Privatizing Social Security

Policy Reports | Social Security

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

Advantages of the Reform

The proposed reform has a number of advantages. In particular, the Personal Security System would:

  • Improve the link between contributions and benefits.
  • Provide better protection for survivors.
  • Equalize the treatment of one- and two-earner couples.
  • Phase out the ongoing transfer of resources from the young to the old.
  • Provide better divorce protection for nonworking spouses.
  • Make the system more progressive.
  • Resolve Social Security's long-term funding problem.
  • Ensure Americans an adequate level of retirement income.

Let's take a closer look at a few of these.

"Over time, this reform will increase the economy's output by roughly 15 percent and the capital stock by roughly 40 percent."

Impact on the economy. Knowing precisely how and when any major fiscal reform will affect the economy is impossible. But economists try to get some insight on this issue by developing and simulating large-scale dynamic computer models. My joint research with Kent Smetters and Jan Walliser, two top economists at the Congressional Budget Office, which uses such a model, indicates that privatizing Social Security can produce a significant short-run increase in national saving and a significant long-run increase in the economy's capital stock and its output of goods and services. Over time, this reform will increase the economy's output by roughly 15 percent and the capital stock by roughly 40 percent.15

However, the transition to such an improved economy will take time. Moreover, how we finance the transition will determine the duration of the transition as well as the economy's final resting place. Financing privatization through a consumption tax, as is advocated here, would deliver the fastest and most efficient transition. In addition to eliminating a distortionary payroll tax, a consumption tax entails an implicit one-time wealth tax on retirees when they consume. The consumption tax also redistributes from older spenders to younger savers, promoting national saving. In contrast to consumption tax finance, income tax finance entails highly distortionary short-run tax rates that dramatically slow down the transition.

Effects of alternative methods of funding the transition. Another of our findings is that using deficit finance to limit the imposition of higher marginal income tax rates as one is paying off Social Security's accrued liabilities makes the economy's short run look better and its long run look worse. Sufficient reliance on deficit finance will leave the economy in a worse position in the long run than the one at which it started. For example, suppose the government lets workers contribute their Social Security taxes to private accounts and then borrows to make up the revenue shortfall needed to pay existing retirees their Social Security benefits. In this case, the workers will have been handed an explicit government IOU - government bonds that are issued to fund the increased debt - instead of an implicit IOU - promises of future Social Security benefits - in exchange for their contributions. Under this policy, future generations won't have to pay high Social Security taxes on which they receive a negligible rate of return. Instead, they'll have to pay high income and other taxes to pay the interest and principal on the explicit debt issued by the government.

Intergenerational equity. Asking the middle-class and rich elderly to pay their share of Social Security's unfunded liability is intergenerationally equitable given the massive transfers made to the elderly through Social Security, Medicare and other post-World War II programs.

Impact on the poor. We've also learned that Social Security's privatization is remarkably progressive with respect to its lifetime impact on the rich and poor. Even without a progressive government matching contribution, the lifetime poor enjoy a larger improvement in their well-being than do the lifetime rich. Why? Because a larger fraction of their labor earnings would otherwise be subject to payroll taxation.

"The poor have the most to gain from privatizing social security."

A business cash-flow tax represents an indirect way of taxing consumption. The current poor elderly living on Social Security benefits will be fully insulated from the tax because their benefits are guaranteed in real terms through the system's indexation of benefits to the consumer price level. So if the consumption tax causes prices to rise, their Social Security benefits will rise proportionately. The middle-class and rich elderly as well as middle-aged and younger members of society will jointly bear the burden of the tax. For young and middle-aged workers, the overall tax burden will decline since they will no longer pay the Social Security payroll tax. For the economy as a whole, the tax change is revenue neutral, with the business cash-flow tax simply replacing the Social Security payroll tax. Simulation analyses show that poor members of current middle-aged generations, of current young generations and of future generations have the most to gain from privatizing Social Security.

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