Tax and Social Security Reform: Thinking Outside the Box

Policy Reports | Social Security | Taxes

No. 275
Thursday, September 29, 2005
by Hans Fehr, John C. Goodman, Sabine Jokisch, Laurence J. Kotlikoff

Combining Tax Reform and Social Security Reform

"Welfare gains from a VAT would be greatest for the lowest-income earners."

The idea behind Social Security privatization proposals is almost every-where the same: to replace a pay-as-you-go pension system with a funded system. Thirty countries have already enacted such reforms to a greater or lesser degree. Under our current pay-as-you-go system, taxes paid by today’s workers are mainly used to pay the benefits of today’s retirees. None of these funds are set aside and invested. As a consequence, when today’s workers retire their benefits will be paid only if even higher taxes can be collected from the next generation of workers. As we have seen these tax rates will be high and collecting them will impose a severe cost on the economies of all developed countries.

An alternative to a pay-as-you-go system is one under which workers put aside funds during their working years to pay their own benefits during their retirement years. Under a fully funded system, each generation pays its own way.

"A 17 percent flat-rate consumption tax would replace income taxes and fund contributions to personal retirement accounts designed to eventually replace pay-as-you go Social Security financing."

This proposal consists of four elements: (1) replace federal personal and corporate income taxes with a 17 percent flat-rate consumption tax, where the rate is measured on a tax-inclusive basis; (2) use 3 percentage points of the new tax to match contributions of 1 percent each by employees and their employers to create 5 percent personal retirement accounts designed to eventually replace the current pay-as-you-go Social Security system; (3) rebate the 17 percent consumption tax conditionally to the bottom one-third of the income distribution to those with health insurance and retirement accounts, pensions or Individual Development Accounts; and (4) apply the Social Security (FICA) payroll tax to all wage income.

Social Security Reform. In structuring a privatization proposal, we examined the plan of Saving and Rettenmaier,39 who propose 5 percent individual retirement accounts funded by 1 percent payroll contributions from employees, matched by a 1 percent contribution from employers and 3 percent from the government. The government’s contribution could consist of a diversion of payroll taxes or payments from general revenue. In either case, the transition is made possible in our proposal by the new consumption tax.

In the Saving/Rettenmaier proposal, the option to establish a personal retirement account (PRA) is voluntary and lower-income workers get larger government matches in order to replicate the progressivity of the current system. As the PRA balances grow over time, government-paid benefits are reduced. Over the course of one’s work life, a 5 percent account should be sufficient to replace currently scheduled Social Security benefits for an average-income worker.

In this analysis we assume that all workers participate in the private system and all retirees remain in the current system. We also assume that all workers contribute the same percent of wages (5 percent) regardless of income.

Economic Effects of the Reform. As with the preceding analysis, the move to a consumption tax and its more favorable treatment of capital leads to higher real wages for workers. In some ways, however, Social Security reform is even more important than tax reform because it allows us to avert major hikes in payroll taxes over time. Overall:

  • Under current policy, taxes as a percent of national income will rise from 36 percent today to 46 percent by 2030 and 50 percent by the end of the century in the absence of any reform.
  • With the package of reforms proposed here, however, taxes peak at 42 percent of national income to 2030 and fall to 33 percent by the end of the century.

"With these reforms, the Social Security payroll tax rate could be cut in half by 2050."

In the simulation shown in Table A-V in the appendix, the flat consumption tax rate itself begins at 17.4 percent, rises to 18.1 percent by 2030 and recedes to 15.7 percent by the end of the century. By far the biggest component of the favorable shift in the tax burden is the avoidance of high payroll taxes needed to pay Social Security benefits:

  • In the absence of reform, the required payroll tax for Social Security will almost double by 2030 and rise to 31 percent of payroll by the end of the century.
  • By contrast, with Social Security reform the needed payroll tax will be one-half its current level by 2050 and one-third of its current level by the end of the century.40
Table VI - Change in Living Standards under Social Security Reform and a Consumption Tax

Lower taxes mean more disposal income, which, in turn, leads to more saving and more capital. Moreover, the expansion of capital leads to higher real wages.

  • Without reform, real wages at mid-century will be 10 percent lower than otherwise because of elderly entitlements.
  • With the set of reforms proposed here, real wages will be 4 percent higher than otherwise by mid-century and 10 percent higher by the end of the century.
  • Without reform, average take home pay for workers will be 26 percent lower by 2050 and 31 percent lower by the end of the century because of elderly entitlements.
  • With the set of reforms proposed here, pretax wages are 21 percent higher at the end of the century than would otherwise be the case and the effective average tax on wages falls from roughly 60 percent to roughly 37 percent.

"With these reforms, living standars."

Distributional Effects of Reform. As noted, this package of reforms benefits low-income families the most, at every age level. It also creates very large and very progressive benefits for future generations. As Table VI shows:

  • For individuals born in 1980 and newly entering the labor market today, families in the bottom third of the income distribution can expect a 13 percent increase in their lifetime standard of living, compared to a less than 1 percent for those in the middle and a less than 2 percent for those at the top.
  • For those to be born in 2030, the gains (relative to what otherwise would have happened) are 54 percent for the bottom third, 27 percent for those in the middle and 11 percent for those at the top.

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