Social Security and Race

Policy Reports | Social | Social Security

No. 236
Monday, October 02, 2000
by Liquin Liu and Andrew J. Rettenmaier

Implications for Privatization

"Individuals who get a low rate of return would have been better off if allowed to invest their payroll tax dollars."

What then are the implications of these findings? One implication is that groups getting a lower return from Social Security than from private investment would be better off if the Social Security system had never been instituted. This does not necessarily mean that privatizing Social Security - creating individual accounts invested in private capital markets - will automatically produce better returns. The accrued benefits in the old pay-as-you-go system remain a real burden after privatization. In fact, the difference between the lower return of the pay-as-you-go system and the higher return from the private capital market does not matter per se. If on privatization the government honors its promise to older generations and issues them recognition bonds for their accrued benefits in the old system, debt-servicing taxes will have to be raised on the younger generations. When these debt-servicing taxes are taken into account, the higher return on workers' private retirement accounts is exactly compensated for by the taxes required to service the liabilities-turned-debts, resulting in the same low return as in the old system.

The gains resulting from Social Security privatization based solely on a rate-of-return comparison is open to criticism. The criticism applies to the naive argument that the private option is more attractive since the rate of return from private investments is greater than the implicit rate of return offered by Social Security and to the more sophisticated argument that even with the transition cost taken into account the rate of return from investing Social Security contributions in the private sector would be the same as from the pay-as-you-go system.

That is not to say that moving to a private system will produce no gains to American taxpayers. As pointed out by Murphy and Welch (1998), incentives matter.14 One feature of privatization that may change incentives is the use of an alternative tax base during the transition. If, along with creating individual retirement accounts, the government begins to service the accrued Social Security debts with general tax revenues or a new consumption tax with a lower marginal tax rate on labor income, then the adverse consequences of the Social Security payroll taxes will be alleviated. When incentive effects of this sort are taken into account, it is possible to see how privatization can make everyone better off.15

A major implication of differential returns/participation values on Social Security contributions by various demographic groups is that Social Security implicitly redistributes money. From the government's point of view, the current Social Security rules may not redistribute efficiently or as intended. Thus it is important to compare the deals for people of different demographic characteristics in order to assess the direction and degree of redistribution implicit in the system.

Given Social Security's redistributive characteristics across demographic groups, what can we say about the distributional impact of privatizing it? Essentially, forced Social Security participation is a tax on all the demographic groups of later generations judged from their below-market returns. While the ranking by rate of return indicates the progressivity or regressivity of the tax system, the ranking by present value reveals the direction of the intragenerational redistribution. For example, since blacks have higher net present values than whites, we can say the system redistributes from whites to blacks. At the same time, we can say that the implicit tax system is regressive since whites have a higher rate of return (a lower tax rate).

"All things considered, privatization is likely to benefit blacks more than whites."

During the transition to prepaid accounts, the debt servicing tax also implicitly redistributes among various groups. Comparing the progressivity of the current tax and of the proposed debt servicing tax allows us to assess the impact of privatizing Social Security. Based on this principle, we argue that since the implicit redistributive tax of Social Security is regressive in the sense that the tax rate falling on blacks is higher than that on whites and that the likely debt servicing taxes (general income tax or consumption tax) are either proportional or progressive, the distributive impact of Social Security privatization is in favor of blacks.

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