Comparing Proposals for Social Security Reform

Studies | Social Security

No. 227
Wednesday, September 01, 1999
by Liqun Liu and Andrew J. Rettenmaier

The Case for Reform

The case for radical reform of Social Security is strong. And with each passing year it gets stronger.

Argument No. 1: The Current System Is on an Unsustainable Path. The 1999 Trustees Report2 predicts that by 2014 expenditures will begin to exceed revenues and will continue to exceed revenues in every year there after. In general, the further we look into the future, the worse the imbalance becomes.

  • Based on the Social Security Trustees "intermediate assumptions," the amount of revenue needed to pay benefits already promised under current law will rise from 12.4 percent of taxable payroll today to 17 percent by 2030 and almost 19 percent by 2070.
  • Based on the "pessimistic assumptions," the needed payroll tax will reach almost 20 percent by 2030 and almost 27 percent by 2070.
  • This implies that 70 years from now workers will have to pay almost one out of every five dollars they earn - and possibly more than one out of every four - just to fund Social Security.

As the Trustees Report indicates, sometime in the next century we will be forced to (a) double the payroll tax rate or (b) cut every benefit in half or (c) some combination of the two. This dire eventuality will arise in large part because people are expected to live longer and have fewer children than they did in the past. Currently there are 3.4 workers per retiree. By 2030 the number will drop to about 2.1. Pay-as-you-go Social Security, which taxes the wages of today's workers to pay the benefits of today's retirees, is also susceptible to demographic shocks like the baby boom.

Argument No. 2: The Current System Is a Bad Deal for Young Workers. 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 some of those tax dollars in the private capital market. For example, Laurence Kotlikoff and his colleagues have calculated that under the current system:3

  • 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 zero.

"Today's young workers will receive only about 50 cents in benefits for every dollar paid in Social Security taxes."

Even with no change in the law, today's young workers will receive only about 50 cents in retirement benefits for every dollar they pay in Social Security taxes during their working lives.4 Cutting benefits or raising taxes will reduce the expected return even more.5

Argument No. 3: The Current System Lowers Saving and Investment and Reduces Economic Growth. The unfunded liabilities of the system (that is, the benefits already accrued by workers and retirees minus expected tax revenues) are twice the explicit national debt - which has already crowded out a significant amount of private investment relative to a prefunded system. Less investment, in turn, means less income and growth.

In addition, both theoretical analysis and empirical evidence show that national saving is lower under Social Security than it would have been if the system had originally been set up as a funded system. The reason is that when young workers in the current system expect a retirement subsidy, and at the same time pay an earmarked payroll tax that lowers disposable income, their ability and incentive to save are reduced.6

Switching to a defined contribution system under which each generation makes deposits to private accounts to fund its own retirement benefits would reduce the distortion.

Argument No. 4: The Current System Penalizes Work and Lowers National Output. Economic theory teaches that if you tax something, you will get less of it. Since the Social Security payroll tax is a tax on income from work, it discourages people from working more hours and earning more income.7 In 1995, economist Martin Feldstein estimated that the economic loss due to the Social Security tax was $68 billion, or 2.35 percent of the tax base. He and Andrew Samwick also estimate that once a prepaid system matures, the economic gains resulting from the reduced cost of financing are more than enough to pay for the contributions to private retirement accounts.8 In other words, privatization pays for itself.

As outlined in Laurence Kotlikoff's approach, the first step of fundamental reform is eliminating Social Security payroll taxes.9 Indeed, much of the gain identified in several privatization plans is associated with switching from a tax on production to a tax on consumption. For example, this could be accomplished by replacing the payroll tax with a national sales tax.10

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