The Myths of Social Security Crisis: Behind the Privatization Push

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

July 21, 1996

No presidential candidate wants to talk about Social Security during the campaign. But events are conspiring to force them to do just that. Three factions on a usually obscure governmental commission, the Advisory Council on Social Security, are about to call for reductions of various sizes in benefits for future retirees.

One of these factions will propose gradually ending Social Security as we know it. The newest presidential aspirant, Richard Lamm, has made a career of bewailing the excessive costs of programs for the elderly. And brokerage houses and mutual funds, lusting after lucrative customers, are pouring millions into a campaign to convince Congress and the president to privatize Social Security. The critics say that Social Security is broke and beyond fixing. Are they right?

As the debate within the Advisory Council and the vigorous lobbying of financial companies make clear, larger debate is now under way. That debate is about whether to fix Social Security or to replace it with mandatory private savings accounts. Though badly overused, the term, “vitally important” fairly describes this debate. Unfortunately, sensible debate is almost impossible because the debate is shrouded in myths and misrepresentations, repeated so often that many people now assume they are true.

Myth 1
Social Security is in crisis.

Well, let’s see. Social Security revenues now exceed outlays by more than $65 billion a year. This annual surplus is projected to more than double in the next decade. The Social Security trust funds are projected to keep growing for 16 years. The system is projected to be in overall surplus for the next 30 years and current financing is likely to cover currently promised benefits for 34 years. Only later are projected revenues and accumulated reserves insufficient to pay legislated benefits.

A problem? Well, yes, because revenues will probably not cover benefits for 75 years, the planning horizon legislators use to determine whether Social Security is solvent in the long run. The problems are real and certainly deserve attention, the sooner, the better. Taxes will have to be increased, benefits cut, or both. But there is no need for political palpitations and heavy breathing. The total projected increase in the cost of Social Security, measured as a share of gross domestic product, is less than the decline in defense spending since 1990. Can a problem that does not become immediate for a third of a century be a “crisis”? In a pig’s eye.

Myth 2
Social Security is part of the current deficit problem.

How can a program that this year is generating $65 billion more in revenue than it spends be a part of the current deficit problem? Obviously, it can’t. The Social Security program, because it runs a surplus, actually reduces the deficit. Repeal Social Security today and next year’s budget deficit would rise by $75 billion, from a projected $144 billion to $209 billion. Repeal Social Security today and the national debt would be nearly $700 billion larger in 2002 than it is projected to be. Balancing the budget by 2002, the zero-deficit target year according to bipartisan consensus, would require over $100 billion more in spending cuts or tax increases were Social Security not on the books.

Myth 3
The Social Security trust fund is a myth. The money has all been spent and it won’t be there when we need it.

This statement contains an element of truth—it points to a genuine problem with government financing—but it directs attention away from the real problem, which lies outside of the Social Security system.

Each dollar of Social Security reserves is invested in special Treasury securities. One way to see the value of these assets is to imagine yourself the financial manager of a large insurance company. You are in charge of a portfolio that includes U.S. government bonds like those held in the trust fund. Far from regarding these government bonds as mythical, you would recognize them as the safest asset in your portfolio. You can sell at any time or hold to maturity for redemption at face value, without the slightest default. Anyone who suggested that such assets were a “myth” would be dismissed as a financial ignoramus. As portfolio manager, you might take criticism for being unnecessarily conservative and sacrificing returns you could earn by investing in riskier securities, such as stocks or corporate bonds. But your holdings of government bonds would be seen for what they are—the most dependable asset in your portfolio.

In one important sense the trust fund has been “spent.” So have the life insurance premiums that were invested in government securities. In both cases, saving that might have gone for investment in new buildings or machines goes instead to pay for current expenditures of the federal government. Because saving was spent on current public consumption, not on real capital assets, the nation lost the added future production that real capital assets could have produced. But the diversion did not occur because Social Security is poorly managed or because private saving was unwise. It occurred because the federal government does not collect enough in ordinary taxes to pay for expenditures on activities other than Social Security.

There is a real problem here, and it’s exacerbated by the anemic level of national saving. If people and businesses in the United States were heavy savers, modest government deficits outside Social Security would be no problem.

Myth 4
Allowing people to invest privately what they now pay in Social Security taxes that is, privatizing—Social Security would raise saving, boost economic growth and increase retirement incomes.

Social Security reserves are invested in Treasury securities that yield the same interest as the Treasury pays on publicly issued bonds. The return on these bonds is projected to exceed inflation by 2.3 percent annually. That return looks pretty modest compared with yields on private stocks, which have exceeded inflation by about 7 percent on the average for several decades. So supporters of privatization the solution is obvious: Let workers and their employers invest in these better-paying private securities rather than send it to the government in payroll taxes. The economy will gain because of the increased return. And workers will earn much larger pensions or, at least, pay less for the pensions they have been promised.

Sounds terrific, right? Well, not quite. Eighty-four percent of Social Security revenues pay for current benefits. Few people are willing to slash benefits of the currently retired, who are in no position to adjust to reductions in benefits they have had every right to expect. If we are going to maintain pensions to the current beneficiaries, only one-sixth of current payroll taxes is available to go into private securities.

Even that switch will not do what is claimed for it. Suppose that payroll taxes were cut by just the excess of current revenue over current outlays—about $65 billion a year—and that people increased their purchases in private securities by that amount. In that event, the federal government would have to borrow an additional $65 billion from private savers. As a result, $65 billion in private savings that otherwise would have paid for private investment will go to finance government operations. The $65 billion in reduced payroll taxes shifted to private assets would just offset the diversion of private savings into government bonds.

What would be the net effect of this diversion? Private investors would hold $65 billion less of private assets and $65 billion more of government bonds. Resources available for private investment are unchanged. If investment does not change, the capital stock available to the private economy will be the same. And, so will economic growth. There is little reason to think that this swap will have any effect on economic growth whatsoever.

But there is more. All plans to privatize Social Security come bundled with tax increases. Supporters of privatization almost never come clean on this stubborn fact. Proposing higher taxes is not a good way to win friends these days. Tax increases are necessary to make privatization work, because payroll tax revenues are not adequate to pay both for benefits today and for the build-up of reserves in new personal accounts. These added taxes reduce consumption. That leaves more of current production for investment in the United States or abroad.

If Congress wants to assure Social Security beneficiaries the same high returns on Social Security reserves that private securities yield, it need only instruct the managers of the trust funds to invest Security reserves in passively managed index funds containing private stocks and bonds. Presto! All of the so-called gains of privatization would accrue to Social Security beneficiaries.

Myth 5
Social Security is the third rail of American politics touch it and you die.

Social Security has been the subject of major legislation three times in the past two decades. In each case benefits were cut. In 1977, Congress scaled back benefits about 20 percent to correct legislative mistakes made five years earlier. In 1983, Congress cut benefits again by raising the age at which unreduced benefits are paid and imposed income taxes on some Social Security benefits. And again in 1993, Congress cut benefits, this time by increasing the proportion of benefits subject to the personal income tax.

Meanwhile, chest-thumping members of Congress and febrile journalists brag of their own courage in daring to call for cutbacks in Social Security. With macho fanfare, they call on all to watch them grab this “third rail”—and somehow not one of them fries.

The truth is that talking about scaling back Social Security is politically chic. One reason is sensible: Most people know about the long-term deficit in Social Security and want to restore the system to financial health. Most acknowledge that some reduction in benefits is necessary—by delaying eligibility, by cutting benefits, or by subjecting Social Security benefits to the same tax rules that apply to private pensions.

Another reason is more political: The Social Security system is the largest government program of income redistribution in the United States. Early in the next century, high-wage retirees will begin to get back in benefits less than they and their employers paid in. The poor will continue to get back more. Social Security provides additional protections—benefits fully protected against inflation, for example—that are available nowhere else. The creation of such a system was a major achievement of the New Deal. It reflected the view that Americans share an obligation to one another, that someone who works a lifetime deserves a pension high enough to support a basic standard of living without the stigma of welfare.

The philosophy of privatization is quite different. It is that each person should make deposits to a personal savings account and enjoy all of the fruits of that saving. Privatization of Social Security would not make the elderly and disabled go away. But it will end a system that requires high earners to help out low earners without forcing low earners to undergo the stigma of welfare. Proposals to privatize Social Security raise important questions that must be answered before these proposals deserve to be taken seriously.

First, will people be free to invest in any sort of asset, as they can through individual retirement accounts? If so, will administrative costs eat up so much of the return, especially on small accounts, that average returns will be low? What will be done in the case of savers who invest unwisely and reach old age with too little to support themselves in retirement?

Second, if choice among investments is limited, who will regulate the investment choices? Who will assure that the elderly can convert their savings into annuities at a fair price?

Third, how large must the tax increases be to make privatization of any kind work and for how long must these tax increases be maintained?

Fourth, how many elderly and disabled people will have to apply for welfare who are spared the necessity to do so by the internal redistribution of the current Social Security system?

It is quite appropriate for citizens in a democracy to review periodically even a highly successful public program. Such review is imperative when financial problems loom. But the propagation of myths and the creation of an entirely artificial sense of crisis serves neither open-mindedness nor cool deliberation. Both will be needed in large doses in the forthcoming review of Social Security.