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Social Security Snares & Delusions

From the January 17, 2005 issue: How not to squander political capital.

Jan 17, 2005, Vol. 10, No. 17 • By IRWIN M. STELZER
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PRESIDENT BUSH WANTS TO REFORM the Social Security system. He is right to want to transform the system into one that meets the needs of an America whose economy and demography markedly differ from the day when Franklin Roosevelt put this safety net in place. He is right, too, to have decided to allow debate on the best way to accomplish this transformation to go on for a while longer before he commits himself to a particular set of proposals that would significantly change a system that many Americans have come to regard as the compassionate face of capitalism.

Some Democrats, predictably, have taken to the barricades to oppose any change, either out of an attachment to a system that represents one of their party's historic achievements, or out of sheer political calculation or spite. They are unlikely to be persuaded by whatever evidence is marshaled in support of change. But for now at least, even centrist Democrats, many willing to consider reforming the system, are lining up to oppose the president, as is the supply-side, deficits-don't-matter (or not very much) wing of his own party. Former House speaker Newt Gingrich and Jack Kemp are warning that the president's plan to "reduce benefits" could cost the Republicans control of Congress. And while most Republican senators and congressmen of course want to be with the president, they are nervous about facing political fire without at least a modicum of bipartisan support to provide "political cover." So far, that cover just isn't available.

Those of us who know that change is needed are hoping that the president's decision to delay specific proposals is not merely intended to give his staff more time to hone its presentational skills, but will permit a substantive debate that will, in the end, result in improvements to the plan now on the White House drawing board. For unless the president considers some important modifications of his plan, his crusade could become for him what health care reform was for Bill Clinton--at least a waste of energy and political capital, at worst a political debacle.

How could one reform Social Security in a way that could result in a financially sound system, stimulate economic growth, improve the fairness of the existing system, and gain support from all save the "no, not now, not ever" crowd?

Start with the reason most offered for reforming the system: that owing to the impending retirement of the nation's baby boomers, the system is on the brink of financial insolvency. Or, if not on the brink, headed toward it. That may be, but is not certainly, true: Some estimates show that taxes currently earmarked for the program, along with earnings on the Social Security Trust Fund (for our purposes let's assume that there is such a thing, rather than reopen the tiresome debate about the "lockbox") will cover outlays until 2028. Others put the date at which the current system will be unable to pay all promised benefits at 2042.

And possibly later. For one thing, if the economy grows more rapidly and efficiently than some predictions suggest, the current system might well prove capable of meeting all of its obligations. Improvements in productivity at rates of recent years, for example, will allow the workforce to support a higher ratio of retirees than is now the case; more rapid economic growth will generate more revenues for the system than some of the middle-scenario forecasts assume.

Besides, we should be careful before spending a great deal of energy worrying about the financial condition of retiring baby boomers. This is not the 1930s, when even retirees who had worked hard, and scrimped, faced a difficult future. This is the 21st century, when many retiring baby boomers will have substantial assets that make them less dependent on their Social Security checks to make up as high a proportion of their retirement income.

Indeed, a case can be made that by putting the issue of Social Security reform on the backburner for several years we would not be emulating Mr. Micawber but, instead, heeding the interdiction widely attributed to Ronald Reagan: "Don't just do something, stand there." After all, in the face of the uncertainties surrounding global warming, the administration has quite wisely avoided the temptation to join the world in overreacting, in "doing something" before it is clear that anything needs to be done, or, if it does, just what. What makes sense for environmental policy might make equal sense when it comes to social policy.

BUT WE SHOULD NEVER discourage politicians bent on prudence. So let's assume that there indeed is an impending problem, and that the president is right to contend it is his responsibility to solve that problem now, rather than to burden his successors with the chore.

It is, of course, also his responsibility to make clear just what his proposed solutions involve. A good beginning would be to abandon the argument that no cut in benefits is contemplated. That argument goes something like this. One reason the system is in financial difficulty is that (here and throughout I am sacrificing a bit of precision in favor of a great deal of clarity) the benefits of retirees are being increased more or less in line with the rise in wages. Reports are the president would change the escalator to the cost-of-living index. That alone, estimates Professor Olivia Mitchell of the University of Pennsylvania's Wharton School, "would fix the solvency problem without individual accounts. Indexing to inflation rather than wages will put it back on actuarial balance."

Now, it is possible to make a conceptual argument in favor of either of those escalators (such automatic increases are far superior to the old system where Congress raised benefits to win reelection). Escalate with wages, and you retain the standard of living of retirees relative to those of active workers. Escalate with inflation, and you retain the absolute standard of living of retirees. Surely a question on which reasonable men can differ.

What cannot be argued, at least not while maintaining credibility, is that a switch from a wage-based escalator to an inflation-based escalator does not result in a reduction in payments to retirees. It does, for the simple reason that in an economy in which productivity is increasing, wages will, over time, rise faster than inflation. That's why proponents of the president's plan argue that using a wage escalator places a far greater financial burden on the system than does the alternative. But if the current escalator is far more expensive than the proposed substitute, then the switch to an inflation index would reduce the benefits that would flow from retaining the wage indexation scheme. A change to a cost-of-living index would lower the cost of the system precisely because it lowers benefits--a good or at least necessary thing, perhaps, but a reduction by any other name remains a reduction. Meanwhile, payments into the system, being based on a tax on wages, would rise faster than benefits paid out, since wages should (one trusts) outpace inflation.

True, were we to switch escalators we would be imposing only a reduction in an increase, but it is a reduction in a promised increase, an increase that is now incorporated in what can be characterized as a social contract between active workers and retirees. That is not something conservatives should lightly contemplate.

In addition to reducing benefits, the proposal being mooted in the White House would allow some portion (one-third is the share recommended by the 2001 Presidential Commission on Social Security Reform) of the funds now being paid as taxes to support the Social Security system to be diverted into personal retirement accounts. The reasons given for this change, which polls suggest younger voters see as the only way they will ever collect any benefits, are two: It will help to create an "ownership society," weaning the individual from dependence on the state; and returns on the privately invested funds will in some economically meaningful sense be higher than those now being earned by the government on behalf of future beneficiaries. Neither reason withstands scrutiny.

No one is proposing to allow participants in the current system to invest even a part of their contribution in any way they might choose. After all, individuals might make the wrong choices, and find themselves less well-off than they would wish when the time comes to lay down their tools or attend their last important meeting. So the proposal now on the table would have the government limit investment options to stock-index mutual funds, bond funds, and cash--the resulting pool to be converted into annuities upon retirement. The theory of forced conversion into annuities, rather than allowing lump-sum withdrawals, seems to be that retirees and their money might otherwise soon be parted, a folly the government is honor-bound to prevent. So much for freeing citizens from the heavy hand of the state.

A good case can be made, of course, for continued government supervision of the private investment of funds destined to support retirees. After all, a society unwilling to tolerate an army of penurious retirees--and politically unable to do so even if it were inclined to let retirees fall where they may--is in a sense the insurer of last resort. Insurers impose limits on the behavior against which they will insure. So the proposed changes in the system will not really create an army of investors freed from dependence on the state. Nor will the reforms in any economically meaningful sense increase returns on investment. Returns will rise only if the risk to which funds are exposed also rises. "Higher returns are not a free lunch," warn economists at Goldman Sachs; "workers would take on more risk." Risk-adjusted returns will remain unchanged. Private accounts allow their holders to earn more, but only by risking more--unless the government is prepared to cover any losses incurred by the private investors.

It is true, of course, that the return on investment in stocks has been higher over the long run than has the return earned by the Social Security Trust Fund. But it is far from certain that the 7 percent historically earned on stocks is a sure clue to what the future holds. Indeed, with share prices selling at higher multiples than in the past, it is not an unreasonable guess that earnings will be closer to 5 percent. A bit of arithmetic: A portfolio invested 50 percent in stocks earning 5 percent, and 50 percent in bonds earning a real return of, say, 2 percent, will have an average yield of 3.5 percent. Deduct 1 percent for management fees (Larry Lindsey thinks this wildly overstates the cost), and retirees will net 2.5 percent, not much of a gain over what the Trust Fund now earns. Never have so many spilt so much ink over so little, or at least so it seems.

PERHAPS MOST IMPORTANT, personal retirement accounts really have little to do with the solvency problem, a point made clear by Comptroller General David Walker, who commented last month, "The creation of private accounts for Social Security will not deal with the solvency and sustainability of the Social Security Trust Fund." Which is why Lindsey, a supporter of the president in this and other matters, says that individual accounts in the absence of other changes "will not fly in the bond market." These private accounts, then, are more what BusinessWeek calls a "values issue" than a fiscal one.

Then there is the nasty question of what are called transition costs, variously estimated at between $2 trillion and $5 trillion, as funds previously headed into the system are diverted to private accounts, while outlays continue at currently planned levels. No one can deny that the president has a point: If returns can be raised sufficiently by switching some funds to private accounts, it should be easy to finance the transition costs to a new, more productive system. Borrowing in order to fund larger reductions in costs is common in the private sector, where businesses often borrow money to pay for investments or organizational changes that will lower future costs by more than the cost associated with the new borrowing. Michael Milken understood that, which was why he was able to arrange financing for predators and sharks who took over fat-laden companies, then lowered their operating costs, repaying loans out of the savings, with something left over to reward the predators.

But the government is already running a substantial deficit, and neither the president nor the Congress has yet demonstrated the cost-cutting devotion that enabled Milken's takeover artists to persuade lenders to accept their IOUs. It is not impossible that lenders would see $2-$5 trillion as too much to swallow, at least at current interest rates. The result might then be higher interest rates, renewed pressure on the dollar, and other unforeseeable and unpleasant consequences. I say "might" because many experts, among them Lindsey and R. Glenn Hubbard, two of Bush's favorite economists, contend that the increased debt can be financed without seriously upsetting financial markets. Lindsey believes that the combination of personal accounts and a switch away from wage indexing will be "rewarded by the bond market." And Hubbard feels the markets will acknowledge that a diversion of funds to personal accounts is "akin to prepaying part of a mortgage."

But in the end no one can be sure of the effect of hitting the markets for a few odd trillion more in borrowing. We can, however, be sure that there is a risk in doing so, making it reasonable to ask whether that risk is worth taking to achieve what seem like the minimal gains in freedom and earnings that might flow from individual retirement accounts.

Fortunately, now that the time pressure has been relaxed a bit by the president, we can explore better ways of accomplishing his goals. President Bush is right to want individuals to have personal accounts, but these could supplement Social Security, rather than supplant a part of it, thereby avoiding the transition-cost problem. So more power to the administration's efforts to devise tax-advantaged schemes to encourage personal saving, schemes that do not require any diversion of funds now destined to finance Social Security. And with the Social Security safety net intact, individuals could be left free to invest these added savings in any way they choose--safely, in order to add a bit to retirement income, or daringly, in the hope of striking it rich.

The president is right, too, to want to consider a reduction in benefits as part of any reform package. And replacing wage-based indexing with something related to the inflation rate might be the right thing to do. But it is not the only possibility: Surely, extending the retirement age to reflect current longevity expectations should also be on the table. But in any case, we should keep our word, unmodified, to those who have long been part of the current system, and confine reductions in benefits to new or relatively recent entrants into the workforce.

Where the president and his team might benefit most from further reflection is in the financing of Social Security. The current system of levying a 12.4 percent payroll tax gives us the worst of all possible worlds. First, it is a tax on jobs--payroll taxes make it more costly for employers to hire, and less attractive for workers to work. These taxes raise employers' cost of hiring by 6.2 percent, and reduce the employees' incentive to work by cutting their take-home pay.

Worse still, the system is regressive. Only salaries up to $87,900 (in 2004) are taxed, meaning that Wall Street mega-earners pay no more than their secretaries. This regressivity is ameliorated by the fact that most high earners continue working after the date at which they receive retirement benefits, and those benefits are taxed at the high rates that apply to all of the income earned by these older but unretired workers. Still, not the fairest of systems.

A truly radical reformer would consider alternatives to the job-destroying payroll tax system. After all, why tax a good thing, like jobs, rather than the many bad things that currently go untaxed? Two leap to mind: pollution and imported oil. Surely a reduction in the payroll tax, funded by a tax on either of those two items, would do more to stimulate economic growth, and to reduce the regressive character of the Social Security finance system, than would any of the reforms now being considered.

Which brings me to my final suggestion. The president is keen to reform the tax system and has announced a bipartisan commission that will report to him July 31 on how that might best be done. The question of how to finance the nation's retirement program is equally taxing, if I might be forgiven a pun, and is not unrelated to the broader question of tax reform. Why not charge the new commission with the responsibility of integrating reforms for the tax and Social Security systems? These reforms could take into consideration the fact that the world has changed since FDR first introduced the Social Security safety net; that the increase in wealth since the days of the New Deal inevitably changes the role to be played by government-funded retirement benefits from near-total provision to a supplement to other incomes; that the payroll tax is an impediment to more rapid economic and job growth; and that experience has taught that it is no bad thing to rely on each new generation to fund the retirement of older ones, since newer generations are richer than their predecessors.

With an appropriate mandate, this commission could make available to the president a more carefully considered set of proposals than he now has before him, and provide the basis for greater bipartisan support. And with luck, those of us who fear that the president has not been as radical as he might have been had he been willing to abandon the payroll tax, might carry the day.

Not incidentally, this pause that might refresh would leave President Bush free to devote that portion of the time and political capital that he is able to spend on domestic affairs to getting his judicial appointments approved, and to begin focusing his attention on the health care system. According to Goldman Sachs's economic team, "Medicare is the much bigger problem. It accounts for more than four-fifths of the projected increase in entitlement spending in coming decades, and its costs--unlike those of Social Security--are largely immune to an increase in retirement age. Indeed, the recently enacted Medicare prescription drug benefit by itself is projected to cause a bigger spending increase than the entire Social Security system!"

Now there's a problem worth tackling in order to bring the deficit under control, while plans for reforming Social Security are, shall we say, refined.

Irwin M. Stelzer is a contributing editor to The Weekly Standard, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).