Saving the Surplus
Wednesday, January 31, 2001
by Dr. Liqun Liu, Dr. Andrew J. Rettenmaier, and Thomas R. Saving
Table of Contents
Alternative Uses of the Social Security Surpluses
"The bonds in the Social Security Trust Fund are merely promises to impose taxes on future taxpayers."
Preserving the Social Security surplus for Social Security involves more than just depositing the funds into the trust fund. The bonds in the Trust Fund are merely promises to impose taxes on future taxpayers. As pointed out by both the Congressional Budget Office and the Office of Management and Budget, to redeem the bonds in the trust fund the government must raise taxes, reduce other expenditures or borrow. [See the sidebar.] The only way the surplus funds can contribute to future Social Security expenditures is by enhancing the future availability of consumption. We can do this by using any surplus to expand the nation's capital stock, thus increasing the country's ability to produce. Essentially, there are three options. Social Security's surpluses can be used (1) to pay down debt, (2) to invest in private capital markets using a single centrally held account or (3) to invest in capital markets via personal retirement accounts.3
Many are attracted to allowing workers to invest part of their Social Security taxes in personal retirement accounts. Upon retirement, the funds in these private accounts would pay for part or all of the promised Social Security benefits. If the contributions to private accounts are implicitly funded by the Social Security surplus, they will increase the nation's stock of productive assets, which will increase the nation's future income.
Paying down the national debt and establishing personal retirement accounts have similar economic consequences. Both actions inject new funds into the capital market. Regardless of what security is initially purchased - a government bond, a private bond, a private security, etc. - the injection of new funds expands the economy's capacity to create new capital (i.e., new machines, buildings, computers, etc.).
"Explicit debt -- bonds held by the public -- is estimated to be $3.4 trillion."
Explicit and Implicit Debt. There are two types of federal government debt. First, explicit federal debt in the form of bonds held by the public is estimated to be $3.4 trillion. This debt is backed by the full faith and credit of the U.S. government. A second type of debt is implicit. Examples are future promises to pay benefits under such programs as Social Security and Medicare. These promises are not backed by the full faith and credit of the government, and the Supreme Court has ruled that future Congresses are not bound by the promises of past Congresses. Nonetheless, many view these programs as establishing a political contract between generations. Reneging on such promises is likely to carry a heavy political cost.
Explicit debt has two bad consequences. First, it crowds out private investment. Every dollar borrowed by government in the credit market is a dollar not available for private borrowers. Second, explicit debt incurred today creates a burden for taxpayers tomorrow. And the act of collecting those taxes will likely discourage work, saving and investment, thus leading to another undesirable economic consequence.
In many respects implicit debt has some of these same economic effects. For example, Social Security's promise to pay future benefits reduces the incentive of today's workers to save. And the payroll tax collected to pay benefits to today's retirees reduces the ability of today's workers to save. In addition, as with explicit debt, implicit Social Security debt implies a higher tax burden on future generations.
We have chosen to define implicit Social Security debt as the present value of the system's accrued liabilities.4 In making this calculation we used a 5.5 percent real interest rate rather than the real government borrowing rate of 2.8 percent. The higher interest rate reflects the fact that this debt is not backed by the full faith and credit of the federal government and hence its payment is less certain than the government's redeeming of a bond.5 The appendix details our calculation of implicit debt.
"Even when explicit debt is paid off, the towering Social Security debt will keep growing."
Figure II presents the estimated implied Social Security liability in current dollars alongside the CBO's most conservative estimates of the debt held by the public and cash holdings under the assumption that the total surplus is used to reduce the explicit debt. In 2001 the implicit Social Security liability is estimated to be $8.8 trillion, or 86 percent of GDP. By 2010 the amount grows to more than $15 trillion, which is about equal to estimated GDP in that year. This debt, together with the debt held by the public less any government cash holdings, is the total indebtedness of the federal government. As seen in the figure, under the reduce-the-explicit-debt option, by 2009 the government's cash holdings will exceed the remaining government debt held by the public, so the government will no longer be in debt as "debt" is normally calculated. But despite the absence of explicit debt, the towering Social Security debt will keep growing.
"Using Social Security surpluses to invest in stocks and bonds results in a total debt that is $536 billion less than if they are used to reduce debt."
Illustrating the Alternatives. Figure III shows the relative size of the combined implicit and explicit debts of the federal government under the two debt reduction options. The white bars show the path of total debt when Social Security and non-Social Security surpluses are used for debt reduction. The bars are the sum of the debt held by the public and the implicit Social Security debt less any accumulated cash. The CBO estimates that beginning in 2007 the government will have paid off all the mature debt instruments and will begin to hold cash assumed to earn the rate of return on Treasury notes. The black bars show the path of total debt when Social Security surpluses are invested in stocks and bonds and the resulting non-Social Security surpluses are dedicated to debt reduction. The lower total debt is defined as the sum of debt held by the public and implicit Social Security debt less the accumulated balances in personal retirement accounts. As indicated in the figure, using Social Security surpluses to invest in stocks and bonds results in a total debt that is $536 billion less than if the surpluses are dedicated solely to reducing debt held by the public.
"Under the pay-down-the-debt option, the government is debt free by 2013 and runs a surplus until 2022."
Why does the investment-in-assets option produce better results than paying down debt? Because of the difference between the historical average return on a representative portfolio of stocks and private bonds (5.5 percent) and the interest rate on government borrowing (2.8 percent). By not paying down debt, the government is effectively "borrowing" at a 2.8 percent rate of interest; by using the same money to invest in assets, it is replacing future Social Security obligations with assets that earn 5.5 percent per year.6 In other words, taking advantage of this "risk premium" plays a central role in our analysis.
To summarize, both the paying-down-debt option and the investing-in-assets option will increase the capital stock and add to the nation's means of production. However, investing in the private market has the additional advantage of improving the government's fiscal position relative to pure debt reduction.7