May 30, 2017

Social Security Reform--Facing Up To The Real Trade-Offs

Fed Chairman Alan Greenspan recently reminded Congress that America faces a choice between large cuts in Social Security benefits and large hikes in taxes when Baby Boomers retire. The 2004 Social Security Trustees' report released March 23 points to the same conclusion.

According to the Trustees, Social Security will start paying out more in benefits than it takes in from taxes in 2018. Between 2020 and 2040, Social Security's annual cash deficit will get deeper by roughly an extra $45 billion each year. Stemming the cash hemorrhage would ultimately require cutting benefits by one-third or raising payroll taxes by one-half.

Ensuring Social Security's fiscal sustainability is a powerful reason for reform, but it is not the only reason. The program's pay-as-you-go structure undermines savings, which may become a scarce commodity in our aging society. It also condemns future retirees to a dismal rate of return on their contributions--far less than what today's retirees have earned and far less than what they could earn if their contributions were saved and invested. Social Security will rightly become a central issue this election year. Before the rhetoric heats up, it's worth reviewing the case for reform.

A Mounting Burden

The Social Security challenge is first and foremost a cost challenge. According to its own Trustees, Social Security will be bankrupt by 2042, well within the lifetime of most of today's working-age adults.  Long before then, its widening cash deficits will place a mounting burden on the budget and the economy--leading to large tax hikes, large spending cuts, or massive new borrowing from the public.

As recently as 1960, there were 5.1 taxpaying workers for every Social Security beneficiary. The Trustees project that this “support ratio,” now 3.3, will fall to 2.2 between 2010 and 2030 as Boomers swell the benefit rolls. A falling support ratio in turn translates into a rising cost rate for a pay-as-you-go retirement program like Social Security. The Trustees project that the cost of Social Security as a share of workers' taxable payroll will grow from 11.1 percent today to 16.8 percent by 2030. Thereafter, assuming that benefits are not cut, costs will continue to rise, although more slowly. By 2078, the end of the Trustees' seventy-five-year time horizon, Social Security is projected to cost 19.3 percent of payroll.

Many people assume that the age wave is a temporary challenge that will recede once Boomers pass away. But this is not the case. The Boomers' retirement is ushering in a permanent transformation in the age structure of America's population--and a permanent rise in Social Security's cost burden.

The magnitude of this burden is obscured by the usual focus on trust-fund accounting. According to the official “actuarial balance” measure of trust-fund solvency, Social Security's long-term deficit is a modest 1.9 percent of payroll. Trust-fund accounting, however, gives a highly misleading picture of Social Security's impact on the budget and the economy. It counts as assets trillions of dollars of contributions that have never been saved, while failing to count as liabilities trillions of dollars of benefits earned by those contributions but payable beyond the Trustees' time horizon.

What matters fiscally and economically is Social Security's cash balance--that is, the annual difference between outlays and earmarked tax revenues. The Trustees project that the program's cash balance will sink into deficit in 2018. By 2030, Social Security will be running an annual cash deficit of 3.6 percent of payroll, or $256 billion in today's dollars. By 2041, the last full year the trust funds are “solvent,” its cash deficit will grow to 4.5 percent of payroll, or $370 billion.  These are the annualamounts by which Congress would have to raise taxes, cut other spending, or borrow from the public in order to pay promised Social Security benefits. Over the next seventy-five years, Social Security's annual cash deficits total a staggering $26 trillion.

A Pattern of Generational Inequity

A responsible reform plan must start with cost-saving measures that close Social Security's long-term cash deficit. Several benefit reduction strategies are possible, including raising the so-called normal retirement age and shifting from wage-indexing to price-indexing for calculating new benefits. The most reasonable strategies stress gradualism and fair warning.

Reform, however, should go beyond restoring fiscal balance and redress the cascading pattern of generational inequity that condemns each new generation of Social Security participants to a worse deal than the last. In a famous 1967 Newsweek article, economist Paul Samuelson called Social Security “a Ponzi scheme that works.” Back then, in an era of abundant youth and few elders, a pay-as-you-go system like Social Security could pay retirees as good a return as a funded system. Today, with the system mature and the population aging, virtually no economist believes that this is even remotely possible. The demographic underpinnings of Samuelson's Ponzi scheme have collapsed.

Over the past two centuries, U.S. stocks have earned a real return of roughly 7 percent. Meanwhile, long-term Treasury bonds have earned a return of between 3 and 4 percent. How does the return on Social Security contributions compare? A generation ago, it compared quite well.  According to Urban Institute calculations, the typical single male retiring at age 65 in 1970 earned a return of 7.1 percent on his lifetime Social Security (Old-Age and Survivors) taxes. Today, it compares poorly. The typical single male retiring in 2005 can expect to earn a return of 2.4 percent. A generation hence, it will compare dismally. The typical single male retiring in 2040 is due to earn a return of 1.8 percent--and this assumes that current-law benefits can be paid in full without any increase in current-law contributions.

Yes, Social Security continues to offer a better deal to some categories of workers than to others. But among younger Americans, virtually all categories--including low-earners--will do much worse by participating in Social Security than they could if their contributions were invested in risk-free Treasury debt.

Hiking payroll taxes to close Social Security's long-term cash deficit would further cheapen the deal. Young workers would ask why they must pay more than today's midlife Boomers for the same (or worse) benefits. And middle- and low-income workers, who bear most of the burden, would ask why they must pay more to subsidize the high-income old. Some advocate getting the wealthy to contribute more by levying payroll taxes on all earnings, without a limit on income. But eliminating the “max cap” would destroy the whole presumption of a contributory system--that what people get back be at least somewhat proportional to what they pay in. In any case, it wouldn't come close to generating enough new revenue to balance the system. Simply cutting benefits poses an additional problem--namely, that most of the elderly are highly dependent on Social Security. According to the Social Security Administration, the program accounts for roughly two-thirds of the total cash income of the typical elderly household in the middle of the income distribution. Among lower-income households, the depend-ence on government is even more absolute.

Shifting at least in part from today's pay-as-you-go system to a funded system is the only way to alter this dynamic. Funding Social Security cannot substitute for measures that raise new contributions or reduce pay-as-you-go benefits. But, in conjunction with cost-saving reform, funding can help create a Social Security system that is not only more sustainable, but that offers a fairer deal and a sounder floor of protection.

The case for funding is simple and compelling. At the macro level, a funded system means higher savings and hence higher productivity and higher national income. At the micro level, it means higher returns and hence higher benefits at any given contribution rate. These advantages are not merely theoretical. They are the reason that the funding strategy is now being embraced by countries as diverse as Australia, Germany, Mexico, Poland, Sweden, and the UK.

A Lockbox No Politician Can Pick

To one extent or another, almost everybody agrees that greater funding is an essential ingredient in Social Security reform. Indeed, much of the public is convinced that Social Security is already storing up a large trust-fund reserve.

Unfortunately, the way that the Social Security trust funds work mocks the whole purpose of funding. Any trust-fund surplus is immediately lent to Treasury, leaving Congress free to spend the money that it pretends to save. Social Security's assets are merely interest-earning Treasury IOUs whose sole function is to keep track of budget authority. They constitute a claim on future tax revenues, not economic savings that can be drawn down to finance future benefits.

In the late 1990s, political leaders promised that henceforth they would translate Social Security's current surpluses into genuine savings by balancing the budget excluding the trust funds. The goal was fiscally responsible, but achieving it rested on a chancy proposition--namely, that Congress would have the fiscal discipline to “lockbox” large unified budget surpluses year in and year out. With a booming economy generating windfalls for Treasury, keeping the lockbox promise was initially painless. Even President Bush's first tax cut observed it. But when the economy slowed and September 11 created new spending needs, the promise was quickly forgotten--and forgotten in a big way. This year, the CBO estimates that the budget will run a deficit of $638 billion excluding the trust funds. This is the amount that Congress would have to raise taxes or cut spending in order to save the Social Security surplus.

Some believe that it is possible to construct a sturdier lockbox. They suggest that Congress establish a special off-budget reserve administered by an independent trustee (such as a Federal Reserve bank) and invested in marketable, non-federal securities. Although this might help, it is doubtful that such an arrangement would in the long run be more effective than an on-budget trust fund. What budget rules, for instance, would prevent the federal government from borrowing against or cashing out the investments? When all is said and done, government would still own the reserve, and whatever government owns it can contrive to spend.

In the end, the most reliable funding strategy may be to transfer ownership of some portion of Social Security contributions from government to individuals--in other words, to put the money into personal accounts. Contrary to popular impression, personal accounts need not involve private-sector brokers or even significant transaction fees. A personal accounts system could be highly regulated, with workers required to choose from a small number of generic, globally indexed portfolios.  However regulated, personal accounts would irrevocably transfer ownership to workers. As constitutionally protected property, bequeathable to heirs, personal account assets could not be double-counted in the federal budget as trust-fund surpluses are. Personal accounts thus constitute a lock box that no politician can pick.

A Free Lunch on the Menu

Genuine funding requires genuine resource trade-offs. To save more, we must temporarily consume less--at least until the productivity benefits of higher savings kick in. Unfortunately, many personal accounts advocates pretend that there's a free lunch on the menu. Just divert FICA contributions to personal accounts, they say, and presto, the problem will be solved.

Yes, the advocates know that Treasury will have to borrow to make up for the missing revenue, thus offsetting the new private savings.  According to their logic, however, the mere fact that contributions are invested in private capital markets will ipso facto make everybody a winner. Apparently, they believe that each worker's personal account can indefinitely earn greater returns (at no greater risk) on the new equity assets than government would lose on the new debt liabilities.

The truth is that any plan that tries to cash in heavily on the spread between stocks and bonds is a dicey and perhaps even dangerous proposition. Such financial arbitrage cannot work in the long run. Over time, the yield on bonds would rise and the yield on stocks would fall, narrowing and possibly even erasing the favorable spread on which the plan depends. Either that, or we have to suppose that markets are irrational, and that the general public will willingly impoverish itself by buying bonds and selling stocks (with no change in the yield spread) so that personal account owners can enrich themselves by doing the opposite.

Plans that issue debt directly to Social Security participants in the form of “recognition bonds” raise an additional concern. By translating implicit benefit liabilities (which have no constitutional protection) into formal Treasury debt (which does), they would in effect render Social Security unreformable. Giving workers property rights to a pay-as-you-go entitlement is folly. The economy might collapse or the nation go to war. But short of default on the national debt, Congress could never reduce taxpayers' liability for Social Security.

Other reform plans try to conceal the trade-offs by raising taxes or cutting spending outside the Social Security system. Some propose enacting a national sales tax to help fund personal accounts. Others say we should pay for the transition by cutting discretionary spending. The problem here is that there is no direct link between sacrifice and reward. The savings measures may never be enacted--particularly if, as is usually the case with discretionary spending cuts, they are just vague injunctions to reduce “government waste.” And even if they are enacted, the measures may not result in overall budget savings. In the case of the national sales tax, the public may view it as a substitute for existing taxes and demand an offsetting tax cut. Once again, a larger deficit may neutralize the private savings boost.

Let us restate the bottom line: Without new savings, any gain for the Social Security system must come at the expense of the rest of the budget, the economy, and future generations. Issuing debt to finance the transition to a funded Social Security system undermines the whole purpose of reform. To be sure, reform plans that rely on debt financing usually promise that the debt will be paid back. But in most plans the borrowing is so large and the payback is so distant that it doubtful the payback will ever occur.

A responsible reform would ideally pay for itself from day one. It would, moreover, find its savings within the Social Security system itself through some combination of benefit cuts and new contributions.

The Central Choice

Personal account reforms come in two basic types: “carve outs” and “add ons.” In a carve out, a portion of the current payroll tax would be diverted to personal accounts. For the carve out to result in genuine funding, the diversion must be paid for by reductions in pay-as-you-go benefits beyond those that would need to be made in any case simply to eliminate Social Security's projected cash deficits. In an add on, the accounts would be funded partly or wholly from additional worker contributions. The contributions would be personally owned savings, and so would not constitute a tax--or at least would not function like one.

A pure carve out necessarily entails cuts in current-law Social Security benefits. Because personal account contributions would earn a higher return than contributions to the existing system, a carve-out plan could pay retirees higher total benefits than today's purely pay-as-you-go system can afford. However, it cannot guarantee that retirees will receive everything that the existing system promises. In practice, most personal account carve outs rely on borrowing to substitute for the lost FICA revenue and mitigate benefit cuts.

The “add on” approach offers a way to ensure the adequacy of future benefits without recourse to budgetary shell games. In fact, with a 2 percent of payroll add on it is possible to ensure that every cohort of workers will receive benefits at least as large as what current law now promises but cannot afford. Is it worth paying a bit more to achieve these superior results? In the end, after all the shell games are played out, this is the central choice that the American public must confront.

Let's be clear: Current law must eventually result in either a steep cut in benefits or a steep hike in taxes. If the choice is to avoid any hike in the Social Security contribution rate, a personal accounts carve out will generate larger benefits than today's pay-as-you-go system can afford. If the choice is to avoid any reduction in promised benefits, an add on will allow for this at a lower ultimate contribution rate. It is impossible to have it both ways: no cuts in total benefits and no new contributions.

A Big Mistake

Critics of personal accounts often charge that they would shift unacceptable risks to individuals. But in fact, a personal accounts system is consistent with any degree of government regulation. It need not and indeed should not amount to “privatizing” Social Security.

A system of personally owned accounts need not allow people to recklessly undersave during their working years. Participation can be made mandatory and restrictions can be placed on the use of account balances. Nor need it put low-income (or simply unlucky) workers at greater risk of poverty and hardship in old age. The government can require workers to shift from equities into fixed-income assets as they grow older, thus protecting them from sudden market declines--even a crash on par with 1929. The government can also match savings contributions for low-earners and provide a guaranteed floor of old-age income protection, thus preserving or even enhancing the progressivity of the current system.

Many personal account advocates, including the President, believe that the accounts should be voluntary. This is a big mistake. Society has an interest in ensuring that people do not under-save during their working lives and become free riders on the means-tested safety net in old age. “Choice” is not important in a compulsory social insurance program whose primary function is to protect people against poor choices.

 Real Resource Trade-Offs

Because the trade-offs that genuine reform requires can appear painful, many leaders try to find excuses--for not knowing, for not acting, or for not acting in good faith. Some simply wish the problem away by pretending that faster economic growth can close the gap between the benefits Social Security promises and the benefits it can pay. Others conjure up reforms that purport to fix the problem without any sacrifice. A few plans are more honest, but these have trouble competing with the “free lunches” for public attention.

The public is weary of convoluted reforms that pretend to make fundamental choices, yet “guarantee” that everyone will continue to get everything they've been promised. Alan Greenspan is right: Social Security reform involves real resource trade-offs. It's time to get serious about reform--and face up to the hard choices.