April 19, 2014

Another Free Lunch On The Menu

There are just two ways to close Social Security's financing gap without burdening tomorrow's workers and taxpayers: Reduce Social Security's long-term cost, or make the cost more bearable by increasing national savings and hence the size of the economy. In the real world, a workable plan must do both. A few weeks ago, we looked at Vice President Gore's plan to shore up the Social Security trust funds (see our alert of July 17)-and concluded that it surely fails on the first count and probably fails on the second. What about Governor Bush's plan to let workers invest a portion of the FICA tax in personal accounts? Until Bush spells out the details of his plan, there's no way to know for sure. It is widely assumed, however, that it will be modeled on the plan developed by economist and Bush adviser Martin Feldstein. If so, another free lunch may soon be on the menu. Like the Gore plan, the Feldstein plan does nothing to reduce Social Security's long-term cost. Like the Gore plan, it banks on large fiscal and economic dividends which may or may not materialize. And like the Gore plan, it ultimately relies on massive infusions of general revenue to keep Social Security afloat. Most people assume that the candidates advocate radically different approaches to reform. And in some respects, especially Bush's emphasis on personal ownership, they do. If Bush embraces the Feldstein plan, however, there will be little to distinguish the two approaches when it comes to fiscal fundamentals.

An Obvious Question

Let's first look at what the Feldstein plan does. Every worker covered by Social Security will have a personal retirement account set up in his or her name. Each year, 2 percentage points of the 12.4 percent FICA tax will be deposited, pro rata, into the accounts. The money will be invested in private financial assets, apparently subject to the requirement that 60 percent of it be in stocks and 40 percent in bonds. At the same time, every worker will continue to receive unreduced benefits under the existing Social Security program. This sort of "carve out" plan raises an obvious question. Everyone knows that current-law benefits are due to exceed current-law taxes by a widening margin when Baby Boomers start retiring. So how does Feldstein pay for them while raising no new taxes-indeed, while diverting one-sixth of existing taxes into personal accounts? Part of the answer is that the plan cashes in on the extra returns earned by those accounts. It first jacks up the return on Social Security contributions by pushing today's trust-fund surpluses (via the personal accounts) into stocks and other private assets rather than into Treasury bonds. When workers retire, it claws back most of their money to pay for current-law benefits. In most versions of the plan, the federal government collects 75 percent of the personal account balances. To bridge the remaining financing gap, the plan relies on general revenue. Feldstein assumes that the extra accumulation of productive economic assets due to the plan will generate large additions to federal revenues by boosting corporate income tax receipts. He therefore allocates a slice of future corporate tax revenue to the trust funds-a slice that covers (incredibly) one-fifth of all current-law benefits by the year 2075. Since neither the clawback nor the corporate tax transfer yield significant revenue for decades, Feldstein faces an additional financial challenge. Although his cost and revenue projections ultimately balance out on paper, the plan must run large deficits from the 2010s through the 2040s. To cover the deficits, the plan draws down the Social Security trust fund. And when the fund is exhausted, it assumes that the Trustees will be authorized to borrow from Treasury.

A Dicey Proposition

Does the Feldstein plan have any clear advantage over the Gore plan? When it comes to the first objective of genuine reform-reducing Social Security's long-term cost-the answer is obviously no. Under current law, the Trustees project that the cost of Social Security will double from 10.3 percent of payroll today to 19.5 percent by 2075. Neither Gore nor Feldstein do anything to reduce this cost growth. Indeed, they both increase it. Gore increases it by adding new benefits for widows and working moms. Feldstein increases it by promising that workers will receive current-law benefits plus some fraction of personal account assets above and beyond what's clawed back. And what about the second objective: increasing national savings? Here the Feldstein plan is likely to do better. The Gore plan's claimed savings depend entirely on the willingness of future Congresses to refrain from spending trust-fund surpluses. The Feldstein plan, through its FICA diversion, attempts to put the surpluses beyond the reach of government. To the extent the money becomes constitutionally protected property, payable to workers or their heirs, Congress will not be able to double-count it as revenue and spend it. Personal ownership guarantees what no lock box can. Still, Feldstein almost certainly exaggerates the extent of the savings boost. For one thing, he assumes that households won't do what he assumes government would-namely, figure out ways to consume whatever Social Security saves. Practically all economists believe that households will offset a sizeable share of personal account assets by saving less elsewhere. Feldstein assumes that there will be no offset. He may also be overestimating the economic return to the new savings the plan does achieve. Not every extra savings dollar can earn the same high rate of return assumed for the stock-heavy personal accounts. Many of the extra dollars will ultimately flow into investments that earn lower returns-like housing, corporate bonds, and consumer credit. To the extent that the return to all investors from the new savings is lower than the return to personal account holders, the plan rests on financial arbitrage. Many reform plans rely in part on arbitrage. To lean on it as heavily as the Feldstein plan does, however, is a dicey proposition. There's another problem: The fact that a large share of account assets will be clawed back by government may lead politicians-and the courts-to conclude that the assets aren't really personally owned. If government has a claim on most of the assets, then it looks like government owns them. And if it owns them, what is to prevent Congress from borrowing against them? The clawback not only undermines the savings rationale of personal accounts, it also undermines their political appeal-which lies in the security afforded by ownership. Most Americans today are more confident about what they own than about what politicians promise. This is especially true of younger Americans-which is why polls show they are receptive to the Bush plan. One wonders whether the support will be sustained once they realize how the clawback works.

Troubling Concerns

The personal accounts clawback is not the only feature of the Feldstein plan voters may find worrisome. There's also the corporate tax transfer, which lays claim to the fiscal dividends that would otherwise accrue to our children and recycles them back into Social Security. We've criticized the Gore plan for earmarking the fruits of America's current prosperity for the retirement consumption of today's adults. Feldstein's plan raises the same troubling concerns about stewardship. The purpose of the corporate tax transfer is to raise new revenue without raising payroll contributions-and thus to conceal the fiscal sacrifice from voters. But it is wrong to suppose that voters won't notice. If future Americans are compelled to pay a special permanent levy to Social Security, it won't matter to them that long-dead legislators, looking forward, believed the income being taxed would not exist without the reform. A tax will always be perceived as a burden-which is why the general revenue financing of the Feldstein plan may prove no more palatable than that of the Gore plan. Banking on fiscal dividends is also risky. If the Feldstein plan fails to work as advertised, the corporate tax credited to Social Security will come at the direct expense of future workers-and may not be enough to keep the budget from sinking in a sea of red ink. It's like wading out to a sandbar while the tide is coming in. A prudent plan would first solve the cost problem, then hope for extra economic and fiscal benefits. The success of the Feldstein plan depends upon its success.

The Last Real Opportunity

Governor Bush's flirtation with the Feldstein plan is ironic. Aside from its "personal accounts"-which are mostly window-dressing-it is almost indistinguishable from the Gore plan. It does not reduce Social Security's cost. It may not do much to raise national savings. And it relies on massive infusions of general revenue. 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. If what our economy needs is new savings, the public wonders why the most talked-about plans amount to little more than elaborate shell games.

Let the candidates take note: The next President may have the last real opportunity to reform Social Security before the age wave begins to roll in. Free-lunch promises may seem like good politics. But they won't fool the public-and they won't solve the problem.