April 21, 2014

The New Debate Over Social Security Reform: Part III

Volume II, Number 8
July 23, 1996

The problems facing Social Security -- massive deficits beginning just sixteen years from now, a cascading pattern of generational inequity that destines each new cohort to receive lower returns than the last, and evaporating public trust in the system -- are leading many to conclude that we should somehow transition from today's pay-as-you-go system, in which current contributions pay for current benefits, to a funded system, in which contributions are saved and invested.

Moving toward a funded Social Security system could indeed have enormous benefits: not just higher returns to retirees, but greater national savings and productive investment, and hence greater wage growth for workers in the years before retirement. The challenge is that, until the transition is complete, workers will have to pay for two retirements: their own, which now must be prefunded, and that of current retirees, who will continue to rely on pay-as-yo-go benefits. Workers will have to save more, retirees will have to receive less, or both. Unless reform faces up to this transition cost, it will not result in new net savings -- or a larger economy. Any gains for future beneficiaries will necessarily come at the expense of future taxpayers.

Unfortunately, most reform plans deny or downplay the need for any sacrifice -- and so veer off course. The third in a series on Social Security, this alert examines the economic challenge of transitioning to a funded system -- and explains why there's no free lunch.


Two approaches to funding Social Security are now gaining adherents. The first advocates that government shore up the Social Security trust funds by investing a portion of FICA contributions to private capital markets. The second advocates partially or completely replacing Social Security with a system of personally owened and privately invested retirement accounts.

At first glance, the government investment of personal ownership approaches could not appear more different. Under the former, Social Security would remain a payroll-tax-financed program in which the government promises to pay a retirement benefit based on workers' wage histories. Under the latter, Social Security would be transformed into a system of self-financed retirement accounts in which benefits depend on investment earnings. Yet these two approaches have one crucial feature in common. As usually formulated, both shy away from the real challenge: raising national savings.

Let's start with government investment. Currently, Social Security surpluses are by law "invested" in special issue Treasury bonds -- which is to say, any annual excess of earmarked tax revenues over outlays is lent to the Treasury, which immediately spends it to cover the federal budget's general fund deficit. Advocates of the government investment strategy would instead invest part or all of the surpluses in private capital markets.

To the extent that investing in corporate equities earns greater returns than investing in Treasury bonds, this approach will improve the balance of the Social Security trust funds. But it will only do so by worsening the balance for the rest of the federal budget. In fact, unless Congress makes up for the FICA revenue it loses by raising taxes or by cutting spending -- advocates neglect to specifiy how this would occur -- Treasury will have to borrow a dollar in private capital markets for every dollar the Social Security trust funds invest there.

This zero-sum game points to a broader problem with the government investment approach: credibility. To keep Social Security outlays from exceeding tax revenues, we would, by 2030, have to cut benefits across-the-board by one-quarter to one-third. The public is unlikely to be reassured by a plan whose promise of greater benefit security rests on the gamble that (this time) Congress really will be fiscally responsible.

The personal ownership approach would move Social Security outside the federal budget, and hence protect future beneficaries from the risk that Congress won't honor its benefit promises. But advocates must still confront the same economic issue -- namely, how will Congress make up for the FICA revenue that now pays for current benefits. In some plans, Social Security participants would be issued "recognition" bonds -- that is, formal Treasury debt -- in the amount of their accrued benefit claims. This too is a zero-sum game that merely shifts the system's costs from current and future beneficiaries to current and future general taxpayers.


Reformers sometimes concede that their plans may not raise national savings -- but claim that this doesn't matter. According to their logic, the mere fact that workers' contributions are invested in private capital markets will ipso facto make everybody better off in the long run. Yes, reformers know that Treasury will have to borrow to make up for the missing revenue. But apparently they believe that Treasury -- or each worker's personal retirement account -- can indefinitely earn greater returns (with no greater risks) on the new equity assets than would be lost on the new debt liabilities.

The truth is that any plan that relies on the spread between stocks and bonds is a dicey and perhaps even dangerous proposition. If the government starts buying stocks and selling bonds on a large scale, the yield on bonds will rise and the yield on stocks will fall -- narrowing the favorable spread on which the plan depends. Moreover, the very fact that government is betting on the stock market to defray the cost of future benefits will increase the risk of government default, and hence the interest cost of governmental debt. This narrows the spread even more, perhaps to the vanishing point. No major country engages in this sort of arbitrage -- not just because of the economic effect on interest rates, but because of the corrosive political effect on the "full faith and credit" of government itself. On the other hand, if FICA contributions are put into personal accounts, the extra interest payable to new government debt holders will largely cancel out the risk-adjusted return to account holders. In the long run, this revolving door is just as unlikely to leave society better off.

Other reformers grant that some net new savings is essential, but minimize what is needed by assuming that each new savings dollar will earn a huge return. If the total long-term real rate of return on business equity is assumed to be high enough, say 15 percent before corporate taxes (a common if outlandish assumption), and if it is further supposed that portfolios will be invested entirely in equities (another common assumption), the transition problem all but vanishes. Workers could earn generous retirement annuities by saving a mere one or two percent of payroll. Meanwhile, the increase in private savings in the form of corporate equity would generate huge additions to federal, state, and local revenues via corporate income and property taxes. Some of this revenue, reformers suggest, could then be cycled back into Social Security, obviating the need for most (or all) sacrifice by current or soon-to-retire beneficiaries.

A few plans fully acknowledge the cost of transitioning to a funded system, but try to design the reform so that the sacrifice is hidden from the public. To this end, they too mostly or completely exempt current and soon-to-retire beneficiaries from programmatic sacrifice -- thus shifting the transition cost entirely to younger workers. But since reformers don't want to advertise this sacrifice either, they must resort to some combination of further strategies: issuing government debt and raising taxes outside the Social Security system.

The problem with financing the transition by issuing debt is not just that it undermines the purpose of reform by neutralizing the private savings boost. It would wreak havoc with the nation's popular, procedural, and constitutional firewall against excessive indebtedness. If we can borrow trillions to finance Social Security transition, why not borrow trillions for any purpose at all? Plans that issue recognition bonds to beneficiaries raise another concern. By translating existing implicit Social Security liabilities (which have no constitutional protection) into formal Treasury debt (which does), we would in effect render Social Security unreformable. The economy might collapse or the nation go to war. But short of default on the national debt, Congress could never again make any change in future benefits.

The problem with the tax hike strategy is that it creates no direct link between sacrifice and reward. If we pay for the transition with (say) a national sales tax, the public is likely to view this as a substitute for existing taxes and demand an offsetting tax cut. Once again, a larger deficit may neutralize the private savings boost.


There is another option: Ask for modest sacrifices from current beneficiaries and require workers to save more. If we mandate extra payroll contributions to pay for the transition -- and allow workers to invest those contributions in personally owned accounts -- the rationale for sacrifice is clear. No one is going to demand that Congress cut taxes and run up the federal debt.

It is indeed possible to design a plan that solves Social Security's fiscal crisis, offers workers the security of personal ownership, and guarantees a fair return to every cohort and income group. (Stay tuned for future alerts.) But it is not possible without temporary sacrifice. Plans that pretend otherwise are engaging in false advertising. Either they conceal from the public where the additional national savings is coming from, or else they saddle future generations with a permanent debt service charge that will require them to pay back (under the table) much of what we claim to be giving them.



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