, the median
net worth (including the value of the home) among all households
with a head of household under 65 years of age was only
$28,000.
To get a sense of the order of magnitude of the annual
loss, it is helpful to begin with the simplest case in which
each dollar of Social Security wealth reduces real private wealth
by a dollar. The forgone private wealth would have earned
about 9.3 percent, whereas the unfunded Social Security
system provides a return equal to about 2.6 percent. The
population incurs a loss equal to the difference between those
two returns. The annual loss of real income would be 6.7
percent of the $9 trillion of Social Security wealth—an amount
equal to $600 billion or 8 percent of total GDP.
Of course, each dollar of Social Security wealth does not
necessarily replace exactly a dollar of real wealth. To the
extent that Social Security induces earlier retirement, individuals
will save more than they otherwise would. Social Security also
affects private saving by providing a real annuity. And there
are some individuals who, because they are irrational or
myopic, do not respond at all to the provision of Social Security benefits.
A number of research studies have been done on the extent to
which Social Security wealth depresses saving and replaces
real wealth.[8] Although none of these is a
definitive study that establishes a precise measure of the
substitution of Social Security wealth for other household
wealth, taken together these studies do imply that the Social
Security program causes each generation to reduce its savings substantially and
thereby to incur a substantial loss of real investment
income. Even a conservative estimate that each dollar of
Social Security wealth displaces only 50 cents of private wealth
accumulation implies that the annual loss of national income
would exceed 4 percent of GDP.
The Gain from
Privatization
Under the current Social Security system, each generation
now and in the future loses the difference between the return
to real capital that would be obtained in a funded system and
the much lower return in the existing unfunded program.
Shifting to a privatized system of individual mandatory
accounts that can be invested in a mix of stocks and bonds
would permit individuals to obtain the full real pretax rate
of return on capital. This would mean a larger capital stock
and a higher national income.
In addition, eliminating the payroll tax would reduce the
distortions in work effort and form of compensation that
currently depress the productivity of the economy and the real
standard of living. When the system of funded individual
accounts is fully implemented, the mandatory contributions
required to fund the current and projected levels of benefits
would be only about 3 percent of payroll, far lower than the
payroll tax, which is expected to rise from 12.4 percent now
to at least 20 percent over the next 35 years.
Conservative assumptions imply that Social Security
privatization would increase the economic well-being of future
generations by an amount equal to 5 percent of GDP each year
as long as the system lasts. Although the transition to a
funded system would involve economic as well as political
costs, the net present value of the gain would be enormous—as
much as $10-20 trillion.[9]
Conclusion
The rapidly deteriorating financial position of Social
Security will eventually force politicians to deal with the problem
of reform. The adverse impact of the current system on a wide
variety of groups—including two-earner couples, the
young, and the poor—may embolden some politicians to go
beyond patching up the current system to proposing more
fundamental reforms than have been considered in the past.
Instead of the usual mix of tax increases and benefit cuts,
we can move to a system based on mandatory, individually owned
private savings accounts.
Such a private savings program would solve Social
Security's long-run financial problems without the necessity
for either huge tax increases or draconian benefit cuts. At
the same time, it would yield enormous benefits to the
economy. In short, privatizing Social Security can increase
real incomes for everyone while ensuring a dignified
retirement for future retirees.
Notes
A longer and more technical version of this
lecture appears in the Papers and Proceedings of the American Economics
Association (American Economic Review, Volume 86, no.
2, May 1996).
1. According to the most recent report of
the Social Security system's Board of Trustees, Social
Security will be insolvent by the year 2029, down from 2030
in last year's report. This represents the eighth time in the last
10 years that the insolvency date has been brought forward. But
Social Security's problems actually begin not in 2029 but as early
as 2012, the year in which the system begins to run a
deficit. 1996 Annual Report of the Board of Trustees of the
Federal Old-Age and Survivors Insurance and Disability
Insurance Trust Funds (Washington: Government Printing
Office), p.4.
2. This is a new estimate of Social
Security wealth based on the detailed Social Security
simulation model presented in Martin Feldstein and Andrew
Samwick, "The Transition Path to Privatizing Social
Security," National Bureau of Economic Research Working
Paper no. 5761 (September 1996), forthcoming in Privatizing
Social Security, to be published by the National Bureau
of Economics Research.
3. Derived from 1996 Annual Report of the
Board of Trustees of the Federal Old-Age and Survivors Insurance
and Disability Insurance Trust Funds
4. Martin Feldstein, Louis Dicks-Mireaux,
and James Porterba, "The Effective Tax Rate and Pretax Rate
of Return," Journal of Public Economics 21 (July
1993): 129-58, and Richard Rippe, "Further Gains in Corporate
Profitability," Economic Outlook Monthly, August
1995.
5. Those taxes average 42 percent of pretax
return. Ibid.
6. Economists measure this waste by the
"deadweight loss" of the tax, i.e., the loss to the
individual in excess of the revenue raised by the government.
Economists can calculate that the incremental deadweight loss
that results from the additional 9.5 percent net Social
Security tax is equal to 4.7 percent of the product of the payroll
tax base and the compensated elasticity of that tax base with
respect to the net of tax share. That is about 10 times as
large as the deadweight loss that would result if the Social
Security tax were the only tax. For details of this
calculation, see page 4 of the Ely lecture as published in
the American Economic Review.
7. The deadweight loss due to the net
Social Security tax is about 2.35 percent of the Social
Security payroll tax base, a deadweight loss in 1995 of about
$68 billion. This deadweight loss is about 1 percent of GDP
and nearly one-fifth of total Social Security payroll tax
revenue. It increases the deadweight loss of the personal income
tax by 50 percent. Details of this calculation are presented
on pages 4 and 5 of the Ely Lecture.
8. See, for example, Martin Feldstein and
Anthony Pellechio, "Social Security and Household Wealth Accumulation: New
Microeconometric Evidence," Review of Economics and
Statistics 61 (August 1979): 361-68; Peter Diamond and J.
A. Hausman, "Individual Retirement and Savings
Behavior," Journal of Public Economics 23
(Feb.-Mar. 1984): 81-114; Alan Blinder, R. Gordon, and David
Wise, "Social Security, Bequests, and Life Cycle Theory
of Savings: Cross-Sectional Tests," in Alan Blinder,
ea., Inventory Theory and Consumer Behavior (Ann Arbor,
MI: University of Michigan Press, 1990), pp. 229-56; and
Robert Barro, "The Impact of Social Security on National
Savings," Washington, D.C., American Enterprise Institute,
1978.
9. The present value gain is the present
value of annual gains of 5 percent of GDR Since the current
level of GDP is now $7.5 trillion, a gain of 5 percent of
that would be $375 billion. The annual gain would increase in proportion
to the GDP and would therefore grow at about 3 percent
per year in real terms. Discounting this at a real rate of 5 percent
(approximately the rate of return net of tax that an
individual investor received on the Standard and Poors portfolio
over the period since 1970) implies a present value of $18.75
trillion.
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