"The failure to reform entitlements [like social security]," said
President Bush in his 2006 State of the Union address, "will one day
leave our children with three bad options: huge tax increases, huge deficits,
or huge and immediate cuts in benefits." Paul Krugman, on the other
hand, feels that "privatization would worsen, not improve, social security"
(Krugman, 2004). While most observers recognize the need to reform social
security in view of an ageing population and retiring baby boomers, many
disagree on the path of the reform. Advocates of personal accounts feel
that Americans must take even greater responsibility for their own retirement
security as it will not only expand personal wealth and but also have a
salutary effect on the economy as a whole. Opponents, on the other hand,
feel that personal accounts would be more expensive and poor providers of
retirement income, especially to lower income workers. Social security,
in my opinion, should not be privatized by introducing personal account
but though investing a part of the trust fund into private securities. The
actuarial imbalance should be further restored not through benefit cuts
but through reducing distortion in labour compensation by imposing taxes
on fringe benefits.
The outlook for US social security trust fund ranges from optimistic to
bleak. Given the wide range of future demographic possibilities, it is hard
to predict with certainty the future sustainability of the social security
program. I will list and discuss the wide range of outlooks for the US social
security trust fund in section I. In light of the uncertain outlook, there
are several ways to reform the social security program. I will discuss some
of the ways, such as benefit cuts, personal accounts, suggested by scholars
and policy makers to reform social security in section II. I will then discuss
why imposing tax on fringe benefits and then investing some of the trust
fund in private securities is the best way to restore the actuarial balance
in section III.
Outlook for Social security
Social security is currently the largest item in the federal budget. Since
social security taxes collected exceed the benefits paid, the surplus revenues
are lent to the treasury to help finance other government expenditure. If
fact, the social security trust fund lends more money to the federal government
than even Chinese and Japanese central banks. And none of this is expected
to change in the near future. Observers generally agree on the benign near
term outlook for social security. Even under pessimistic assumption about
the state of the economy, the program will continue to collect more payroll
tax revenue than needed to finance benefit payments till 2015 (Burtless,
1997). The surplus will increase by between $70 and $150 billion a year
and will earn a rate of return payable on government debt sold to the public,
providing ample contingency funds even in case of a prolonged recession
(Burtless, 1997).
The long term outlook for social security, however, will worse due several
underlying demographic factors, such as birth rates and mortality. The baby
boom generation will begin retiring in the next decade. Due to increasing
life expectancy, the retiring baby boomers will live and collect social
security benefits for longer. The growth of working age population, on the
other hand, will slow down due to a 40% drop in fertility rate over the
past quarter century. As a result, the number of workers contributing to
social security will rise very slowly while the number of beneficiaries
will rise sharply (Burtless, 1997). The dependency rate will continue to
rise over the next century even after the baby boomers are gone (Bostworth,
1996). The financial implications of increasing dependency rate are less
certain and depend on growth or the economy and productivity.
The cost rate - the pay-as-you-go tax rate needed to finance the social
security system in a given year - will slowly rise upwards between now and
2015 and rise sharply over the next 20 years as the baby boom population
moves into retirement (Burtless, 1997). If taxes are not increased or benefits
cut the social security program will face serious funding problems in the
future. The current projections show the actuarial deficit - the present
discounted value of the difference between future income and outgo - of
the social security trust fund to be equal to 2.2% of payroll. The long
term deficit will only worsen because the simple passage of time requires
additional tax increases as the 75-year valuation period extends further
into the high cost years of the next century. Under the intermediate projections,
the payroll tax rate will need to increase to about 16.5% in 2030 and continue
to rise to 18% in 2070 for balance to be maintained (Bosworth, 1996). There
is, however, a wide range of uncertainty around these projections. Under
the optimistic scenario, the annual balance of the social security trust
fund will by only slightly negative after 2020 and will improve after 2040.
Because the predicted accumulation in the fund between 1995 and 2020 is
so large, the interest earnings will allow the trust fund to remain solvent
for the infinite future (Burtless, 1997). Under the pessimistic scenario,
on the other hand, the costs will continue to soar and exceed tax revenues
by more than 4% of GDP but 2060 (Burtless, 1997).
Measures to Reform Social Security
Given the wide range of projections for the actuarial balance of the social
security trust fund, a variety of reforms have been proposed to restore
balance. In order to understand why taxing fringe benefits and investing
social security surplus in private securities is the best option to restore
long term social security balance, let us critically evaluate some of the
other proposals. One of the ways proposed to meet the projected shortfall
in the social security fund is to reduce benefits to retirees. The simplest
way to reduce benefits is to cut the basic pension of all retirees. To meet
the long term shortfall in Social Security, benefits would have to be cut
by 15% immediately (Burtless, 1997). If, due to political pressures, Congress
were to decide to reduce benefits only to new retirees, benefits would have
to be reduced by almost 18% (Burtless, 1997). If benefit reduction is delayed,
larger cuts would be necessary to restore the actuarial balance of the trust
fund. Prudent policymakers, in my opinion, should avoid across the board
benefit cuts. Social security is the main source of income for most retirees,
providing over 80% of the income available to over half of all elderly individuals
and couples. Since these retirees will few additional sources of increase,
an across the board benefit cuts would result in offsetting increases in
Supplemental Social Security payments or higher poverty rates. Mean-testing
benefit cuts based on life-time income would concentrate benefit reduction
among high wage earners, leading to widespread disaffection and demands
to be let out of the system. Means-testing benefit cuts based on retirement
income would destroy incentives for retirement saving through private means.
Benefits to retirees can also be trimmed by reducing the annual cost-of-living
adjustments (COLA). According to a report by a Senate-appointed commission,
the CPI, on which the annual COLAs are based, overstates changes in cost
of living by an average of 1.1% per year (Burtless, 1997). Even the reduction
in COLA by 1.1% a year would eliminate only three quarters of 75-year imbalance
(Burtless, 1997). Reductions in COLAs are, in my opinion, undesirable. Firstly,
the accuracy of the overstatement found by the commission is questionable,
since about half of the overstatement is attributable to unmeasured quality
improvements in goods and services. Secondly, if continued every year, a
1% reduction in COLAs would reduce the pension of an 80 year old by 16.5%,
exacerbating the problem of poverty and low income among the very aged.
The increase in poverty among the elderly if COLAs are reduced would be
greater than would be the case if across the board benefit cuts are implemented
(Burtless, 1997). Another way to reduce benefits is by increasing the retirement
age. An increase in retirement age from 62 to 67 phased over a two decade
period has already begun in 2002. If, as some policymakers suggest, higher
retirement age of were to begin immediately, many new retires will find
their retirement calculations go awry. Moreover, immediate reduction in
retirement age would unfairly and arbitrarily target a certain section.
In general, reduction in pensions would benefit future workers at the cost
of the current elderly. Current and future workers will, on an average,
be much wealthier and in a better position than current retirees to accept
the tax increases or benefit reductions needed to restore balance in Social
Security trust fund. It hardly makes sense for current generation of retirees
to make sacrifices so that wealthier future generations can enjoy modest
increases in living standards.
Another proposal to improve the Social Security balance is to move to a
funded system. Under this proposal, a part of the payroll tax would be put
into individual accounts, which would be controlled and managed by workers.
This proposal will require generating additional revenue to pay current
retirees the promised benefits and restore actuarial balance. The double
burden paying off current obligations and saving for their own retirement
makes it costly for the transitional generation to move from a 'pay-as-you-go'
to a funded system, forcing generations into conflict over which group will
have to make the larger sacrifice (Burtless, 1997). Supporters of social
security privatization claim that it will increase returns to workers. While
workers may earn high returns, these returns must be balanced with additional
risks of investing in private securities. It is unclear if risk-adjusted
returns on individual accounts will be higher. The large costs incurred
in managing and selling mutual funds are almost impossible to avoid (Diamond,
1996). These costs will eat into the higher returns A system of private
accounts will also be unable to provide insurance against longevity and
inflation (Orr, 2002). Few, if any, countries have been successful at organizing
efficient annuity markets based on individual choice. As a result, retirees
risk outliving their money and might be forced to fall back on a minimum
government provided pensions at an age when they are most vulnerable. Not
many private retirement products are indexed to inflation. Retirees therefore
risk a reduction in their real income and may be forced to reduce consumption.
The US economy may not reap some of the other economic benefits of individual
accounts. As the US has well organized set of capital markets, it would
not reap the benefits, as Chile did, of moving from poorly organized markets
to well organized ones. Moreover, because of the structure of the social
security system, there will be little or no increase in national savings
or capital accumulation due to privatization. Currently, Social Security
is an integral part of the total federal budget. The surplus is lent to
the government to finance its other programs. Social security can be used
as a vehicle for raising national savings only if it is differentiated from
the operating budget of the government. Ultimately, there is no way of guaranteeing
that partial privatization of social security would increase national savings
(Bosworth, 1996). Furthermore, if the government were to increase its borrowing
to offset the loss of payroll tax revenue, privatization would contribute
little to capital accumulation beyond what could be achieved by investing
a part of the trust fund in private securities (Diamond, 1996).
Increased taxes and management of the OASDI fund
As discussed above, benefit cuts or individual accounts are an undesirable
way to restore the actuarial balance of the social security system. In my
opinion, a better way to achieve balance would be to pre-fund the system
by imposing taxes on fringe benefits and investing a part of the trust fund
in the private economy. Currently, only wages are taxed while fringe benefits,
such as health insurance, remain untaxed. This is unfair to the workers
who derive a large part of their compensation from wages. Increasingly,
this has resulted in a part of labour compensation being paid out in the
form of fringe benefits. Taxable wages now are only about 40% of GDP. Taxing
fringe benefits will reduce some distortions in labour compensation and
increase inflows into social security trust fund. It will also have less
deadweight losses, such as decrease in total number of hours worked, than
would be the case with a tax increase. The social security trust fund will
continue to build surplus well into the next decade until benefit payments
begin to rise.
A small tax increase alone will not solve the problems of financing future
benefits. It will have to be combined with a more aggressive investment
strategy for a part of the trust fund. More aggressive investments will
help achieve actuarial balance since, on an average, stock and corporate
bonds have higher returns than treasury securities. A part of why treasury
securities offer low returns is because of their liquidity premium. Since
the cash needs of social security are predictable, it does not need to accept
lower returns for higher liquidity. Social security funds can therefore
be invested in illiquid securities for higher returns. In my opinion, the
Social Security Administration should adopt a well diversified but passive
investment strategy across various asset classes to boost long-term returns
while reducing risks. Since Social Security trust fund is invested only
in treasury securities, diversification would not only increase return but
also reduce the risk of trust fund being wiped out by high inflation. Social
Security trust fund will be better equipped than individuals to bear the
higher risks of investments in private securities. Social Security is a
better risk bearer as it can spread risks over time, using the part of trust
fund in treasury bonds as a cushion (Diamond, 1996). Social Security will
earn higher returns than individual account for a given strategy since,
because of economies of scale, it can reduce administration and fund management
costs.
Some question the ability of public sector managers to invest such a large
amount of money. A passive investment strategy will not require managers
to pick a particular security but invest across asset classes. Social Security
can also outsource a part of the fund management to the private sector through
a competitive bidding process. Many nations, such as Norway, Singapore,
the UAE, manage their budget surplus by investing in domestic and international
private securities. Recently, China announced plans to invest as much as
$200 billion in private securities. Most of the investments have earned
2-3% excess returns above the risk free rate. There is no reason to think
that the US Social Security Administration will do any worse. Others fear
excessive government involvement in the economy by investing in private
securities. Innovations in capital markets, such as index funds, now make
it possible for Social Security to invest in the private economy while having
little say about the allocation of capital in the economy. Moreover, the
global capital markets are large enough that a few hundred billion dollars
would not dramatically change the capital allocation process.
Conclusion
Clearly, the social security system faces actuarial imbalance due to retiring
baby boomers and an ageing population. Future benefit payments to retirees
will be much greater than tax inflows from workers and interest earnings.
The imbalance will only get worse as the 75-year period moves into the high
cost years of the next century. Benefit cuts not only will arbitrarily and
unfairly target a certain generation but will also increase poverty among
the elderly. Individual accounts have huge transition costs that would be
borne by the transitional generation while the benefits will flow much wealthier
future generations. While they may provide retirement income, private accounts
will not provide insurance against inflation and living too long. In my
opinion, the balance should be restored by a marginal tax increase and a
more aggressive investment strategy for the trust fund. Taxing fringe benefits,
such as insurance, will reduce distortions in labour compensation without
many of the dead weight losses that accompany tax increases. The surplus
built up as a result of tax increases can be invested more aggressively
in private securities. Not only will diversification reduce risks of investing
in a single asset class but also improve returns by taking higher risks.
A passive diversified investment strategy will also eliminate most of the
risks of investing in private securities
Burtless, Gary (1997), "Social Security's Long-Term Budget Outlook",
National Tax Journal v50, n3 (September 1997): 399-412.
Bosworth, Barry P. "Fund Accumulation: How Much? How Managed?",
in Social Security What Role for the Future?, edited by Peter A.
Diamond, David C. Lindeman and Howard Young, National Academy of Social
Insurance, Washington, D.C., 1996, Chapter 2, pp.89-113.
Diamond, Peter A. "The Future of Social Security" in Social
Security What Role for the Future?, edited by Peter A. Diamond, David
C. Lindeman and Howard Young, National Academy of Social Insurance, Washington,
D.C., 1996, Chapter 7, pp.225-233.
Economic Report of the President (2002), "Economic Report of the President: Strengthening Retirement Security", Population and Development Review, March 2002, vol. 28, no. 1pp. 165-172.
Orr, Douglas V. (2002), "The Social Security Reform Debate: Effects of Financial and Labor Market Institutions", Review of Radical Political Economics v34, n3, pp. 285-293.