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Social Security S.O.S.

The Time is Now to Save Our Sinking System

Research by Kevin Murphy

Widespread pessimism about the future of the U.S. Social Security System is certainly justified: Current estimates predict that the system will run out of funds around 2030, and today's young workers can expect to receive, at best, only about 50 cents in benefits for every dollar they will pay in Social Security taxes over their careers. The return these workers ultimately will receive will be even less, maybe much less, depending on what is done to balance the system, and when.

The grim present and future reality has led to the search for alternatives. Some call for privatization, some advocate a voluntary system, while others favor less radical adjustments to the current system. In a recent paper, "Perspectives on the Social Security Crisis and Proposed Solutions," University of Chicago Graduate School of Business economics professor Kevin Murphy analyzes the current Social Security System and, together with co-author Finis Welch of Texas A&M University, proposes ways to improve the system through privatization and other adjustments.

The authors' basic view is that many of the touted gains from privatization are more apparent than real, and any real gains have more to do with the details of what is done to the system -- whether private or public -- than with privatization per se. The authors stress the profound importance of doing something about the problem sooner rather than later -- and of resolving the political uncertainty over what will be done to salvage the system.

The Current System

The current US Social Security System is essentially a tax transfer program. Until 1986, tax rates were adjusted to keep current taxes and benefits roughly in balance so that the system was essentially "pay-as-you-go." Since 1986, the system has run a significant annual surplus which had ranged from $23 billion to $60 billion per year. Significant surpluses are expected to continue for the next 15 to 20 years until the peak of the baby-boom generation reaches retirement age. Accumulated system assets are invested in special US Treasury securities. While the short-term financial picture is good, the long-term picture is not.

According to the authors' calculations, most American workers (earning between $17,500 and $45,000 annually) can expect average returns ranging from 26 cents to 57 cents on the dollar for men and from 31 cents to 71 cents on the dollar for women (assuming an increase in the tax rate to 13.8 percent and no other changes in current law). Marginal returns are significantly lower. In general, returns are not very good.

The system is scheduled to continue for the indefinite future, and the authors calculate that younger people will bear most of the debt burden -- contributing up to 67 percent more per dollar of benefits than did those retiring at age 65 in 1997. The increase in tax rates and the taxable earnings maximum through time implies that young people must make larger absolute tax contributions as well. With a less than fair rate of return, making larger contributions translates into a larger overall loss. The net lifetime cost to a man currently age 65 who earned twice the average level of earnings over his career is $59,100, compared to $273,900 for a man with the same relative earnings history who is 35 years old in 1997.

The Basic Problem

Many discussions of the current status of the US Social Security System focus on the possibility of bankruptcy. While this prospect is certainly real, focusing on it draws attention away from the more fundamental issue of the large unfunded debt that even a balanced social-security system imposes on today's young. The authors' calculations show that while raising the Social Security tax rate to 13.8 percent (from its current 11.2 percent) might bring the overall system into balance, it would only exacerbate the burden the system places on today's young and future generations.

According to figures, the net of future tax payments owed to men 43 and older and women 35 and older is about $6 trillion. Of this, about half ($2.9 trillion) is owed to those currently retired. With Social Security's trust-fund balance of only $0.4 trillion, the $6 trillion promised to older adults necessitates a net tax on younger generations of about $5.6 trillion, an amount greater than the outstanding national debt. Moreover, these calculations assume that the tax rate is raised immediately from its current 11.2 percent to the proposed 13.8 percent. Such changes do not appear to be on the immediate horizon.

"We are going to have to pay the higher 13.8 percent tax sometime; it is much better to do it now rather than later," says Murphy. "Any delay in instituting this increase will make the magnitude of the debt imposed on younger generations even larger, since older generations will pay less of the outstanding obligations."

The authors point out that sadly, most of our current problem is really attributable to a problem of design. The low returns offered to today's younger workers are largely a necessary by-product of a pay-as-you-go system (while not exactly a pay-as-you-go system, the current system is very similar). But why were earlier generations spared such a poor return? The answer is that the pay-as-you-go system was phased in over time by gradually increasing both taxes and benefits to provide higher returns to the early contributors. While not sustainable, such high returns are always possible in the early stages of a pay-as-you-go system.

Is Privatization the Answer?

It is tempting to conclude from the above analysis that abandoning the pay-as-you-go system in favor of an alternative-funded system with returns tied to the real returns on capital is the natural solution to the system's problems. Unfortunately this is not the case. The authors found that privatization yields identical benefits at retirement as does the pay-as-you-go system.

"Basically, the higher return on the worker's private investment is exactly compensated for by the tax required to pay off the existing liabilities of the system," says Murphy.

This is not to say that all privatization attempts would be futile. Other privatization schemes would have real effects, but these effects result from redistributions or changes in incentives associated with the method of privatization, and not privatization per se. One could redistribute or change incentives within the pay-as-you-go system and achieve exactly the same results.

What about the difference between the private return and the return paid by the pay-as-you-go system? This simply does not matter, say the authors. The low return paid in the pay-as-you-go system results entirely from the excess paid to the early contributors to the system. So long as this debt and all obligations to older workers are honored when switching to the private system, privatization provides no gain.

What Does Matter?

Many Social Security reform arguments ignore important aspects that affect the system including incentives, the heterogeneity of assets and other complications. Murphy and Welch summarize what matters and what does not:

  • Incentives. The current Social Security System actually provides "disincentives to work" for those eligible for benefits. A private system with defined contributions (which would credit individual contributions), flat tax rates, and fair benefit payment schedules would reduce marginal tax rates on work for both the young and old and thereby improve efficiency. If people are compensated dollar for dollar for their contributions to the system -- rather than suffering a continual loss on pooled contributions -- there is more incentive to work and to contribute to an individual benefit package.

  • Alternative Transition Paths. Given that the current system serves largely as a tax on the young, it may be desirable to shift more of the burden to older people. One way to do this is to balance the system by cutting benefits rather than raising taxes. This would spread the burden across both older and young groups. Alternatively, the debt incurred while privatizing the system can be paid off using a somewhat higher tax rate in the short run and eliminating this transition tax in the long run.

  • Changing the Tax Base. So far the authors have concentrated on programs that fund Social Security taxes from the tax base of labor earnings. Others have suggested that switching to an alternative tax base for the transition tax, such as consumption, may generate significant efficiency gains. Such gains in principle could be generated without changing to a privatized system.

  • Differences in the Rates of Return Across Assets. Currently, trust-fund assets are invested in special US Treasury securities. Some have suggested that it would be advantageous to shift these holdings to higher-yield assets such as broad-based mutual funds either by privatization or by the trust fund itself investing in private equities or bonds.

    If there is a gain to be had by switching to holding private assets then such a gain is independent of even the existence of Social Security. This can be seen by comparing two scenarios. In the first scenario, the trust fund buys fewer government bonds and instead buys private-sector assets. This requires the private sector to buy the extra bonds and sell the private-sector assets. This is exactly the same series of transactions required if the government were simply to sell more bonds and use the proceeds to purchase private-sector assets without regard to Social Security or the trust fund. If there is a gain to such actions, then the government has a money machine that it is not taking full advantage of, regardless of the fate of the Social Security trust fund. Such a money machine might exist, for example, if government debt is valued for its liquidity. In such cases this debt can earn a lower than market rate of return and be a source of revenue for the government similar to the government revenues from money creation.

    In general, privatization does give individuals greater control over their portfolios, but if markets are complete, privatized transactions will have no real effects on Social Security's fortune.

  • Political Risk. One major problem with even a repaired pay-as-you-go system is that benefit levels and taxes are always subject to change based on political forces. A defined-contribution system would eliminate much of this political risk while substituting perhaps more economic risk.

  • Political Commitment. The current problems with Social Security stem mostly from the better-than-average payment deals given to past workers. Politicians have promised a lot, and rely on future generations to shoulder the promised pay-outs. It is always tempting to continue to make such transfers in the future.

"Preventing ourselves from digging an even deeper hole is probably one of the most compelling reasons for getting away from a pay-as-you-go structure," says Murphy.

According to authors' calculations, balancing the system would require an immediate 2.6 percentage point increase in the tax rate. In 10 years the required tax increase jumps to 3.5 percentage points, and to 4.7 percentage points in 20 years. The same base calculations hold for changes in benefits.

"Clearly, the longer we wait," says Murphy, "the greater the burden on future generations. Doing something sooner rather than later is the most important step."

Kevin Murphy is the George Pratt Shultz Professor of Economics and Industrial Relations at the University of Chicago Graduate School of Business.

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