Patchwork reform comes in many guises, but the underlying strategy of all is the same: cut benefits and/or raise taxes. Since overt benefits cuts are unpopular, reformers usually talk about indirect ways of achieving the same result. And since taxpayers are sure to resist tax hikes, reformers usually search for some way to increase the tax base or to include new taxpayers. However, almost every important reform idea has severe drawbacks.  

Raising the Retirement Age. The official retirement age of 65 is already scheduled to rise gradually to 67 for people reaching retirement in the next century, thanks to Federal Reserve Chairman Alan Greenspan, who chaired the commission that brought about the reform in 1983.³⁴ Some people want to go further - to increase the retirement age to 70, do the same for Medicare and index the eligibility age to rise with increases in life expectancy.  

Yet this apparently innocuous reform faces two big problems. First, it is in direct conflict with people's preferences. The trend over the past 50 years has been toward earlier rather than later retirement, and that is unlikely to change.³⁵ Second, raising the retirement age has an adverse impact on minorities. As noted above, blacks have shorter life expectancies than whites. So do Hispanics. The two-year increase in the retirement age already scheduled will first affect people born in 1960. Among this group, the scheduled increase will take away only about a fifth of each expected Social Security benefit check for white males but will extinguish about two-thirds of benefits for black males. Raising the retirement age to 70 would exacerbate the inequity for minorities.  

Means Testing Benefits. At last count, more than 800,000 millionaires were collecting Social Security benefits. Is this fair? Why should Ross Perot receive government checks funded by day laborers? Why not cut off benefits for those well-off retirees who do not need a government pension? One problem is fairness. After all, Ross Perot has paid taxes just like everybody else. A bigger problem is that Social Security checks going to very rich retirees are a mere drop in the bucket. To make a serious dent in the flow of benefits, you would have to touch retirees who are solidly middle class. For example, government currently taxes 85 percent of Social Security benefits for higher-income retirees. But it defines "higher income" as single retirees with incomes above $25,000 and couples above $44,000. Even this tax on the middle-income elderly raises less than $6 billion a year, while Social Security and Medicare spending total $524 billion.³⁶  

Inflation Indexing. Social Security benefits are currently indexed to increase over time with the rate of inflation. Most economists believe the mechanism is too generous. Even so, small changes in the cost-of-living adjustment (COLA) will produce only small improvements in the long-term financial crisis. Major change, such as abolishing COLAs altogether, would significantly reduce government outlays. But with each passing year, Social Security checks would buy fewer goods and services, leaving the elderly with a progressively lower standard of living. This method only works if we're willing to renege on promises made to people when they were planning for their retirement.  

Taxing Untaxed Wages. The FICA payroll tax reaches only about three-fourths of all wage income. Does it make sense to tax the other fourth? There are reasons not to. For example, much of this amount goes for employee fringe benefits - primarily health insurance and pensions. They are not taxed because government policy is designed to encourage private health insurance and private pensions. About half of untaxed wages consists of income above the $65,400 cap discussed above. Should we apply FICA taxes to all the income of wealthier taxpayers? The highest-income taxpayers already face a 40 percent marginal tax rate. Add FICA taxes and the marginal tax rate would exceed 50 percent. Experience teaches this would do more harm than good. In 1986 the top rate dropped from 50 percent to 28 percent and both the amount of taxes and share of total taxes paid by the highest-income earners rose! So reversing the process and raising the current rate above 50 percent is likely to produce less revenue, not more.³⁷  

Taxing Capital. About one-fifth of national income is capital income. Should recipients pay Social Security taxes on this income? Since a lot of capital income is received by higher-income taxpayers, this proposal runs into the previous objection: it would push marginal tax rates so high it would be self-defeating. There's also a more basic objection. Taxes on capital tend to shrink the supply of capital, which leads to lower wages. Therefore taxes on capital often turn out to be hidden taxes on labor.³⁸ 

  For every dollar of extra aftertax income to investors, $12 of additional aftertax income goes to wage earners - a relationship that has been fairly constant over time.  

• Thus more than 90 percent of any new taxes on capital will be paid by wage earners rather than recipients of capital income.

Some countries already have reformed their pay-as-you-go systems, pointing the way for others. Among the most notable alternatives to pay-as-you-go social security are the following:    

• Britain allows employers and workers to opt out of the state pension system's second tier by setting up private pension plans with benefits at least as generous as the government system. ⁴¹ 
• Australia requires workers to contribute to privately managed retirement savings accounts.⁴² 
• Chile requires workers to save for their own retirement by making regular deposits to private pension accounts, similar to American Individual Retirement Accounts (IRAs).⁴³

   
• The Chilean system has been copied to one degree or another in Argentina, Bolivia, Colombia, Costa Rica, Hong Kong, Mexico, Peru and Uruguay, and it will soon be implemented in Ecuador and El Salvador.⁴⁴ 
• Singapore requires employees and employers to contribute jointly to individual investment accounts, which may be used not only for retirement income but also to pay medical expenses or make the down payment on a home.⁴⁵ 

Private Alternatives in the U.S. We need not look overseas or to Latin America to find examples of private alternatives to Social Security. The initial Social Security Act permitted state and local governments to opt out of the system - a loophole Congress closed in 1983. But before the option was ended, employees of Galveston, Brazoria and Matagorda counties in Texas chose to leave Social Security for a private alternative that has more than 5,000 participants today.⁴⁶ In the private plan, contributions are similar to those for Social Security, but returns are quite different. A moderate-income employee in the private plan can expect a monthly pension of $2,740 compared to Social Security benefits that would have totaled about $775. A middle-income employee can expect to receive $6,843 from the private plan, compared to $1,302 from Social Security. [See Figure VIII.]   

Employees of the three counties continue to pay their Medicare payroll taxes and to receive Medicare benefits upon retirement. But they rely on private life and disability insurance. The private life insurance benefit is three times the employee's salary. Social Security, by contrast, pays a one-time death benefit of $255 to a surviving spouse. The private disability insurance pays 60 percent of an individual's salary and is relatively easy to qualify for. Social Security disability benefits, by contrast, can be very difficult to qualify for and are unavailable to people who have not worked a minimum amount of time.   

The experience of these Texas counties is not that unusual. An estimated 2 million government employees are in private systems outside Social Security because they work for state, county and local governments that opted out before 1983. A study by William Even (Miami University) and David Macpherson (Florida State University) looked at the experience of about 1 million of these employees and found them earning real rates of return between 1.6 and 3.0 percent, while their cohorts earn negative rates of return from Social Security.⁴⁷ In general, participants in private plans will retire on pensions that are from three to seven times larger than their Social Security benefits would have been.   

Advisory Council Proposals. ⁴⁸ A 13-member bipartisan Advisory Council on Social Security, appointed by the Clinton administration, recognized that the stock market historically has provided returns two or three times higher than those from government securities. However, the council couldn't agree on a single approach to Social Security reform, and last year instead proposed three different ones, none of which was supported by a majority of the council.   

One proposal would have the government invest 40 percent of the Social Security trust fund - an inflation-adjusted $800 billion - in the stock market over 15 years. Investments would be in a broad range of stocks much like stock-index funds, and the government would not vote its shares. But politicians would be tempted to try to influence investments that would control as much as 10 percent of the nation's equities. They would almost certainly try to use their control to encourage or discourage certain industries, achieve social goals, reward friends or punish enemies. Critics note that this is what has happened with similar plans in Sweden and Japan.   

The other two proposals envisioned individual investments in the equities markets. One would allow individuals to invest 5 percentage points of the 12.4 percent payroll tax in Personal Savings Accounts for retirement. The other would increase the Social Security payroll tax by 1.6 percentage points, allowing individuals to invest the amount of the increase in their personal retirement accounts.  

Choice. At least initially, people should have a choice between Social Security and a private plan.   

Tax differential. Those who opt out should pay lower taxes than those who stay in. This differential should be large enough to encourage most people to choose a private plan.   

Secure benefits for current retirees. The federal government should guarantee that those currently on Social Security receive their benefits.   

Transition would be easy if it were a matter of allowing employees and their employers to deposit their FICA payroll taxes in private accounts instead of sending them to Uncle Sam. But if no one paid the payroll tax, how would we fund current retirees' benefits? Clearly, government must borrow or raise other taxes or both. Critics argue that throughout the transition the current generation of workers will have to pay twice: once for current retirement benefits and again for their own future benefits. The critics overlook the huge economic boost from privatization, which will make the temporary double burden bearable.   

When people save money they otherwise would have consumed, the economy gains access to new capital. When all employees increase their savings, the amount of new capital will be huge. In Chile this large increase in private capital made possible the privatization of virtually the entire Chilean economy. Banks, factories, farms and other assets that had been nationalized by a socialist government were sold to the private sector, which used pension fund money to buy them. Similarly, the increase in capital generated by Singapore's provident fund system provides investment funds that sustain a high rate of economic growth.   

Economists Martin Feldstein and Andrew Samwick have calculated that the higher rate of return in a privatized U.S. system would in time permit retirees to maintain current levels of benefits by saving only 2 percent of their income.⁴⁹ Professor Feldstein estimates that the value of future pension benefits would rise by 60 percent, from $11.3 trillion to $18 trillion.⁵⁰ This real increase in the country's wealth amounts to more than $25,000 for every man, woman and child in the country - or more than $100,000 for a family of four.   

NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.  
 

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