Among the issues discussed are the problems of the current system; proposals for the reform; and the impact of reform on the poor, women, and minorities.
SOCIAL SECURITY and Its Discontents
Perspectives on CHOICECATO INSTITUTE
Copyright © 2004 Cato Institute
All right reserved.ISBN: 978-1-930865-55-6Contents
Acknowledgments........................................................................................................................................viiIntroduction Michael Tanner...........................................................................................................................1Part I: The Crisis1. Reengineering Social Security for the 21st Century Thomas F. Siems................................................................................132. The Trust Fund, the Surplus, and the Real Social Security Problem June O'Neill....................................................................373. "Saving" Social Security Is Not Enough Michael Tanner.............................................................................................534. Property Rights: The Hidden Issue of Social Security Reform Charles E. Rounds Jr..................................................................695. Private Investment of Social Security: The $10 Trillion Opportunity Martin Feldstein..............................................................816. The Moral Case for a Market-Based Retirement System Daniel Shapiro................................................................................89Part II: Women, the Poor, and Minorities7. Social Security Choices for the 21st-Century Woman Leanne Abdnor..................................................................................1118. The Impact of Social Security Reform on Low-Income Workers Jagadeesh Gokhale......................................................................1339. Disparate Impact: Social Security and African Americans Michael Tanner............................................................................147Part III: Solving the Problem10. No Second Best: The Unappetizing Alternatives to Individual Accounts Michael Tanner...............................................................16511. Empowering Workers: The Privatization of Social Security in Chile Jos Piera.....................................................................18912. Perspectives on the President's Commission to Strengthen Social Security Andrew G. Biggs..........................................................20113. The 6.2 Percent Solution: A Plan for Reforming Social Security Michael Tanner.....................................................................281Part IV: The Tough Questions14. Speaking the Truth about Social Security Reform Milton Friedman...................................................................................30915. Administration Costs and the Relative Efficiency of Public and Private Social Security Systems Robert Genetski....................................31316. Personal Accounts in a Down Market: How Recent Stock Market Declines Affect the Social Security Reform Debate Andrew G. Biggs.....................333Part V: The Public17. Public Opinion and Private Accounts: Measuring Risk and Confidence in Rethinking Social Security John Zogby.......................................357Contributors...........................................................................................................................................371Index..................................................................................................................................................373
Chapter One
Reengineering Social Security for the 21st Century Thomas F. Siems
One of our nation's most challenging public policy debates concerns Social Security reform. The program is in crisis and in need of reform as a result of maturation of the current pay-as-you-go (PAYGO) Social Security system coupled with an aging American population.
People who have participated in Social Security since its inception have received much higher average annual real rates of return on their contributions than have later participants. This is due, in part, to the basic design of the PAYGO program under which earlier participants received windfall gains as the necessary result of moving from the start-up phase to a mature phase, while later participants receive below-market returns. In contrast, real financial market returns increased over this time frame, widening the gap between market returns and Social Security returns.
With demographic changes, including the retirement of the baby-boom generation and increased life expectancy, looming on the horizon, action must soon be taken to ensure Social Security's future. Social Security gradually expanded from its inception through the early 1980s by increasing benefits and coverage for various groups. To pay for those modifications, payroll tax rates and the maximum earnings ceiling have been steadily raised. Now the Social Security trust funds are in long-term financial imbalance, and benefit cuts and more payroll tax rate increases seem inevitable if Americans are to retain the important social protections that Social Security currently offers.
Now is the time to consider more dramatic changes, including various proposals that allow for prefunding through individual accounts. Several researchers have put forth proposals that aim to (1) give individuals greater choice among retirement options, (2) provide greater incentives for Americans to work and to save to bolster their economic security, (3) restore Social Security's solvency, and (4) preserve at least some of the current program's social protections. Although there will certainly be some transition costs in moving to a new system, continued delays in addressing Social Security's long-run financing needs will more than likely require even greater and costlier changes in the future.
The Rise of Social Security: Demographic Uncertainties
Like many industrialized countries, the United States has instituted programs to help individuals face the uncertainties brought on by disability and old age. The structure of these programs was initially shaped by important social, economic, and demographic changes that rendered traditional systems of economic security increasingly unworkable. To fully understand the reasons why the programs were structured as they were, let's review the circumstances and changes that led to their adoption.
The social insurance program in the United States, known as Social Security, was signed into law by President Franklin D. Roosevelt on August 14, 1935, and was designed primarily to pay eligible individuals aged 65 or older a continuing income after retirement. Three important social, demographic, and economic changes provided impetus for this legislation: (1) the Industrial Revolution, (2) increased life expectancies, and (3) the Great Depression.
As the American economy shifted from an agricultural to an industrial base during the last two decades of the 1800s and the early 1900s, the Industrial Revolution transformed the way people worked, where they worked, and with whom they worked. In the agricultural economy, most individuals were self-employed. People willing to work could generally provide at least a bare subsistence for themselves and their families. But, in the industrial economy, many individuals became wage earners who worked for industrial corporations. As a result of that transformation, factors outside individuals' control (e.g., recessions, business closures, and layoffs) threatened their economic security to a greater extent than before.
The Industrial Revolution also moved families from farms and small rural communities to cities that had industrial jobs. In 1890, 28 percent of the American population lived in cities; by 1930 that percentage had doubled to 56 percent. That movement of labor and the resulting trend toward urbanization also contributed to another significant demographic shift: the breakup of the extended family and the rise of the nuclear family.
In the agricultural economy, the extended family was available to provide support and assistance when needed. In the industrial economy, extended families became splintered as some family members moved to the cities and others stayed behind. As a result, individuals in need of assistance found it increasingly difficult to find support when their economic security was threatened.
Increased life expectancy also helped bring passage of the Social Security Act. Thanks to improved health care programs and facilities, from 1900 to 1930 Americans increased their average life span by 10 years, and the number of elderly Americans increased dramatically.
Furthermore, in the early 1930s America was in the midst of the worst economic crisis in its history. As the Great Depression unfolded, millions of people were unemployed, numerous banks and businesses failed, and billions of dollars of wealth were lost as domestic stock markets plunged. For millions of Americans, economic security vanished.
As a result of those social, economic, and demographic changes, political pressure grew for greater government involvement to restore confidence and provide for the economic security of citizens. To address those concerns, President Roosevelt conceived a social insurance program. Philosophically, social insurance relies on government institutions to provide citizens with economic security. Social insurance began in Europe in the 19th century, and several European and Latin American nations already had some form of social insurance by the time it was adopted in America. While the details of social insurance programs can vary considerably, they generally combine an insurance element and a social element. That is, they provide insurance against some defined risk in a manner shaped by broader social objectives, rather than by the participants' self-interests.
The major provisions of the original Social Security Act of 1935 included old-age assistance, unemployment insurance, aid to dependent children, and grants to the states to provide various forms of medical care (Table 1). Title II, Federal Old-Age Benefits, was the social insurance program most people think of as Social Security today. It sought to provide economic security for the elderly by requiring workers to contribute to their own future retirement benefits through taxes paid into a trust fund. As originally conceived, Title II differed from Title I (Grants to States for Old-Age Assistance) in that it was not meant to provide welfare benefits. Title I was a temporary relief program that would no longer be needed as more people obtained retirement income through the contributory system. Under the 1935 legislation, Title II benefits were to be paid only to the primary worker when he or she retired at age 65 and were to be based on lifetime payroll tax contributions. Taxes were to be collected first in 1937, with monthly benefits payable beginning in 1942. The delayed payment established a minimum participation period to qualify for benefits and allowed the trust fund to be built up.
Over time, a number of amendments have been made to the original Social Security Act. In 1939 benefit amounts were increased and the start date for the payment of monthly benefits was accelerated by two years, to 1940. As explained later, the 1939 legislation effectively transformed the system into a PAYGO program. Two new categories of benefits were also established: dependent benefits (for spouses and minor children of retired workers) and survivors' benefits (for survivors of covered workers who died prematurely).
By 1950 there were more welfare beneficiaries receiving greater average benefit checks under Title I of the act than there were Social Security retirees (Title II beneficiaries). To remedy that, amendments to the act were passed in 1950 to substantially increase benefits for existing and future Title II beneficiaries. In the mid-1950s amendments to the act initiated a disability insurance program to provide citizens with additional economic security. Amendments in the early 1960s lowered the eligibility age for old-age insurance to 62. In 1965 a new program-known as Medicare-was established to extend health coverage to most Americans aged 65 and older.
In the 1970s another new program, Supplemental Security Income, essentially replaced the already-established assistance programs for the aged, blind, and disabled. Automatic cost-of-living adjustments linked to the consumer price index were also provided under the 1972 amendments.
The 1983 amendments, based on recommendations made by a bipartisan commission chaired by Alan Greenspan, instituted the partial taxation of Social Security benefits for middle- and upper-income earners, made coverage compulsory for new federal civilian employees and employees of nonprofit enterprises, and provided for a gradual increase in the retirement age to 67. In 1993 new legislation increased the taxation of benefits at higher income levels.
Those amendments have made Social Security the largest and most comprehensive public program in the United States. Social Security is part of nearly every American's life and an important source of income for most of today's older Americans. Social Security provides more than half of the total income of two-thirds of today's retirees. Social Security provides nearly all of the income of one-third of the elderly. The Social Security Administration estimates that, without Social Security benefits, 48 percent of individuals aged 65 and older would live in poverty, nearly five times as many as are in poverty today.
The Fall of Social Security: Demographic Realities
For the most part, the mandatory contributions that are paid into Social Security are paid out immediately in benefits to retirees, disabled Americans, and their dependents and survivors. That is, Social Security is not a funded plan under which contributions are accumulated and invested in financial assets and liquidated and converted into a pension at retirement. Rather, Social Security is essentially a PAYGO program, in which most Social Security taxes are used to immediately pay benefits for current retirees. However, since the 1983 reforms, contributions paid in have exceeded payments to retirees and have generated a relatively modest surplus, which is invested in government bonds. This partial advance funding has resulted in some accumulation of reserves, representing over 28 months of benefit payments, in the Social Security trust funds.
As an unfunded program, Social Security gives windfall returns to the first generations of participants, because they paid in little relative to the benefits they receive, and gives below-market returns to later generations. Paul Samuelson of the Massachusetts Institute of Technology found that an unfunded system with a constant tax rate provides a positive rate of return that, in equilibrium, is equal to the rate of growth of the payroll tax base. As shown below, in a dynamically efficient economy, this rate of return is lower than the return on capital investment. Now that the nation's Social Security system has matured (the tax rate has stabilized), it is inevitable that subsequent generations (including today's workers) will receive below-market rates of return on their contributions.
Even if there are many workers providing benefits for relatively few retirees and wage growth is strong, the PAYGO plan benefits the earliest generations at the expense of later generations. Consider a simple overlapping-generations model in which people are born in every time period, live for two periods (one as younger workers and the other as older retirees), and then die. As time passes, older generations are replaced by younger generations. In each period, two generations overlap, with younger workers coexisting with older retirees.
A funded system is portrayed in Table 2 and a PAYGO Social Security system in Table 3. The columns represent successive periods (moving to the right) as time passes, and the rows represent successive generations (moving down). Each generation is labeled by the period of its birth, so that generation 1 is born in period 1 and so on. In each period there are two overlapping generations: the presently working generation and the previously working, but now retired, generation.
In the funded system (Table 2), each working generation contributes to an investment fund that accumulates as time passes. The proceeds from the fund, including interest earnings, are then used to pay that generation's benefits when it retires in the subsequent period. As shown, under a funded system, each generation contributes to its own retirement. For generation 0 (the currently retired population), nothing has been accumulated so that generation must rely on private savings and pensions.
In contrast, the PAYGO Social Security system provides a startup bonus to generation 0 retirees by using the contributions of generation 1 workers to pay benefits to those already retired (Table 3). This is an unfunded program because contributions never accumulate in a trust fund but are immediately paid out. Contributions from each working generation are used to finance benefits for the older generation in the same period. Notice that the two programs differ in the number of periods in which benefits are paid. While both programs show four periods of contributions, the funded program provides three periods of benefits whereas the PAYGO plan provides four. This highlights the greatest differences between the two programs: the funded program has an accumulated fund and the PAYGO plan does not, and the PAYGO program has a start-up bonus and the funded system does not. It is interesting to note that the temptation of the start-up bonus is what led to the 1939 amendments that created today's PAYGO system.
This simple analysis demonstrates three important facts:
First, the PAYGO program provides initial (generation 0) retirees a windfall equal to the benefits provided by generation 1 workers because generation 0 never paid taxes into the system.
Second, subsequent generations earn a return from the PAYGO plan equal to the growth rate of aggregate wages.
Third, generations 1 onward suffer combined losses exactly equal to the start-up bonus paid to generation 0 retirees.
In sum, below-market returns from a mature PAYGO scheme are inevitable as each generation is effectively forced to service the implicit "debt" issued to finance the windfall for earlier generations.
The effects of the maturation of the PAYGO plan are further exacerbated by the declining ratio of workers to beneficiaries due to demographic changes, which reduces the growth rate of the payroll tax base. In 1945, a decade after Social Security was established, the ratio of workers to beneficiaries was 41.9 to 1.8 By 1950 that ratio had fallen to 16.5 to 1. And, as shown in Figure 1, the ratio of workers to beneficiaries has continued to decline, dropping to 5.1 to 1 by 1960 and to 3.2 to 1 by 1975.
Although this ratio has held fairly steady since the mid-1970s and currently stands at around 3.4 workers per beneficiary, the Social Security trustees project that it will steadily decline as the babyboom generation retires and Americans live longer. In 30 years the ratio of workers to beneficiaries is expected to be approximately 2 to 1 and still falling.
The baby-boom generation consists of individuals born between 1946 and 1964, a period during which the return of World War II soldiers and postwar prosperity prompted many families to add dependents. By itself this would not be a problem, but the baby boom was followed by a baby bust with markedly lower birth rates. The inevitable result is that fewer workers will be available to support a growing number of retirees. Aggravating this imbalance is a gradual increase in average life expectancy in the United States, even as the age for full Social Security benefits has remained unchanged from the program's inception until this year.
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