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
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).