The Magazine

Saving Private Accounts

The missing ingredient in the Social Security debate.

Mar 28, 2005, Vol. 10, No. 26 • By LAWRENCE B. LINDSEY
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LAST YEAR AMERICANS SPENT--on consumption, investment, and government--$1.06 for every dollar we earned. We balanced our collective checkbook only by selling assets we owned and by borrowing directly from foreigners, including institutions like the People's Bank of China, to whom one might prefer not to be increasingly indebted. This borrowing is directly tied to an ever growing trend for us to consume foreign-produced goods at the expense of American production. At the moment, foreigners are lending to us quite willingly and at low interest rates, in large part because it helps their own economic strategies. But it would be irresponsible to assume that this lending will go on indefinitely.

So it is surprising that the issue of promoting national saving is not at the center of the debate over Social Security reform. Done right, the reform process offers enormous potential for improving our national saving rate and thus reducing the amount we are borrowing from foreigners over the next century. This is a historic opportunity to adopt a safer economic course. But we must move carefully because there is ample confusion in Washington on the different approaches and their effects on saving.

The first part of any credible Social Security reform plan is to eliminate the actuarial deficit in the system. The system has promised to pay out, in present value terms, $10 trillion more than it will collect in revenue. There are a number of ways of closing this gap, but with different implications for national saving.

One way is to raise payroll taxes by 50 percent to make sure that the government collects all the money it needs to pay the benefits now promised. At best, this might increase saving for a few decades via deficit reduction, but only if Congress, in a break with its past habits, does not spend the extra revenue on non-retirement programs. Once Social Security payments caught up with the enhanced revenue, though, the plan would forever be moving money from one set of people who would otherwise spend it--workers--to another set of people who would spend it instead--retirees. So even in the best case, this would do little to increase national saving. Even worse would be removing the wage cap that determines both Social Security taxes and benefits. Martin Feldstein calculated that eliminating the cap would produce very little net federal revenue. Entrepreneurs faced with a 50 percent tax rate would pay less federal income tax as well as lower payroll taxes. Much of the lost income would have funded business fixed investment, further lowering national saving.

The second way of bringing the system into balance is to change the formula for determining benefits, in a way that gradually reduces the current growth rate in real benefits. As things now stand, there will be a 45 percent increase in Social Security benefits, even after inflation, over the next half century. The system could be brought into balance by limiting future benefits to the level enjoyed by those retiring from the system today, while fully indexing those benefits to inflation. This could even be coupled with a generous minimum Social Security benefit, thus both making the system more progressive and providing a better safety net. The $10 trillion saving to the Social Security system of doing this could be viewed as a one-time improvement in the federal government's balance sheet of the same amount, but would also be an equivalent reduction in expected benefits for future retirees.

National saving would likely rise as a result. In order to maintain the level of consumption in retirement that the government previously promised, but could not deliver, individuals would have to gradually increase their personal saving during their working lives. This may not be easy for some folks. So a second part of any Social Security reform that promotes national saving in this way should be a personal account plan that helps people save and learn the benefits of saving by watching their own accounts grow.

The president's proposal would allow workers to direct a portion of their payroll taxes into a personal account. Any shortfall in meeting current benefits because of the taxes redirected to these accounts would be made up for by government borrowing. But, for an individual to establish an account, his regular Social Security benefit would be lowered prospectively by the amount of payroll tax that is diverted into a personal account. Although the president has not specified an exact offset, this adjustment would likely incorporate an interest rate that repays the government for its borrowing costs. Thus, the individual would keep all of the proceeds of his or her personal account and have a net benefit gain equal to the amount by which the actual return in private stocks, bonds, or other investments exceeds the government's borrowing cost.