On June 25, the Senate Subcommittee on Securities, chaired by Phil Gramm (R-Tex.), held an important hearing on Social Security privatization. The sole witness was Jose Pinera, architect of Chile's hugely successful privatization. Now a fellow at Washington's Cato Institute, Pinera was Minister of Labor and Social Security in Chile from 1978 to 1980. Since then, he has traveled the world preaching the virtues of privatization.

In 1981, Chile abolished its state-run Social Security system for new workers and allowed workers in the old system to opt-out if they wished. Under the new system, workers do not pay Social Security taxes, but rather are required to contribute 10 percent of their pay into a pension savings account. These accounts are similar to individual retirement accounts or 401(k) plans. The worker invests the assets as he chooses from a variety of professionally managed mutual funds.

When the system was established, it was estimated that workers only needed to receive a real rate of return of 4 percent per year for them to be as well off in retirement as under the old state system. But in fact, most workers have done far better, making a 12 percent return on average since 1981. At retirement, workers are required to purchase an annuity that will pay them 70 percent of their pre-retirement earnings. Anything extra, they may spend as they please.

Of course, there are protections in the system for those whose savings turn out to be inadequate to give them 70 percent of their pre-retirement income. And of course taxes must still be paid to provide benefits for those still in the old system. But as time goes by, those taxes will fall as fewer and fewer people remain in the state system.

The privatized Social Security system has not only benefited workers, but the Chilean economy as a whole. Much of this came from increased saving that financed investment, leading to higher productivity. According to economist Sebastian Edwards of the University of California - Los Angeles, privatization of Social Security in Chile led to an increase in national saving from 10 percent in 1986 to almost 29 percent in 1996. And as Jose Pinera notes, the higher growth resulting from the higher saving and investment increased government revenues, helping to finance the transition from the old system to the new.

Another factor contributing to growth in Chile was a vast increase in the supply of labor resulting from abolition of the payroll tax. Since the linkage between taxes and benefits in the old system was tenuous at best, the payroll tax strongly depressed employment and work effort. But under the new system, where workers know with certainty that they will get back all of their contributions, they do not view the mandatory saving as a tax, but rather as part of their benefits.

In the July-August issue of Foreign Affairs, economist Martin Feldstein of Harvard argues that the U.S. would also achieve higher growth from a privatized Social Security system here. This higher growth, resulting from higher productivity from a larger capital stock, would offset much of the transition cost. Higher revenues from faster growth would allow today's workers to continue paying taxes to provide benefits for current retirees, while still saving enough for their own retirement. Over time, the tax would fall to zero, while the higher return on private saving would give today's workers a better retirement income than they would have under Social Security.

While any reform of Social Security in the U.S. is years away, other countries are moving forward. On July 8, New Zealand became the latest country announcing plans to privatize its Social Security system along Chilean lines.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, July 16, 1997.