Republicans and Democrats are passionately arguing about the future of Social Security. Although there is merit in each side's argument, neither side is portraying the situation accurately. In my view, movement toward a privatized individual account Social Security system offers the best option, where individuals save and accumulate assets to provide for their retirement.
It is true, as the critics correctly observe, that there is no magical gain in privatizing since all systems have to provide income for retired persons. But there is also no magical gain in privatizing a government steel plant since steel still has to be produced, yet there are good reasons to privatize steel. I also believe that there are excellent reasons to aim for a privatized individual account Social Security system.
Pay as you go Social Security started first in Europe as a relatively easy way to provide a minimum standard of living for the elderly. It was introduced in the United States during the 1930s partly to discourage the elderly from competing for jobs when unemployment of younger workers was staggeringly high. It was a cheap system then because there were more than 10 workers per retired person, so the Social Security tax could be small relative to the benefits received by retirees. Indeed, the first several generations of retirees earned very high returns in retirement income on their accumulated Social Security tax payments.
But as birth rates fell drastically, and the life expectancy at age 60 expanded enormously, fewer workers are now being forced to support more and more retirees. The result is a huge rise in Social Security taxes in every nation with a pay as you go system. The combined tax on employees and employers in the United States, excluding contributions to Medicare, is now 12.4 per cent and rising, and that percentage is much higher in Japan and most Western European nations. The expectation of continuing growth in this tax rate explains why countries as different as Sweden and the United Kingdom have partially moved toward a privatized individual account system. It also helps understand why Hong Kong, Poland, and other countries with low birth rates that recently introduced Social Security have important components of individual accounts in their systems.
I do not believe that the main advantage of a private account system is that individuals can get a higher return on their old age savings by investing in stocks. There are no free lunches from such investments since the higher return on stocks is related to their greater risk and other trade-offs between stocks and different assets. However, neither is there any special "transition" problem in moving to a fully funded privatized system since future generations in some way or another under all systems have to pay the implicit debt due to commitments toward present and future retirees, unless they default on some of these commitments. But it is better to transition smoothly to fund this debt by starting now rather than require a sharp increase in taxes on later generations.
Retirees for whom Social Security income is not a major part of their retired assets will invest much of their own savings in stocks. Studies indicate that this is precisely what they generally do with their IRAs in order to have a balanced portfolio between stocks and the implicit Social Security assets guaranteed them. Since lower income men and women accumulate few assets other than their Social Security assets, a fully funded system through personal savings would enable these men and women to have more balanced portfolios between stocks and bonds.
If there is no obvious gain from allowing most individuals to invest in stocks to help cover their retirement, and if there is no fundamental transition problem, what, if any, are the advantages of a funded privatized system? I believe the advantages are mainly political, not "economic," that privatization helps to separate saving for retirement from interest group politics, taxation, and government spending.
Pay as you go systems are in trouble throughout the world in good part because of changes in the number of workers per retiree, but also because of politically determined decisions that changed the system from a saving system for old age to an inefficient and complicated welfare system for some of the elderly. For example, despite the growing mental and physical health of older persons, political pressures in all nations with pay as you go systems forced a restructuring of Social Security payouts to encourage retirements at earlier ages than even the originally established age 65. In the United States many retirements occur age 62 or earlier, while Italians retire frequently while in their mid fifties, and very early retirement is common also in Germany, Belgium, and many other European countries.
In addition, the link between contributions and benefits has been separated, so that each additional dollar contributed in taxes pays on the average no more than about 40 cents in additional benefits. Hence, the Social Security system has evolved into two largely independent systems: a sizeable tax on wages, starting with the first dollar earned, and retirement benefits that are "guaranteed" by the government. There is only a modest link from an individual's accumulated tax payments on his earnings to these "guarantees."
Just as important are the political implications of federal fiscal behavior. Tax revenue from Social Security taxes at present exceeds payments to retirees. This excess is counted as part of the growing Social Security Trust Fund, but in fact also enters into the consolidated federal budget account, and helps reduce the reported spending deficit. Reported deficits during the past decade would have been much larger if Social Security was not running a surplus during this whole time period.
Valuable evidence on this tendency to spend tax revenues comes from the 1990s. Federal spending was first kept down by deficits, but then both federal and state government spending grew rapidly with the sharp increase in tax revenues during the boom years at the end of the century. This pattern indicates that the large current federal deficits will force a slowdown of government spending growth during the next several years. Privatization would significantly increase the pressure on spending by removing some personal retirement savings from government revenues.
Social Security tax revenues are expected to fall below spending on retirees in less than twenty years. If we simply raised Social Security taxes now-say by two percentage points-consolidated federal deficits would appear much smaller, and the federal government would be under less constraint to reduce spending. Both theory and evidence indicates that a good fraction of the additional revenue would indeed be spent. "Putting aside" assets for the future is very difficult for all governments, subject as they are to immense demands for spending now from various interest groups.
A good individual funded savings system would require individuals to save 4-6 per cent of their incomes (President Bush suggests 4 per cent)-and invest these savings in private individual accounts that would meet certain government-established criterion. At the same time, Social Security taxes should be cut by a couple of percentage points from its present level to ease the burden on workers. These taxes could be cut since under this saving system younger workers would be contributing to their own retirement. Moreover, a tax cut would reduce the Social Security surplus, so the government would be less tempted to spend more by rapidly growing Social Security "reserves."
These private accounts would accumulate tax-free until individuals decide to retire. The age of retirement within broad limits would be left to individual choices, but like IRAs now function, these funds would continue to grow with savings for persons who retire at later ages because they like their work and are in good health. At retirement, individuals would get access to their assets, either in a lump sum or as an annualized income, and they would then pay taxes on their withdrawals.
As in Chile and other countries with private retirement accounts, the government would guarantee every retiree a minimum income-similar to but larger than the minimum Social Security guaranteed income under the present system. Unfortunately, such guarantees create a "moral hazard;" that is, savers may want to make risky investments that give high payoffs if they succeed since the government partly bails them out if they fail. Or they may not save at all. The minimum required savings rate overcomes the latter incentive to "game" the system, and regulation of which types of investment accounts are approved takes care of the incentive to be overly risk-taking.
As in the President's proposal, we should limit Social Security accounts to index funds-that is, funds that do not try to beat the market and invest in a balanced market portfolio of stocks and bonds. Individuals who are contributing more than the 4 per cent minimum could take greater risks if they want to since they do not pose any moral hazard from bad investments on these larger accounts. Index funds both reduce the overall risk of an account, and have very low management fees since it is quite cheap to run these funds, as shown, among others, by Vanguard and Barclays. High management fees is a common complaint about the Chilean system, although this system has yielded high returns to investors even net of these fees, and the fees have come down a lot in recent years.
Some government involvement in a private system is necessary, especially if, as in my system, there is a guarantee to all retirees of a minimum standard of living. I suggested the use of index funds for private retirement Social Security accounts as a way to keep government involvement in the new system to a minimum. The index fund industry is easy to enter, and so is very competitive. Since it involves minimal buying and selling of stocks and bonds, and no research on picking "winners," this industry has very low administrative charges. Private accounts under this system would most definitely not have high administrative management costs. Moreover, these funds still provide individuals with choice since they can and do vary the fraction of their assets allocated to bonds versus stocks. Those savers who are very risk averse could choose funds with high bond-stock ratios.
There is no guarantee that government interference would not increase further in such a privatized system since the retired would continue to press for additional benefits. But experience shows that governments interfere less when an industry is privatized than when it is a public enterprise, especially in access to capital and financing of budget deficits.
So the really strong arguments for privatization are that they reduce the role of government in determining retirement ages and incomes, and improve government accounting of revenues and spending obligations. All the other issues are really diversions because neither advocates nor opponents of privatizing Social Security generally answer the most meaningful question: Is there as strong a political economy case for eliminating government management of the retirement industry as there is for eliminating their management of most other industries? My answer is "yes."
Gary S. Becker is University Professor of Economics and of Sociology at the University of Chicago Graduate School of Business and the University of Chicago , and Senior Fellow at the Hoover Institution.