Social Security: unless shit changes, we are fucked.

By Joe Viseur

                The phrase “Social Security” has long become a phrase that does not make you feel “secure” in any sense at all. As a 25 trillion dollar liability looms over the United States and its citizens, the phrase “Social Security” sends shivers down the spines of economists, politicians, young workers and retirees alike. According to the Social Security Administration, the Social Security Program will begin to run deficits into its “trust fund” by 2018 and, by 2042, the Social Security Trust Fund will be exhausted, necessarily reducing benefits by 27 percent if policy does not change{Tanner, Michael 2004; 53}. What are we to do? According to Friedman (and his colleagues at the Cato Institute), the way to fix this problem is to put control back into the hands of the citizens and privatize the Social Security Program. In this paper, I will first explore the fundamental problems of Social Security’s funding, and how much would need to change if the current system is to be maintained. Friedman’s proposal for reform will then be presented and will be analyzed as a solution. Following this, a more politically viable solution from the Cato Institute will be compared to Friedman’s proposal. It is important to note, however, that both solutions hinge on the privatization of Social Security, at varying degrees. In both situations, the privatization of the Social Security system will not only help partly release the government of a $25 trillion dollar liability, it also assures us that individuals will have more control over their future, taxes will stay low, and all retirees, rich or poor, will have a greater return on investment (exactly what Dr. Friedman realized in the 1970’s). Milton Friedman reminds us that “Our general assumption is that individuals can best judge for themselves how to use their resources.{Friedman, Milton 1999; 312}.” We should be free to choose how we prepare for our future.

                Social Security was enacted by President Franklin Delanor Roosevelt on August 14th, 1935, as part of the new deal. It was created to combat the challenges of increased life expectancy, the Industrial Revolution, and the Great Depression. Payroll taxes, taken from every worker, were designated to be put into a “trust fund,” were to be given some time to accrue an ample amount of funds, and then redistributed to the elderly. The act was amended in 1939 to increase benefits, accelerate payment to 1940, and add dependent benefits and survivors’ insurance {Siems, Thomas F. 2001; 17}. This amendment created a monster of a problem for Social Security. Instead of letting a large amount of wealth accumulate from the payroll taxes before the program started, the program became a pay-as-you-go program, which will be from here on out referred to as a PAYGO program. In a PAYGO program, the payroll taxes  on the working stay in the “trust fund” for (on average) less than a year before they are redistributed as Social Security benefits. The “Trust Fund” merely acts as an accounting sheet that records inputs and outputs, with only a small accumulation of interest. It is a fact that 90 percent of all payroll tax receipts are paid out in the same year {Feldstein, Martin 1997; 82}. The contributions to Social Security “do not provide the government as a whole with additional resources.” Thus, the trust fund “does not build real assets {Siems, Thomas F. 2001; 21}.” Now, in 1945, this was not a problem. 49.1 workers were supporting only one retiree, so the PAYGO program could sustain itself. But in 2001, that ratio decreased to about 3.4 to 1, and that ratio is expected to be less than two to one as the baby boomers begin to retire. To add on to this, increased spending on government programs and the War on Terror in recent time has made any near term surplus contribution to the “trust fund” to replace depleted “assets” almost an impossibility {Siems, Thomas F. 2001; 22}. Without an increase in taxes, decrease in benefits, or increase in government return on investment, the government will have a funding crisis on its hands. The Social Security Administration estimates that without Social Security benefits,“ 48 percent of individuals 65 and older would live in poverty.”  If policy does not change, 2018 will be the first year that the Social Security program will have expenditures greater than revenues, and by 2042, any reserves the “trust fund” accumulated in surplus years will be exhausted {Siems, Thomas F. 2001; 22}.  When that fund is exhausted, Social Security, if left unchanged, will become a direct transfer payment to retirees, with a 27 percent reduction in payments to those retirees. That 27 percent reduction could put thousands of elderly people into poverty, further putting a burden on the families that care for them.

 How do we fix this problem if we do not want to change the original system of Social Security? According to Henry Aaron of the Brookings Institution, who is vehemently opposed to privatization, “increased funding to raise pension reserves is possible only with some combination of additional tax revenues, reduced benefits, or increased investment returns from investing in higher yielding assets (testimony before the Senate committee on Finance, 106th Cong. 1st Sess., January 19th, 1999).” These are the only ways to fix Social Security if the system stays the same. There is no other way.

Increased taxes can help boost the reserves of the Social Security system. The most direct way to do this is to increase payroll taxes.  The current tax rate for Social Security is 12.4 percent. Dr. Robert M. Ball writing for the Century Foundation proposed that the payroll tax be increased by three more percentage points, coupled with cutting benefits. His call to “moderately” increase payroll taxes would be “not too terribly painful {{Aaron, Henry J. 1998; 137}and {Turner, Michael 2002; 168}}.” The National Academy on the Aging Society says that taxes should be above twenty percent, going against the opinion of most economists (Turner, Michael 2002; 167}. Would these tax increases save Social Security? It might, but it could make us worse off in the future, and even today. Gary and Aldona Robbins, two prominent economists from the Institute for Research on the Economics of Taxation, noted in a 1998 study that payroll tax hikes between 1979 and 1982 “resulted in the permanent loss of 500,000 jobs.” They also estimated that the 1988 and 1990 payroll tax hikes permanently lost “510,000 jobs and [caused] a reduction in the US gross domestic product of 30 billion dollars per year {Turner, Michael 2002; 169}.” the Congressional Budget Office estimates that, with a 3 percent increase in the payroll tax, the “marginal after tax consumption would go down by ten percent.” This equals a “three percent contraction in labor supply. This, in turn, would lead to an unspecified, but significant, decline in U.S. GDP {Turner, Michael 2002; 169}.” This is a substitution effect.  How willing are we to increase taxes? The negative effects of a payroll tax increase are evident. Are we solving the problem of Social Security by increasing taxes? Quite simply, no. Payroll tax increases have happened in the past and they have not changed the nature of the PAYGO program. We would simply be dodging another bullet with another tax increase, and we would only be hurting ourselves more in the process. Increasing taxes “does not change the solvency of the program {Turner, Michael 2002; 172}.” The diversion of other taxes, like a sales tax, towards the Social Security trust fund would have a similar effect. We cannot continue to increase taxes if the program keeps expecting more and more retirees and benefits.

                Another way to improve Social Security’s longevity is to cut benefits. Robert Ball of the Century Foundation, Henry Aaron of the Brookings Institution, and many others support benefit cuts. Ball proposes that increase in benefits for retirees should be slowed to “about three percent {Turner, Michael 2002; 176}.” He would do this by lengthening the benefit computation period from 35 years to 38 years. This possibly means more years of low wages or no wages would be included “when determining the average wage on which to base benefits {Turner, Michael 2002; 177}.” So retirees would receive less. There have not been many proposals, however, to cut benefits from the current program. The organizations representing retirees would simply not allow it. Any program suggesting a cut in benefits is likely to be questioned and shot down, mainly because politicians have to represent their constituency. You take away “grandma’s check,” you get voted out of office. While the idea of reducing the amount of benefits paid out is a good way to cut back on the programs spending, it does not have much political feasibility because retirees feel that they have a right to always receive Social Security benefits.

The only other way to save the current Social Security system is to find a way to achieve a higher rate of return  on monies put into the system. “In practice, this is investing Social Security Funds in private capital assets {Turner, Michael 2002; 178}.” Aaron and  Ball, along with Paul Krugman of the New York Times, believe this is the way to permanently escape the insolvency of the PAYGO program as it functions today. By getting a better return on government investment, more funds can be deposited into the Social Security trust fund more frequently, with less increases in taxes and less benefits cut. This is true. On the average the market gives a pre-tax return of 9.3 percent annually {Feldstein, Martin, 1997; 84}. Government investment in private market capital would allow for faster accumulation of funds and for benefits to continue to be increased at their current rate. The problem here, though, is that government would have a huge influence on the private market. Allowing the government to purchase stocks would give it the ability to obtain a significant, if not controlling, interest in virtually every major company in the United States. Would the government be regulated with their investments? How much influence would they have? Would a government bureaucrat have the ability to sit on a company’s board? These would be questions the people and corporations would have to ask. While  there are many benefits to government investment, the costs of their influence greatly outweigh the benefits. The government’s investment in private corporate capital would put political considerations into the investment decision process, and would limit certain risks that could be taken by a firm if the government has an investment in them. It would be a move towards the socialization of our market-based economy. Alan Greenspan commented on the danger of this government investment in the private sector, stating

“ I don’t know of any way that you can essentially insulate government decision-makers from having access to what will amount to very large investments in American private industry… I have been around long enough to realize that that is just not credible and not possible. Somewhere along the line, the breach will be broken (testimony before the Senate committee on Banking, July 21, 1998).”

                An increase in taxes would extend the longevity of the Social security program, but would permanently eliminate jobs and lower our consumption. A cut in benefits is not politically feasible and would make our retirees worse off. And an increase in government investing would allow political influences to affect investment decisions, and would be a move towards the socialization of our free market system. So how are we going to fix Social Security? According to Milton Friedman and the Cato institute, the answer is simple. Privatization of Social Security will not only save Social Security and our government; privatization will also make current and future retirees much better off.

`               Milton Friedman states in his 1979 book Free to Choose that “moral responsibility is an individual matter, not a social matter.” Social Security is a program that epitomizes the antithesis of this statement. It is an impersonal, inefficient way of solving the problem of old-age poverty. His proposal, through brash and unequivocally controversial even today, provides a simple and beautiful solution to the problem of Social Security. Friedman states that “ Too many vested interests…stand in the way,” of this program’s success. But he outlines the program nonetheless to “provide a vision of the direction in which we should be moving, a vision that can guide incremental changes{Friedman, Milton, 1979; 120}.”

                Friedman’s proposal has two components: first, all the specific programs of welfare (including Medicare, Medicaid, and housing subsidies, in addition to Social Security) will be replaced with “a single comprehensive program of income supplements in cash- a negative income tax linked to the positive income tax{Friedman, Milton 1979; 120}.” Second, present commitments to Social Security will be met while the government requires (in essence, forces) people to “make arrangements for their own retirement.” Under our current system, our positive income tax is based on a few variables. You are permitted to earn a certain amount of income without paying any tax. The exact amount of this non-taxable income “depends on your family, your age, and whether or not you itemize your deductions {Friedman, Milton 1979; 120}.”  If your income exceeds your deductions, you pay no tax. But this is based on an annual basis. Suppose your income in one year is greater than your deductions, but the next year it isn’t. You would pay taxes in the year your annual income was above your allowance, and you would receive no assistance (holding all benefits at zero.) You end up paying more tax for the two years together than if the income had been split evenly. The negative income tax avoids this inefficiency altogether. “When your income was above allowances, you pay tax, the amount depending on the tax rates… When your income was below allowances, you receive a subsidy, the amount depending on the subsidy rates {Friedman, Milton; 121}.” The negative income tax assures that every taxpayer receives a minimum amount of income, but avoids the mess of a huge bureaucracy, encourages individual responsibility, and most importantly, removes distortions on labor supply with transfer payments and retains “an incentive to work and earn enough to pay taxes instead of receiving a subsidy. {Friedman, Milton, 1979; 121}.” Friedman uses the example of a family of four who lives in a world with a negative income tax and a subsidy rate of 50 percent. The break-even point for taxes and subsidies is 7,200 dollars (that is, no taxes are imposed and no subsidies are given out at this level of income). If this family had zero income, they receive 3,600 dollars. If their income was 1,000 dollars, their subsidy would be 3,100 dollars, bringing their total income up to 4,100 dollars. So for a retiree, they always receive a minimum amount, relative to their individual break-even point. Friedman argues that this system is best because it gives the most useful tool in combating poverty: cash. It is non-discriminatory, and eliminates the huge administration costs that are created by maintaining a ridiculously large and inefficient bureaucracy. It would allow people to run their own lives, instead of being dictated by a bureaucracy how to run their lives, or when and how much to work. And in this system, Friedman believes private charity will flourish due to the fact that it is not crowded out by the current welfare system. {Friedman, Milton 1979; 123}. Social Security would be directly affected, of course. The payroll tax would be repealed when the negative income tax is enacted. Friedman states that those who are living in the current Social Security system would given the amounts they are entitled to under current law. Workers who have earned coverage in the Social Security system could have two choices. He or she could choose to take those benefits as “a future annuity,” or that person could receive “government bonds equal to the present value of the benefits to which he would be entitled {Friedman, Milton; 123}. If a worker has not earned coverage in the current system yet, they could receive a capital sum, or more commonly known as a refund. The accumulation of funds in the “trust fund” would end. The payments out to the afore-mentioned constituencies would be funded out of the general tax fund and the sale of government bonds. While the cost to fund this transition in the short run would be significant, it is important to note that the actual debt of the country would remain unchanged. The debt is reduced by “ending promises to future beneficiaries {Freidman, Milton; 123}.” The creation of such a system would add to personal saving, thus leading to a “higher rate of capital formation and a more rapid rate of growth of income[Friedman, Milton; 124}.”   

                Freidman recognizes that the program faces huge obstacles regarding reform. The retirees and the bureaucracy stand firmly against it, and with good reason. In different states and situations, many people would receive more benefits using the current system than when on the new system. And of course, the creation of such a tax would put the bureaucracy out of a job. Friedman lets his hope for success shine through when he says that what might not be politically feasible today “may…become politically feasible,” tomorrow {Friedman, Milton, 1979; 126}. While Friedman’s specific reform is not occurring today, the call for reform is building quite a lot of momentum. The Cato Institute, a think tank of which Dr. Friedman was a member, has not only published numerous papers researching the current need for change in the system, they have also presented a proposal for reform that is intriguing. While achieving privatization through very different means, the spirit of the Cato institute’s proposal catch the spark of Milton Friedman’s desire for individual control regarding one’s future and retirement.

                The Cato institute was founded in1977 as a non-profit public policy research foundation. The organization derives its name from the Cato letters, a series of libertarian pamphlets that helped found the ideas for the Revolution in 1776. It is a Libertarian think tank-that is concerned with, according to their website, “individual liberty, limited government, free markets, and peace.” Cato has been specifically concerned with the growing problems of Social Security since the creation of the organization. They believe that the system is inherently flawed and the PAYGO structure has left future retirees with a depreciated and undesirable retirement situation. Cato also disagrees with Social Security on a philosophical level. They believe that mandated contribution to Social Security infringes on the individual freedom of the citizen and prevents them from doing what they think best with their assets. Cato recognizes the insolvency of the Social Security Program, but also realizes that a complete elimination of the program would not be politically feasible. After three decades of research on the topic of Social Security, much of it being in the last decade and with contributors such as Martin Feldstein and Milton Friedman himself, Cato has proposed a reform plan for Social Security. While different from Friedman’s proposal, privatization is still the cornerstone of this solution and individual control is still a main priority. The presentation of this proposal will allow comparisons between the two plans to be made, and those comparisons will help highlight the practical feasibility present in both solutions in distinct ways.

                Michael Tanner, Editor of the collection of essays Social Security and its Discontents, presents Cato’s solution to the Social Security crisis. The plan is to give each worker a choice. Either stay on the current system, or go along with Cato’s solution. Cato’s solution is this: use the current payroll tax of 12.4 percent and reallocate 6.2 percent into voluntary personal accounts. If you choose the Cato option, you choose to “forgo future accrual of Social Security retirement benefits {Tanner, Michael 2004; 281}.” The money invested in these personal accounts goes directly to the worker that deposited them. The other 6.2 percent is used to fund those still on the old system. Those who contributed to Social Security in the past will receive a bond for their past contributions. The bond does not necessarily have to equal that persons contribution, it can be less, “if set against future markets for appreciation {Tanner, Michael 2004; 290}.” Once the funds are deposited, they can be re-accessed using a W-2 form the next year. Once the funds are available for investment, the funds are invested in a portfolio that is 60 percent stocks, 40 percent bonds. Investors can choose the weight of the risk in 3 separate options. Once funds reach a “trigger level of funds,” the worker can choose from more options of investment, similar in options to a private 401k. These changes after the “trigger level of funds” are allocated at will and are optional. One does not need to further alter investment options if one so chooses. At retirement, the worker can choose between an annuity, a lump sum withdrawal plan, or a combination of the two . The funds will be managed by private firms. The initial management of funds before the “trigger level” will be determined by way of competitive competition with each individual worker. The worker designates who will be managing their funds. While the firms will be bound by the government to make certain investments at a lower risk level below the trigger level, the firms are not bound after the trigger level of funds has been reached. This maintains competition within the system between financial firms and keeps the market competitive and the consumer protected. In addition to this, once funds reach a point 120 percent above the poverty level (240 for families), participants can choose to opt out of the program and not pay the 6.2 percent tax. If a participant’s funds fall below the 120 percent poverty level, the government pays for their retirement of a means-tested program{Tanner, Michael 2004; 290-295}.  

                There are many benefits and advantages to the 6.2 percent solution that make it much more appealing than the current system. For one, it is almost guaranteed that these private, individual accounts will overtake Social Security’s rate of return, which holds at a weak two percent {Tanner, Michael, pg 267}. If the current system were to maintain the current return for future retirees, there would have to be a tax increase of 4,193 dollars per worker by 2078. Tanner states that “with a private system, required contributions are lower, would be seen as part of worker’s direct compensation, stimulating more employment and output {Tanner, Michael 2004; 284}.” As estimated by Feldstein, there is a net benefit of anywhere between 10-20 trillion dollars mostly from higher returns in private accounts.  But that benefit would also come from more employment and output. This system benefits the poor and minorities, who have a shorter life expectancy. With this solution, they can choose to have a lump sum payout and receive greater, more equal benefit during their lifetimes. With this increase in funds, the poor can escape the circle of poverty, and if some of the funds are left unspent, they can be bequeathed to future generations. The Cato It is a individual, private investment, with higher rates of return, that provides more benefits for retirees, helps the poor, and alleviates the governments 25 trillion dollar liability. It is important to note that the case of Flemming vs. Nestor in the Supreme Court established the precedent that individuals do not receive Social Security benefits as a right (Tanner, Michael; 287}. It is a tax, and can be removed from the budget at any time. With this privatized system, not only do you have more control over your retirement, you also have released yourself from the liability of the fallout of Social Security.

                One of the major criticisms of privatization is that the transition costs to establish such a program are huge. And this is true. The costs to completely change the face of Social Security, re train employees, etc. etc. are huge. Cato proposes that 8.3 billion dollar of Social Security funds that are sent off to Medicare should go back to Social Security, to fund the transition. The 87 billion in corporate welfare earmarks should also be returned into the transition budget. It is also important to note that “ a portion of the returns is actually taxed away through corporate taxes before returns are realized at the level of the individual investor{Tanner, Michael; 295}.” This should be allocated in the transition fund. With a 34.1 percent recapture rate on a corporate tax of 35 percent, this could be a significant source of funds to change the system. A one percent reduction in nondefense discretionary spending also yields 20 billion dollars. If the government can fund a war in Iraq with billions upon billions of dollars, they can fund the temporary cost of transition. This should not be a limit on the process of reform. While the transition will take years, future liabilities will decrease, leaving the United States government better off.

                The comparisons between these two plans reveal striking differences in application of a similar philosophy. Friedman’s approach is somewhat theoretical in nature and throws most of the established doctrine and precedent of Social Security and welfare programs out the window, while the Cato Institute’s proposal works within the situation of Social Security and presents a solution that would not replace all programs, but would make individual accounts the new face of Social Security. Which one do we choose? It is hard to say. Friedman’s proposal would eliminate whole governmental organizations, inefficiencies, and would allow for more equity between the rich and poor through an non-discriminatory system. It allows for greater freedom of choice, as the Friedman proposal allows for 100 percent discretion in preparing for the future. There is no one stopping you from doing what you want with your money, and as Friedman said, the individual knows what is best. The poor also have a minimum income amount, which allows for funds to always be present for necessities. The Cato plan has benefits too, though. Their plan allows for a controlled investment in private capital, which has a rate of return that is much higher than Social Securities. The individual owns the account, as well. While more limited than the Friedman plan, the Cato plan is much more viable politically because it does not technically eliminate Social Security. Both plans invite freedom of choice. Both allow for the individual to control their future. So which do we choose? By political default, the choice has to lie with Cato’s proposal. Negative income tax returns have been proposed by “Nixon, Ford, and Carter” before and they failed miserably{Friedman, Milton 1979; 124}. The public is not ready to eliminate the (no pun intended) security of the familiar. Friedman recognized this when he proposed his plan for reform. It is still true today. One thing is clear, however. Social Security cannot maintain the status quo. If it does, tax increases and increased government control on the individual will further deteriorate the future of every American who plans on retiring, and that is just about everyone. Privatization allows for a greater return at much less a cost to the government, and Cato has created a proposal that gives the worker individual control, higher return, and a fail-safe, just in case. Cato’s plan still hinges on privatization though, and this follows the Libertarian ideal of choice. Milton Friedman wouldn’t oppose a reform from Cato that hinged on that idea at all.