Privatizing Social Security

Policy Reports | Social Security

No. 217
Wednesday, July 01, 1998
by Laurence J. Kotlikoff

Executive Summary

The U.S. Social Security system is broke. It does not have the assets to pay promised benefits. Unless the system is fundamentally changed, solvency will require either massive tax increases for future workers or draconian cuts in benefits for future retirees.

Social Security is also treating the vast majority of people who are working and paying taxes very badly. For example:

  • Eighteen-year-olds entering the labor market today and earning only an average income can expect to accumulate more than $700,000 in tax payments by the time they reach age 65.
  • Yet they can expect to withdraw from the system just over $140,000 in benefits (discounted to age 65) - a fraction of what they will have paid in.
  • And receipt of even these benefits will be uncertain - since it will likely require that future workers face 50 percent higher payroll tax rates than now exist.

Some defend the current system on the grounds that it is progressive, providing a safety net for those who might otherwise be unable to maintain a decent standard of living in retirement. Although it has done much good, the system takes a bigger share of the lifetime income of the poor than it does of the rich.

  • Virtually all groups born since World War II can expect to pay more in taxes than they will receive in benefits, but this burden is not distributed equitably.
  • Those who fare the worst are the middle class, who face a burden (as a percent of lifetime income) that is several times higher than those who earn the highest incomes.
  • The burden for the top tenth of the income distribution is not only lower than for those in the middle, it is only one-half that of the burden faced by the bottom tenth.
  • Because of their shorter life expectancies, blacks do worse than whites.
  • And those without a college education do worse than those with college degrees.

Even if Social Security keeps all of its promises, the vast majority of working taxpayers will get a return on their contributions far below what they could have earned by investing those same tax dollars in the private capital market. For example:

  • Baby boomers will get a real rate of return of less than 2 percent.
  • Generation Xers will get less than 1 percent.
  • Today's newborns will get a rate of return close to a zero.

Fortunately, there is a better way. The plan proposed here would replace that portion of the payroll tax used to pay for Social Security retirement benefits with a consumption tax. Instead of paying Social Security taxes, workers would deposit those dollars in private accounts earning the rate of return paid by the international capital market. Near the time of retirement, they would convert their investments into annuities providing a retirement income larger and more secure than that promised by Social Security.

This plan has been endorsed by 65 of the nation's leading academic economists, including three Nobel Prize winners. Not only would it solve the problem of Social Security, it also would create other economic benefits for society, increasing the nation's output per person by an estimated 15 percent.

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