Introduction
In the coming years the baby boom generation will put an increasing amount of pressure on the current US system of social security. This system is an unfunded defined benefit system but is better known as the "pay-as-you-go" system. It relies on the younger generation to supply old age security for the retirees. The growing needs of these new retirees are going to cause a deficit in the Social Security fund. This deficit can be funded in three ways: reduce future retirement benefits, increase taxes or save more now and invest those savings productively (Felstein and Samwick, 1).
Many economists are suggesting that the "pay-as-you-go" system
is not working and that we need to move toward a privatized system. In such
a system employers and employees would be required to put a percentage of
an employee's paycheck into a personal retirement account (PRA) instead
of a Social Security Trust Fund. However, a switch from our current system
of Social Security to a privatized one, incurs some serious transition problems.
The basic problem is that nobody would be paying for this generation of
retirees because all their kids are all paying for their own retirement
(Gramlich, 61).
This essay will discuss the transition to a privatized social security system.
The first section will discuss our current unfunded defined benefit system.
A discussion of the problems with this system will shed some light on why
the US is considering privatizing social security. The second section will
discuss how the US can transition into a privatized social security system.
In this section the idea of a mixed system including both the "pay-as-you-go"
and the privatized system will be explained as a probable way to transition.
Current US System
The current US system of Social Security is known as an unfunded defined
benefits system. It is better known as "pay-as-you-go" because
the program has "assets substantially less than its actuarial liabilities"
(Feldstein and Leibman, 7). The program taxes the current work force and
then transfers that money directly into the hands of the retirees within
the same year that they are collected. Workers pay into the system now and
in return are paid in their retirement by defined benefits equal at least
to the amount they had paid during their working years. Individual's benefits
are positively related to their past earnings (Feldstein and Leibman, 7).
The system was developed by the government in absence of a market for real
annuities. There are several rational for the current system (Feldstein
and Leibman, 8). The first is to counter individual life-cycle myopia or
shortsightedness in not saving money for retirement. The second deals with
the potential for individuals to game the system if retirement funds were
based on a means tested basis. This case involves a person undersaving for
retirement knowing the government would pick up the tab. Additional benefits
can be attributed to increases in the political economy in this system (Feldstein
and Liebman, 14). In this system a parent is making an investment in the
human capital of its generation's children and a good investment will provide
a good return for their retirement. Also built in to this system is an incentive
for laborers to leave the work force when they reach they reach the age
required for Social Security eligibility. In this sense, there is a decreasing
value in the old labor in terms of human capital and this system is "buying
the elderly out of the labor force" (Feldstein and Liebman, 14).
The current system has several down sides and one is the deadweight loss
associated with the Social Security payroll tax. This tax both "distorts
the supply of labor and the form of compensation" (Feldstein 1996,
2). The tax is a real tax and incurs deadweight losses which are inevitable
because of the low return implied by this system (Feldstein, 2). The deadweight
loss calculates the individuals who would have been included in the market
without the increase in tax caused by the Social Security tax. This deadweight
loss is not the "small triangle" but rather a trapezoid because
it is being calculated on top of the existing federal and state taxes (Feldstein
1996, 4). The payroll tax may have additional affects beyond the number
of hours an individual works. These other dimensions include occupational
choice, location, and effort (Feldstein 1996, 4). Depending on the elasticity
of the payroll tax this deadweight loss could account for as much as 1 percent
of GDP and nearly one-fifth of the payroll tax revenue (Feldstein 1996,
5). This raises the question of how efficient this system is.
The second problem associated with this system is a decrease in national
savings. An increase in taxes may discourage people from saving. Also, if
people can be sure of their old age security this is a disincentive to save
for the future. The substantial loss of investment income associated with
this decline in savings is seen as a problem. Investment is a substantial
part of a countries growth and more growth means more revenue from taxes.
This is another argument for the inefficiency of this system.
Transition to Privatization
With so many seen problems to the current system many economists are suggesting
that there be a shift to a more privatized Social Security system. The basic
idea behind this model is to mandate the employer and employee to deposit
a regular contribution into a private retirement account that is invested
in stocks and bonds. The benefit of this system is in the ability to invest
the money collected. In this system a retiree can reap a greater return
on his or her investment into social security. Funds from this account can
be withdrawn gradually when an individual reaches retirement age or bequeathed
to a spouse or other heirs. This represents more of a funded system in the
sense that it accumulates wealth over time as the retirement funds earn
money off of investment. However, these funds are managed by individuals
and not by the government.
The biggest problem for the government when switching to privatization of
Social Security is how to maintain its obligations to existing retirees.
This is known as the transition stage. The transition will have to be funded
by any of the three ways described above, decrease benefits to retirees,
increase taxes or to save now and invest those savings in a productive way.
For obvious reasons it is preferable to raise saving rather than cut benefits
or increase future taxes.
A mixed social security system can provide just the solution for the transition.
In this system, old and new systems work together to finance the cost of
the transition (Feldstein and Samwick, 3). In this system the current "pay-as-you-go"
system would serve as the baseline for the program with a slice of the tax
going into a small personal retirement account (PRA) or a Personal Security
Account. There are several variations but the end effect is to try and smooth
out the transition over time.
The "pay-as-you-go" benefits associated with this program can
be managed differently over time but the premise is that the program will
not have enough money to support all the retirees and may have to borrow
in order to keep the defined benefits going to current retirees. This part
of the two-tier system acts like a safety net (Cogan and Mitchell, 155).
The idea is to Issue a benchmark level of benefits by the "pay-as-you-go"
system and then supplement that percentage with either borrowing early on
and hopefully by people personal accounts later on. The government in time
can issue a benchmark level. The benchmark level gives the government responsibility
over only the "pay-as-you-go" portion of the retirement fund.
The private account is left up to the individual to manage (Feldstein and
Samwick, 19). This is called a guaranteed benchmark level. Shifting the
benchmark level shifts when and how much the government will have to increase
the funding for the program.
The small PRA solution solves some problems with the current system while
adding additional benefits. Firstly this system adds to the national savings.
The savings in the account multiply over time and provide a substantial
increase in the savings rate across the country. It is difficult to predict
what the exact response will be to this increase in savings and it depends
on how individual households adjust other behavior (Feldstein and Samwick,
12). In addition, this system maintains some of the equality of the old
system. The high earners will still be rewarded by having more in their
account than low earners (Gramlich, 60). This solution also has the appeal
of giving individuals ownership over their social security rights.
A Personal Security Account is much like a PRA but it is a much larger slice
of the tax revenue. It is also a much larger step towards privatizing Social
Security. This system would be two-tiered. The first tier would support
the transition stage. This tier would be supported for a short time on the
money already at hand. In the long run it would have to be financed by a
transition tax that could be spread across many generations (Gramlich, 62).
The transition tax is not defined and could be any kind of tax. This system
incurs debt that will have to be paid off in the long run. The second tier
is the Personal Security Account that takes over completely, with exception
of the disabilities tax, after the transition. This system has built in
risk because of the large amount of money being invested in the stock market
by private individuals.
Conclusion
The current unfunded defined benefit Social Security system is not going to be able to supply the defined benefits to retirees over the coming years because of the increase in dependency rate caused by the baby boomers. This system has built in inefficiencies that plague its survival as well. In addition to national and state level taxes, the Social Security tax only adds to the deadweight loss associated with any normal tax. This tax affects the labor market by making it harder for some individuals to enter it. In addition this system affects the national savings rate. The payroll tax goes straight to the hands of retirees. The money is never invested. There is also no incentive for people to save extra money for retirement because they are already covered by the government.
The privatization of Social Security must battle the hurdle of the transition
stage. A mixed system can help smooth out government debt and help the system
transition into a more privatized system. It does this by a system of benchmarks
in which the current "pay-as-you-go" system is still in place
and the government guarantees a certain percentage of the individual's benefits.
Over time the PRA or Private Security accounts will take over and complete
the transition.
Cogan, John F. and Olivia Mitchell, (2003), "Perspectives from the
President's Commission on Social Security Reform", Journal of Economic
Perspectives, (Spring 2003), vol.17, no. 2, pp. 149-172.
Feldstein, Martin and Jeffrey Liebman, (2001), Social Securtity, National Bureau of Economic Research Working Paper 8451, (September 2001)
Feldstein, Martin and Jeffrey Liebman, (2001), Potential Paths of Social Securtity Reform, National Bureau of Economic Research Working Paper 8592, (November 2001)
Feldstein, Martin (1996), "The Missing Piece in Policy Analysis: Social Security Reform", American Economic Review, Vol. 82, No. 2, May 1996, pp. 1-14.
Gramlich, Edward M. (1996), "Different Approaches for Dealing With Social Security", The Journal of Economic Perspectives, Vol. 10, No. 3, Summer 1996, pp. 55-66.