Privatizing Social Security

Policy Reports | Social Security

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


The U.S. Social Security System is broke. Indeed, it's in much worse fiscal shape than the public thinks or government representatives acknowledge. Paying all of Social Security's promised benefits on an ongoing basis appears to require an immediate and permanent 6 percentage point increase in the current 12.4 percentage point payroll tax used to finance the system. That means the system needs to take 6 cents more out of every dollar earned by the average American worker not only in this generation, but in every generation that follows.

This staggering truth about Social Security's long-term finances cannot be read in the Trustees Report.1 On the contrary, the trustees say the system needs only 2 cents more per dollar earned to stay afloat. Given that workers have only 100 pennies out of each dollar they earn to give away to government and that they are already paying roughly 30 cents on the dollar in net taxes (taxes paid net of transfer payments received), taking even 2 more cents is serious. Indeed, even this substantial understatement of the system's fiscal position has been large enough to get President Clinton's attention. His response has been to initiate a national "conversation" about "saving" Social Security.

"A growing number believe the only way to ‘save' Social Security is to privatize it."

Most Democrats and Republicans have taken saving Social Security to mean simply coming up with a set of piecemeal fixes that will leave the system basically intact. But a growing number in both parties believe that the only way to "save" Social Security is to privatize it. Full privatization entails letting workers contribute their Social Security payroll taxes to private accounts and using another fiscal instrument, during a transition period, to pay existing retirees their full Social Security benefits and existing workers their accrued Social Security benefits. Under full privatization, the system is shut down at the margin, and no new benefits accrue. Partial privatization lets workers contribute some, but not all, of their Social Security payroll taxes to private accounts and accrue Social Security benefits by making additional contributions.

Unfortunately, with the help of the trustees, both sides are conveniently ignoring two-thirds of the system's true fiscal problem. Consequently, neither the patches proposed by the would-be saviors nor the proposals of the would-be privatizers come close to guaranteeing current retirees and workers all the Social Security benefits due them based on their past contributions to the system.

In saying that he wants to save rather than reform Social Security, the president has suggested preserving the existing system. Since the alternative to being its savior is being its destroyer and since no would-be privatizer wants to wear that label, members of Congress are discussing only partial privatization schemes that resemble mandatory, small-scale IRAs.

For the self-appointed saviors of Social Security, these schemes are easy targets. First, they entail high transaction costs per dollar invested. Second, they lack progressive elements that would help the poor to save. Third, they permit people to invest in the financial markets in a risky, undiversified manner. Fourth, they permit different workers to earn very disparate rates of return. Fifth, they provide no direct protection of dependent spouses. Sixth, they provide no clear mechanism for converting account balances into inflation-protected pensions in retirement.

In addition to all these defects, the "saviors" of Social Security rightly point out that the proponents of these schemes are making heroic assumptions about the stock market's performance over time, which is another way of saying they are not adjusting properly for the market's risk. In this respect, the saviors of Social Security, who seek to invest the Social Security Trust Fund in the stock market, are open to the same criticism.

Is full privatization a rational alternative? Can it be accomplished in a way that deals with all the legitimate objections to partial privatization? And can it guarantee that the old Social Security system pays all the benefits it owes? The answer to each of these questions is yes.

"Privatization can be accomplished in a way that guarantees the old Social Security system pays all the benefits it owes."

The Personal Security System is a plan for fully privatizing the retirement portion of Social Security. I developed it with Jeffrey Sachs, an economics professor at Harvard University, and 65 of the nation's leading academic economists, including three Nobel Prize winners, have endorsed it. The plan protects dependents, assists the poor, limits transaction costs, prevents people from playing or timing the market, provides everyone a fully diversified portfolio, ensures everyone the same rate of return on their contributions, transforms account balances at retirement into inflation-protected pensions and has a fiscal mechanism for paying off 100 percent of the accrued liabilities of the old system. What's more, the plan is simple. Furthermore, its method of paying off all the liabilities of the old system is transparent, hinging neither on heroic assumptions nor on hard-to-discern details.

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