The Social Security system is in growing financial distress. It is unfair. It is inefficient. And it is user unfriendly. Tinkering with it at the edges will solve none of these problems. The solution is to privatize the retirement portion of the system—in a way that is fiscally sound, equitable, efficient, informative, and accessible.
The System Is in Crisis
The Social Security system faces a long-run funding crisis. Crisis is a strong word, one we don’t use lightly. According to the conservative projection (known as the “high-cost” projection) of the system’s actuaries, we need to raise, immediately and permanently, the combined employer-employee OASDI payroll tax rate by 50 percent—from 12.4 percent to 18.4 percent—to avoid having to raise the tax rate by a much larger percentage down the road.
This required 6 percentage point payroll tax hike is huge! We Americans have only 100 percentage points of our earnings to give away to assorted government bodies, and these bodies are already taking a hefty share of what we earn. Furthermore, Social Security is not our only insolvent entitlement program. According to the Health Care Financing Administration’s conservative Medicare projections, we need to raise, immediately and permanently, the Hospital Insurance payroll tax rate by more than 10 percentage points. Adding this tax hike to the requisite 6 percentage point Social Security tax hike would more than double the FICA tax, leaving ourselves and our kids sending almost one in every three dollars we earn to these programs.
Now the self-styled defenders of Social Security will tell you that “Medicare is Medicare’s problem” and that “Social Security’s finances aren’t all that bad.” On Social Security they say, “Use the actuaries’ intermediate projection, not their conservative one.” According to the intermediate projection, only a “modest” and “manageable” 2.5 percentage point immediate and permanent payroll tax hike is needed. (This increase is for the entire future; for the next 75 years, the requisite tax hike is 2.2 percentage points.) Furthermore, they’ll tell you that this “moderate” problem can be handled with a much smaller payroll tax hike if one also a) raises the retirement age for receipt of benefits, b) changes the formula that calculates benefits, c) taxes all of Social Security benefits under the federal income tax, and d) makes other minor modifications to the system. Their packages of proposed fixes are carefully tailored so that each x, by itself, seems small. But together they add up to reducing our lifetime labor incomes and those of our children by roughly 2.5 percent.
Giving away another 2.5 percent of our labor incomes to Social Security, as the intermediate projection tells us we need to do, is a major, not a minor matter. But history teaches us, and prudence compels us, to judge Social Security’s finances based not on the actuaries’ intermediate projection, but on their conservative one. Anyone old enough to remember how Social Security was “saved” in 1977 and again in 1983 should understand that the intermediate projection is not to be trusted.
The fact is that the intermediate projection has routinely been overly optimistic—and by a wide margin. That, after all, is why Social Security’s finances are, yet again, in crisis. The current intermediate projection, which in any case forecasts a 37 percent increase in Social Security costs relative to GDP, appears to be seriously off base on two counts. First, it assumes much smaller improvements in longevity than our top demographers forecast. Second, it assumes much higher future real wage growth than we’ve experienced in recent decades.
The System Is Unfair
It’s well known that our pay-as-you-go Social Security system has effected an enormous redistribution from current and future Americans to cohorts who are now either elderly or deceased. What is less well known is that the system also redistributes large sums from men to women, from single people to married couples, and from two-earner couples and singles to single-earner couples.
Take, as an example, a 40-year-old single man earning $25,000 in 1997. For this man, the lifetime net tax from participating in Social Security measured as of age 65 is $397,000. (This and related numbers in this section were calculated by Eugene Steurle, of the Urban Institute, using a 6 percent real discount rate.) For him, participating in Social Security is equivalent to arriving at age 65 with $397,000 less in assets—a fantastic sum for someone earning only $25,000 a year. The corresponding loss for a single woman the same age and with the same earnings is $14,000 less—because, on average, women’s greater life expectancy allows them to collect benefits longer than do men. Now if this single man and woman were to marry and only one of them were to work, their net loss from participating in Social Security would drop to just $134,000 per person, or roughly one-third their net loss when they are single. The reason for this difference in the treatment of one- and two-earner couples is that Social Security provides dependent and survivor benefits for free to noncontributing spouses.
Now suppose the nonworking spouse of the couple decides to work and earns $11,000 a year. The per person loss now becomes $241,000. The loss is large, but it’s smaller than the $276,000 loss each would incur, on average, were they single. The $35,000 additional loss from being single again reflects the fact that Social Security provides dependent and survivor benefits to spouses free of charge.
Social Security’s intragenerational redistribution is enormous and capricious. Would the American public freely choose to take tens of thousands of dollars from single people and give them to married people? Would the public freely choose to take hundreds of thousands of dollars from two-earner married couples and give them to single-earner married couples? Unlikely.
The System Is Inefficient
The benefit provisions of Social Security are so complex and arcane that most Americans have very little understanding of how the system redistributes among them. They also appear to have little understanding of what their marginal contributions will yield in terms of marginal benefits. The failure to link, closely and clearly, Social Security benefits to Social Security contributions means that most contributors are likely to view the system’s 12.4 percentage point payroll tax as a pure tax. Given the size of other marginal labor income taxes and given the fact that the distortion of labor supply decisions rises as the square of the total effective tax on labor supply, the Social Security system could well be doubling the distortion of Americans’ labor supply decisions.
Americans patient enough and smart enough to decipher the precise degree of benefit-tax linkage under Social Security will find quite different answers depending on their situations. If they are secondary earners, they’ll find that their marginal contributions yield zero additional retirement and survivor benefits. If they are primary earners, they’ll learn that each dollar they contribute may produce more than a dollar in additional benefits.
Would Americans vote for a system in which many secondary earners receive not a penny back in Social Security retirement and survivor benefits despite a lifetime of contributing to these programs? Would they vote to subsidize, at the margin, the labor supply of primary earners (primarily men) as part and parcel of overtaxing, at the margin, secondary earners (primarily women)?
The System Is User Unfriendly
Ask yourself the following question. When was the last time the Social Security system, on its own, sent you a benefit statement? The answer, of course, is never. Next, ask how long it takes the system to send you a benefit statement after you request it. The answer is about six weeks. Finally, ask yourself whether the statement you get tells you the amount of your retirement benefits in today’s dollars or in future inflation-eroded dollars that you can’t easily interpret in terms of current purchasing power. The answer is in future inflation-eroded dollars.
Now we are all free to plow through Social Security’s 500-page handbook to try to figure out our own benefits, but the handbook is so poorly written and so confusing that even Social Security’s actuaries say it’s hopeless.
Certainly, Social Security could improve its benefit reporting. But since the system hasn’t, in over half a century, been able to figure out how to send out regular benefit statements, don’t hold your breath. Moreover, Social Security’s benefit statements are not only economically illegible, they also come with a false advertisement. Specifically, they contain assurances from the Social Security Commissioner to the effect that workers can rely on receiving their specified benefits when they reach retirement. As indicated above, Social Security’s long-term finances are so dire that workers can, in truth, rely on precisely the opposite of the Commissioner’s assurance.
The Personal Security System
The Social Security system is in deep water. Fortunately, there’s a solution that makes sense, that’s fair, and that is consistent with all the legitimate goals of the old system. The solution is to privatize the retirement portion of Social Security. Our privatization proposal, which we call the Personal Security System (PSS), has been endorsed by 70 of the country’s top academic economists, including three Nobel prize winners. The proposal has the following seven features:
Scope of the proposal: Only the OAI payroll tax (about 70 percent of total OASDI contributions) is eliminated. Contributions made to and benefits received from the Disability Insurance and Survivors Insurance portions of the Social Security system are unchanged.
Earnings Sharing: To protect nonworking and secondary-earner spouses, total PSS contributions made by married couples are split 50-50 between the husband and wife before being deposited in each’s own PSS account.
Government Matching of PSS Contributions: The federal government matches PSS contributions of low-income contributors on a progressive basis. It also makes PSS contributions through age 65 on behalf of disabled workers.
Tax Treatment and Survivor Provisions of PSS Accounts: PSS contributions are subject to the same tax treatment as current 401k accounts. Contributions are deductible and withdrawals are taxable. Through age 65, survivor provisions governing PSS balances are identical to those governing 401k accounts.
Investment of PSS Account Balances: Workers and their spouses invest their PSS contributions in regulated, supervised, and diversified investments. For example, these investments might be restricted to inflation-indexed, exchange-rate hedged, high-grade domestic and international government and corporate zero-coupon bonds that come due when the worker reaches age 65. Alternatively, the portfolio rules could specify particular equity and debt shares that might vary by age, but that preclude trying to “time the market.” Investment transactions costs need not be large. Workers would be in certified and highly diversified index funds that, like such funds now on the market, would be forced by competition to levy extremely low fees. If the government chose, for example, to restrict PSS account balances to being held in a market-weighted global financial securities index fund, that fund’s fees would be priced at only 20 to 30 basis points. Furthermore, such a restriction would eliminate workers’ abilities to time the market. Since all fund managers would have to offer the same portfolio, moving from one fund manager to another would not alter one’s portfolio.
Annuitization of PSS Account Balances: PSS balances cannot be withdrawn before age 65. At age 65, PSS balances are pooled with those of other cohort members. The federal government purchases, in a competitive fee-bidding process, single-life, real annuities for each cohort member in proportion to his or her PSS account balance.
Payment of Social Security Retirement Benefits to Current Retirees and Workers: Current recipients of Social Security retirement benefits continue to receive full inflation-indexed benefits. When current workers retire, they receive the full Social Security retirement benefits accrued as of the time of the reform. These benefits are calculated by filling in zeros in the OAI earnings records of all Social Security participants for years after the transition begins. Since new workers joining the workforce will have only zeros entered in their OAI earnings histories, new workers will receive no OAI benefits in retirement. Thus, over a transition period aggregate Social Security retirement benefits will decline to zero.
Financing the Transition: During the transition, Social Security retirement benefits will be financed by a value-added tax or a federal retail sales tax (to be collected by the states). The PSS tax will also finance the government’s PSS contribution match. Over time, the PSS tax rate will decline as the amount of Social Security retirement benefits declines. Provisional calculations suggest that the VAT or sales tax would begin below 10 percent and would decline to a permanent level of roughly 2 percent within 40 years.
Simulations of this approach to Social Security reform show long-run improvements in U.S. living standards of more than 10 percent and long-run increases in the U.S. capital stock of roughly one-third. These gains reflect the partial alleviation of the enormous fiscal burden facing future generations arising from current entitlement programs.
How will the PSS affect the poor? Social Security’s cost-of-living adjustment insulates its beneficiaries from the potential increase in consumer prices associated with the new PSS tax. Hence, the current poor elderly will experience no higher fiscal burden. Moreover, simulation analyses show that poor members of the current middle-aged generation, of the current young generation, and of future generations have the most to gain from privatizing Social Security.
The PSS proposal asks current Americans, old and young, to help pay off Social Security’s unfunded retirement benefit liability. Since it insulates the current poor elderly, only rich and middle-class elderly face a higher fiscal burden. Asking them to pay their share of Social Security’s unfunded liability is intergenerationally equitable particularly given the massive and growing Medicare burden facing future generations.
Unlike many Social Security reform proposals, the Personal Security System would substantially alleviate the benefit crisis facing future generations. It would also improve economic efficiency by linking retirement income to retirement saving without sacrificing secondary earners and the poor.
The Personal Security System would improve benefit-tax linkage, enhance survivor protection, equalize treatment of one- and two-earner couples, offset the ongoing transfer of resources from the young to the old, provide better divorce protection to nonworking spouses, make the system’s progressivity apparent, resolve Social Security’s long-term funding problem, and ensure Americans an adequate level of retirement income. It would also, over time, provide a considerable boost to the economy. What more could one want?