Nothing sounds better to a politician than the prospect of fixing a problem without anyone having to give up anything. Unfortunately, much of the recent discourse about Social Security reform reflects this perspective. From the political right, the message is “if we just adopt personal accounts everyone comes out ahead.” From the political left, it is “if we just make a few minor adjustments the program can pay all promised benefits indefinitely.”
The problem with both messages is that they ignore fiscal realities. Social Security can’t be fixed with personal accounts that no one has to pay for or with aspirin-style benefit constraints or tax increases. The reluctance of policymakers to publicly acknowledge the necessity of people having to give up something significant now and in the future presents an enormous obstacle to making the changes necessary to bring about a more sustainable system and assure the nation’s economy can absorb the burden of a rapidly aging society.
The free lunch perspective starts with a misperception of the problem
The perception that Social Security can be fixed without sacrifice evolves in part from the way the program’s finances are discussed. For decades, policymakers have focused on a summary measure of the program’s projected deficits over the next 75 years, referred to as actuarial imbalance. Reform options then tend to focus on how this imbalance can be closed. However, the most important issue is not the imbalance itself, but the steeply rising costs that cause it.
The existence of a trust fund credited with a dedicated stream of federal taxation gives the illusion of a distinct entity accumulating resources to pay for benefits, now and in the future. The fact is that the trust fund is simply a label given to a governmental account. Like all other government activities, the cost of Social Security is financed with a tax that is deposited in the U.S. treasury, and any excess that may come in helps to finance other government activities. In reality, there is no separate savings account for Social Security.
The onslaught of baby boomer retirees now only a few years from drawing on Social Security will drive the program’s cost from 4.3 percent of the economy (GDP) today to 6.3 percent by 2035 — an increase of nearly 50 percent by the time today’s thirty year olds begin drawing benefits. The money needed to pay for this rising benefit cost — whether from receipts credited to the Social Security trust fund or to the treasury’s general fund — has to come from the productive sector of the economy. If the benefits as now prescribed by law are to be paid, that higher cost would come in the form of higher taxes or higher public borrowing, either of which will cause a drag on the economy. Consequently, it is not an imbalance of income and outgo, but the cost of the program that should be the focus of the issue.
Financial markets alone cannot come to the rescue
Thinking of the Social Security problem as merely a trust fund shortfall also causes lawmakers to view the program in isolation. Perhaps if viewed in isolation, Social Security’s long-term cost growth might be bearable. But Social Security is not a “hardened silo,” and its long-term outlook must be assessed in a broader context. What matters fiscally and economically is the rising total cost burden of government entitlements in our aging society. Focusing on one program’s future shortfalls ignores this context. It ignores the fact that Social Security is the largest program in the federal budget; it ignores how much of the economy Social Security absorbs; it ignores competing (and even greater) costs for health care spending; and it ignores the changing age composition of society that will soon impose an unprecedented burden on future workers. Viewing Social Security as if it were in a world of its own leaves the impression that with a little imaginative accounting or some minor tweaks its problems can be eliminated.
Prominent among those ideas is making use of stocks and bonds to reform its financing. Although approaching it in different ways, both political parties have talked about it. One camp says if we allow people to use a piece of their Social Security taxes to create personal accounts, they can get higher returns than they can from a program that will have too few resources to meet its commitments in the future. The other camp says that if we invest the Social Security trust funds in the financial markets, we can get a higher return than they now earn by investing exclusively in federal bonds.
The problem with both approaches is that they typically do not require people to pay more to acquire these financial assets. Instead, they would use current taxes. But if current taxes are used, the government would have to borrow to make up for the revenue loss. The government is already running large budget deficits even with excess Social Security taxes that are now being collected. Using existing taxes to invest in stocks and bonds will only mean the government has to borrow more. In effect, with one hand it would be channeling money into the markets and with the other hand it would be taking it back.
An analogy might be where an individual borrows to make deposits to his or her 401(k). If the individual borrows the money from his or her home equity account, that person is not any richer. The value he or she has in the house declines, while the value of the 401(k) rises. The money contributed to the 401(k) would make its way into the financial markets, but the bank holding the home equity line would have to borrow or use resources from the financial markets to make the loan. The individual is willing to pay more interest because of the ability to defer federal taxes on the income and the hope of earning a favorable return from the 401(k). He or she may come out ahead in the end if the stock market renders a larger return than the interest paid on the loan. But he or she could also lose if the investments produced a lower return.
If everybody did this, there would be winners and losers, but in the aggregate no new money would have been added to the pool of resources in the financial markets. However, if that pool is to grow, new money must be added. And only through such additional funding would productivity rise helping the economy to grow. In the absence of new funding, all that occurs is a reshuffling among assets that people hold, and people would merely be rearranging the returns they get through different instruments.
Similarly, if the government were to borrow the money to allow individuals or the Social Security trust funds to make investments, there would be a reshuffling of assets within the markets themselves. The increase in borrowing means there would be more bonds to sell. As the price of bonds falls with the increase in supply, interest rates will rise and money will move out of stocks and into bonds. In effect, the demand for stocks for the personal accounts or trust fund purchases would be offset by the exodus seeking the higher interest rates from bonds. There may be short run investor responses to the reshuffling, but at some point the markets would level out again because there would be no new funding to raise the price of stocks. While people might now hold stocks through their new personal accounts or collectively through the Social Security trust fund, their other stock holdings in 401(k)s, IRAs, and the like might be lower as bonds take a greater role in their portfolios. And while their new accounts or the Social Security trust funds might look better on paper, there would be little change in the worth of people’s assets.
The belief that people would be better off simply because the markets were involved in reforming Social Security stems from political perceptions about the impact it would have on fiscal policy and personal behavior. Looking at the government side, the perception is that future Congresses might be more fiscally responsible because there is less money to spend. Money tied up in the markets would not be available for government spending. On the individual side, many people who would not otherwise have any personal financial resources would now see some asset accumulation and strive harder to increase it.
But these potential advantages could be easily offset. Lawmakers might view the creation of personal accounts or trust fund investments as a substitute for spending constraints. If that happens, the cost of government could rise significantly, and after the “senior boom” begins receiving benefits it will be far more difficult for policymakers to do anything but borrow. Bond prices would fall accordingly, interest rates would rise, and stock values will be held down.
On the personal side, while some workers might be induced to save more, others might be induced to save less–they would see their new Social Security accounts as an alternative to contributing to their 401(k)s, IRAs, and the like. If this occurred, the adverse effects of greater borrowing by government would be intensified by less saving by individuals. In the end, national saving could be adversely affected and the economy could grow to a lesser extent than if the change hadn’t been made.
The point is that in the absence of new funding all that might have been accomplished by using the financial markets to shore up Social Security is a shifting of what part of people’s financial well being is reflected through Social Security and what part is reflected through their other forms of saving. Some people might hold stock who didn’t hold it before, and others who did might hold less. But nothing definitive would have been done to increase the size of the economy. Without an increase in the economy, the burden of supporting tomorrow’s elderly will be no different than it was before.
The “borrow now, save later” perspective
A number of proposals to create personal accounts would attempt to shore up Social Security by offsetting future Social Security benefits to reflect the asset accumulations that build up in the accounts. Future benefits would be reduced based on how much of an annuity could be paid if the personal account balance were turned into monthly payments. One such proposal would guarantee that the combination of the annuity and traditional Social Security benefit would be no lower than promised under current law, in effect substituting payments from the personal account for a portion of the future Social Security benefit and filling any gap with general revenues.
These proposals would eventually reduce Social Security expenditures. However, they basically involve a “borrow now, save later” mentality. The problem with them is that it would take decades before the cost of the traditional benefits was noticeably reduced. In the near term, there would be little net effect on national saving (the increased government borrowing and personal account investments would offset one another), but it is in the near term that greater saving is most needed. The first wave of the baby boomers will begin drawing Social Security benefits in three years and they will be eligible for Medicare in six years. The Congressional Budget Office projects that the share of the economy needed to cover the expenditures of Social Security, Medicare, and Medicaid could rise from 8.4 percent of the nation’s gross domestic product today to more than 17 percent in 2030, and this ignores the financing needs of the government’s discretionary programs (defense, bio medical research, highways and infrastructure, law enforcement, etc.) as well as interest on the federal debt which can only grow with the emerging deficits. It also ignores the draw on the economy from liquidation of pension plans and other private resources of the swelling number of aged.
A plan that would increase government borrowing beyond what is currently projected for three or four decades can hardly be considered a plan to increase national saving, and something that takes that long to materialize can hardly be called a “transition.” The economic dividends they promise would come long after the cost of government has risen to unsustainable levels — if they come at all. The new debt would be immediate and certain, while the savings would be neither. It would depend on the willingness of future leaders to impose pain on future voters that current leaders are unwilling to impose on today’s voters.
Simply put, timing matters. Some would defend such a plan contending that it merely moves forward a Social Security debt that would otherwise arise in the future, implying that it is a cost we would otherwise have to incur. But the truth is that the long-range Social Security deficits are not explicit government debt. They are contingent obligations. Those deficits can be as readily eliminated by benefit constraints or tax increases as by borrowing. It would not be moving future debt forward in time; it would be creating new debt at a time when we need to be reducing debt. At best, it may have a neutral effect on national saving in the near term but it is an increase in national saving that is most important, and a plan that takes multiple decades before saving is increased is not a plan at all.
A few other charades
The “free lunch” parade takes other forms of well. One of the most blatant is the idea of not counting new debt incurred to fix Social Security as part of the national debt. One approach would ignore outlays made from the Treasury to buy stocks and bonds for the Social Security trust funds. Since those securities would be posted to the trust funds as assets, proponents claim that it is really a wash. The hypocrisy of such action is that the same proponents would argue that outlays made to fund personal accounts should be counted. Their real motivation is to mask the cost of buying stocks and bonds for the trust funds. But the government takes a risk in buying those financial assets for the trust funds and to suggest that expenditures haven’t been made is a delusion. Hiding those purchases in calculating the deficits and debt of the government does nothing to change national saving and as suggested earlier, it may even substitute for real policy changes that do, i.e., expenditure constraints that reduce consumption. The fact that Social Security’s financial flows are tracked through Treasury accounts labeled as trust funds already reduces the transparency of federal accounting. This would only exacerbate that problem.
Another charade is the idea of raising the interest rate paid on the bonds held by the Social Security trust funds. It would make the recorded income of the trust funds look larger and thus give the appearance of shoring up the trust funds. But since those bonds and the interest paid thereon are only IOUs from the government’s general fund, raising the interest rate would only be an accounting change among Treasury accounts. It would raise the future claims that the Social Security trust funds have against the government but it would do nothing to increase the government’s future resources or national saving.
Still another charade emerges with proposals that would charge the revenue diversion from creating personal accounts to the government’s general fund instead of the Social Security trust funds. 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.
Because of criticism that a carve-out plan would worsen the financial condition of the trust funds, some proposals call for charging the revenue loss to the general fund. The trust funds would continue to be credited with the full amount of Social Security taxes. Thus, the trust funds’ condition would not appear to be worsened and the amount of change needed to bring them into balance would not be increased.
This, however, would be nothing but a fiscal shell game. It makes no difference to the federal government’s bottom line whether the revenue loss is charged against the trust funds or the general fund. Either accounting means the government has to borrow the money to cover the revenue diversion. Charging the diversion of funds into personal accounts against the general fund rather than the trust funds is sometimes called an add-on plan even though nothing is being added. Using the term add-on carries the favorable image of not harming the Social Security trust funds. Going through this charade may look better than a carve-out as far as the trust fund is concerned, but it makes no difference to the federal budget and national saving. For an add-on to work it must actually add something to the total amount of resources going into the nation’s financial markets. Or, looked at another way, it only matters if it makes people save more of their discretionary income.
In the real world: if there’s no pain, there’s no gain
Thinking about how we finance Social Security makes people focus on the wrong issue. Real reform will only come from understanding and accepting that it is the rising cost of entitlements that will impair economic growth. It is not the program’s projected deficits but why the deficits will emerge in the first place. Thus, the key issue in reform is not whether the Social Security trust funds or personal retirement accounts have assets posted to them. It is the economy’s ability to pay off whatever future claims are created. Borrowing or raising taxes to cover those costs would only impede the economy’s growth.
Finding a cure for what ails Social Security won’t happen without political pain –as yet a condition most lawmakers have not conceded. But dwelling on free lunchsolutions neither reduces the long-term cost of the program, nor contributes to a larger economy so that the remaining costs will be more affordable. It only passes the buck to future lawmakers and intensifies the burden on future workers who will have to carry the economy of tomorrow.