The Economic Cost of the Social Security Payroll Tax

Studies | Social Security

No. 252
Friday, June 28, 2002
by Liqun Liu and Andrew J. Rettenmaier

Economic Gains from Social Security Privatization

Figure II - Taxes Under Three Scenarios

"Some countries, like Singapore are Chile, require workers to save for their own retirement."

As noted above, there is a loose link between marginal taxes paid and marginal benefits received under the U.S. Social Security system. The same is true of most pay-as-you-go social security systems in the world today. However, some countries have established mandatory savings programs as an alternative to pay-as-you-go social security. In these systems, workers are required to save for their own retirement. For example, Singapore has had such a system since the mid-1950s. Chile has had a mandatory savings alternative to pay-as-you-go social security since 1981. Currently, more than 20 countries mandate some form of individual retirement savings.13

In a mandatory savings system, when workers earn an extra dollar, they must place a portion of it in an account just as they pay FICA under the current U.S. system. However, unlike FICA taxes, funds placed in mandatory savings accounts are the individual workers' property, and the workers tend to view them as such. Thus when workers place funds in private accounts that earn the market rate of return, they tend not to view the contribution as a tax because they get to keep all they deposit.

Mandatory savings systems can also have welfare losses. The reason is that government may be requiring people to save more than they want to save. Put another way, a government may force people to allocate their lifetime consumption (between pre- and post-retirement years) differently than they wish. However, in what follows we assume that no welfare loss is associated with mandatory private savings, and we continue with the conservative assumption that the "pure Social Security tax" is the best way to measure the burden of the current system.

"Unlike Social Security taxes, funds placed in a mandatory savings account are an individual worker's private property."

The Potential Gain from Privatization. The net economic gain from privatization depends on a comparison of the welfare costs of the current system and the welfare costs after privatization. While the welfare costs of the current system indicate the potential gain from Social Security reform, not all welfare costs can be avoided. Over the years taxpayers and retirees have accumulated sizable benefits based on past participation in Social Security. We assume those accumulated or accrued benefits must continue to be paid, requiring either more debt or higher taxes or a combination of both. The additional debt or the higher taxes will continue to cause welfare losses.

Figure III - Tax Rates Before and After Partial Privatization Reform

Many options exist for financing the accrued benefits after privatization, and we compare several of them to the current system. Our first two estimates are based on reforms that would result in total privatization of Social Security. We then follow the outline of one of the proposals suggested by the President's Commission to Strengthen Social Security and estimate welfare gains associated with partial prepayment.

Prepayment and Privatization. Prepayment and privatization of Social Security are often used interchangeably, when in fact they have separate meanings. Prepayment refers to saving now and using the proceeds of the saving to fund future Social Security expenditures. This saving can occur publicly, through a government-owned fund or privately through individually owned accounts. The unifying component is that the fund(s), regardless of who owns them, are invested in stocks and bonds and other assets. Prepayment can be partial or total. Partial prepayment involves advance funding of some but not all of future generations' Social Security benefits. With partial prepayment, future Social Security benefits are funded by taxes and by selling stocks and bonds. Total prepayment would require higher initial savings, but it would eventually allow all Social Security payroll taxes to be eliminated.

Privatization is a form of prepayment and refers to individually owned assets. Privatization can also be partial or full.14 Individually owned investment accounts, in the context of Social Security reform, are often referred to as Personal Retirement Accounts (PRAs). During retirement, the funds in the PRAs are used to pay all or part of the Social Security benefits workers expect to receive. When workers make deposits to PRAs they are prepaying their Social Security benefits.

"With complete prepayment, a payroll tax would no longer be necessary to pay benefits."

Total Privatization Using Government Bonds. Under this option, workers would receive recognition bonds15 equal to the present value of the future benefits they are entitled to, based on their earnings up to the year Social Security is reformed. From that point on, additional benefits would be financed with mandatory payroll deductions and deposits to PRAs. These funds would accumulate at the market rate of return.16 Following privatization, a payroll tax would no longer be necessary to pay benefits. However, some tax - we assume a payroll tax - would be necessary to service the additional debt (the new recognition bonds). Workers would view this entire tax as a pure tax given that it would have no bearing on the size of their own retirement benefits. Each year after this, a transitional payroll tax would pay the interest on the additional debt, keeping the absolute amount of the debt constant. Thus the only distortionary factor after privatization would be the transitional debt-servicing payroll tax.17

"If the transition to personal accounts is funded by issuing debt, by mid-century the reformed Social Security will have reduced the welfare loss of the current system by 60 percent."

To the extent that privatization leads to a reduction of the payroll tax, the PRA-based reform will improve efficiency and make workers better off. Our calculation of the welfare costs of the transitional payroll tax leads to the following conclusions:

  • For the first two decades of the reform, the payroll tax needed to service the debt under the new system is higher than the pure tax rate under the current system. [Figure II.]
  • Thus for the first 20 years or so, the welfare loss is actually higher under the reformed system.
  • However, by mid-century, the reformed system will have cut the annual welfare loss under the current system by 60 percent. Appendix Table I.]
Figure IV - Welfare Gains Under Three Reforms

Total Prepayment with Tax Financing. Instead of issuing government debt, accrued benefits could be paid for through contemporaneous taxes as the benefits come due. In this case:

  • The payroll tax needed in the new system would be higher than the pure tax in the current system for the first three decades of this century. [Figure II.]
  • However, by mid-century, the welfare losses of the current system would be 72 percent less. [See Appendix Table II.]

"If the transition to personal accounts is funded by additional taxation, the tax rate would climb to 11.7 percent of payroll by 2026, but eventually fall to zero."

Unlike the debt-service tax, which declines over time, the contemporaneous taxes would rise until 2026 when they reach 11.7 percent of payroll. But as Figure II shows, they would eventually decline to zero. The contemporaneous transitional taxes are initially lower than the debt-servicing taxes under the previous scenario, but by 2009 they are higher. They remain higher until 2046 and then are always lower, reaching zero by 2075. The main difference then is the timing of the welfare cost reductions. With government bonds, the welfare gains are higher from 2009 to 2045, but with contemporaneous taxation the welfare gains in the future are higher.

Partial Prepayment with Contemporaneous Taxation. Most current Social Security reform proposals do not involve full prepayment of retirement benefits. Instead, they allow workers to set aside a portion of their payroll taxes under a mixed retirement system, partially prepaid and partially financed with taxes. Figure III depicts a mixed system involving PRAs based on 2 percent contributions. Specifically, we assume that all workers aged 55 and younger contribute to PRAs. At retirement, the PRA balances are annuitized and offset the worker's promised Social Security benefits dollar for dollar. During the accumulation period up to retirement, we assume the PRAs earn a real return of 4.6 percent. We assume the accounts are annuitized at a real return of 3.0 percent. We further assume that defined benefits are reformed in a manner similar to that suggested in the second option put forward by the President's Commission to Strengthen Social Security. In that option, beginning in 2009 and thereafter, the benefit formula is based on price-indexed earnings rather than wage-indexed earnings.18 In this way, real benefits are essentially set at their 2009 level.

"By the time today's newborns reach retirement age, personal accounts funded by 2 percent contributions would reduce the welfare loss of the current system by more than half."

Under these assumptions, Figure III shows the status quo, reform tax and pure tax rates. The pure tax component of the reformed system is initially slightly lower than that of the status quo, moves higher from 2009 to 2029, then again turns lower. The ultimate gains relative to the status quo are smaller than in the previous two scenarios, and for several decades the welfare costs are higher. The gains are smaller for two reasons. First, the portion of the payroll tax, viewed as a pure tax, is higher in the long run. Second, because the PRA reduces one's ultimate Social Security benefit payment, a higher share of the net tax payment is viewed as a pure tax by workers. Nonetheless, the reform is worthwhile:

  • By mid-century, the reform would reduce the annual welfare loss of the current system by almost one-third (31 percent).
  • By the time today's newborns reach retirement, it would reduce the welfare loss by more than half. [See Appendix Table III.]

A Recap. Figure IV depicts the welfare gains, as a percentage of taxable payroll, associated with the three reforms discussed above. Total privatization using contemporaneous taxes to pay the accrued benefits has the highest up-front costs and produces the greatest long-run gains. Partial prepayment, through a reform similar to one suggested by the President's Commission to Strengthen Social Security, results in a modest increase in the welfare cost for 20 years but ultimately produces a welfare gain equal to about 3 percent of taxable payroll.

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