Towards A Good Samaritan World

Wednesday, December 15, 2004


I wrote this e-mail to Andrew Sullivan this morning in response to a letter he posted from Michael Kinsley supposedly proving that Social Security reform will not work:

Michael Kinsley seems to think that in order for privatization to work, it needs to generate “higher returns for retirees than current arrangements.” It’s as if Kinsley thinks that “current arrangements” were sustainable.

Under current arrangements, the level of benefit growth rises with wage growth. If wages rise by 4%, benefits rise by 4%. Wage growth is typically faster than the inflation rate. So the real value of Social Security benefits rises with time. Meanwhile, demographic changes are underway, such that the ratio of Social Security beneficiaries to workers paying the payroll tax steadily increases. Right now, payroll tax receipts are larger than Social Security benefits, so we can pay all the benefits while still having money left over for the “trust fund.” After 2018 (according to projections) this will be reversed: we will have to pay more benefits than we collect in taxes. The government will have to raise taxes or cut spending in order to pay off the trust fund’s “bonds.” By 2042, the bonds will run out, and the trust fund will be bankrupt. The SSA will still continue to pay a portion of the scheduled benefits, perhaps 70-75%, and the ratio will continue to decline thereafter.

Now, there is something a bit silly about any projection that purports to forecast forty years into the future. Politics is too changeable. We know now that Social Security is not a “third rail.” Bush has campaigned on reform twice and won. Four decades’ worth of politicians will have the chance to change Social Security before this bankruptcy date. And will the generation that retires in 2040 take their sudden benefit cuts standing still? Surely there would be an electoral revolt if the government let that actually happen.

The bottom line is that Congress can take away your benefits at any time. Social Security is called an “entitlement” but that is exactly what it is not, according to the 1960 Supreme Court case Flemming vs. Nestor, in which Nestor was deprived of his Social Security benefits for past membership in the Communist Party—and the Supreme Court upheld this. Social Security is just a transfer, revocable at will by the government. Private accounts would be property rights—a true “entitlement,” the “ultimate lockbox.”

Kinsley is right about one thing: claims that Social Security privatization will generate higher returns for retirees are partly bogus. Higher returns from the stock market will be offset by taxes to pay benefits to current retirees. The economic benefits from privatization flow mainly from a higher national savings rate. But that depends on Congress. If we wanted to balance the budget and shift from a pay-as-you-go to a fully-funded retirement system, we would have to create private accounts, because with the government out of the borrowing business, it would have nowhere to put younger workers’ savings except by acquiring private assets, which is inconsistent with the free-market system. That scenario would be excellent for economic growth. But given the current big deficits, it’s academic.

And privatization alone will not solve the problem of Social Security’s long-run insolvency. To do that we’ll need to raise the retirement age (perhaps by indexing it to longevity) or cut the benefit growth rate by indexing it to the CPI rather than wage growth or introduce means-testing of Social Security benefits. (I say: all three!)

What privatization will do is take political risk out of people’s retirement plans. Since “current arrangements” are unsustainable, young people have no idea what they will be retiring on, and even people in their 50s are nervous. Political risk is unknowable and people have only one choice. Private accounts would substitute political risk with market risk. And market risk allows people to make choices, according to their own level of risk-aversion. (Probably most people would invest private retirement accounts the way IRAs are currently invested, with a portfolio mainly of stocks in youth, shifting into bonds as they near retirement.) With political risk removed, people could have what the current system can never give them: (lower-case) social security.

But why should Andrew Sullivan publish me when he can link to Arnold Kling? Since Arnold has covered this territory before, he emphasizes an angle that he begun a week ago: Social Security reform should really be favored by the left:

[U]sing debt rather than payroll taxes to fund current beneficiaries would have one important real effect. It would shift the overall tax burden away from payroll taxes and toward general revenues, which means primarily income taxes. Thus, the transition toward privatization would make the funding of Social Security more progressive, meaning that relatively more burden falls on the rich and relatively less falls on the poor. In that regard, it is somewhat surprising that the Left opposes privatization and the Right supports it...

One effect could be to shift the composition of portfolio holdings so that Americans invest more in stocks and less in bonds. If stocks are under-valued, as they have been historically, this would improve the allocation of capital in the United States. To believe that this will happen, you have to believe that U.S. capital markets are inefficient today, and that their efficiency will be improved by steering more people toward ownership of stocks. Greater efficiency would increase economic growth, which, as Kinsley points out, is a way for privatization to improve the outlook for the future. Conservative economists are inclined to view markets as efficient, so that privatization would not cause such a portfolio shift. Therefore, this is another argument for privatization that is more likely to be supported by the Left (for example, Berkeley economist Brad DeLong) than by the Right.

Bush the Leftie. Money to fight AIDS in Africa. An education bill to help minority kids in failing schools. A push for civil rights for illegal immigrants. Meanwhile, the Democrats are the party of the cultural elite and middle-class entitlements.

I also posted a new article about political risk and Social Security on my website.


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