The question of whether or not we should privatize America’s Social Security system is one that will be increasingly important as the baby-boomer generation reaches retirement age and the current system is unable to maintain benefits. To address this critical question, I will be discussing five papers: "An Overview of the U.S. Social Security System: Problems and Options," (1995) by Kevin Stephenson, David Horlacher and David Colander; "Public Pensions, Government Expenditures and Intergenerational Transfers," (1992) by Paul Johnson and Jane Falkingham; "Different Approaches for Dealing With Social Security," (1996) by Edward M. Gramlich; "The Missing Piece in Policy Analysis: Social Security Reform," (1996) by Martin Feldstein; and "Social Security Privatization: A Structure for Analysis," (1996) by Olivia S. Mitchell and Stephen P. Zeldes.
In the United States, retirement security is composed of employment-related pensions, private savings, and a social insurance system that is publicly financed. In 1935, the Social Security Act was enacted in America to protect its retired and elderly citizens. The act has been amended many times over, though its function remains the same; it is a public system providing social insurance. The income maintenance program of the Social Security Act is entitled Old Age, Survivors, and Disability Insurance (OASDI). Once the Medicare program was established in 1965 including hospital insurance (HI) the complete program became known as OASDHI (Stephenson, Horlacher, and Colander, 1995).
As a publicly funded system, Social Security is financed through taxes to both firms and individuals; ninety-five per cent of American workers pay taxes towards Social Security. Once retired, a person typically receives $8100 a year from the Social Security Trust Fund. The Social Security system in the United States functions as a pay-as-you-go system where taxes from one taxes paid in one period are used to pay benefits to retirees of that same period. Thus the system is multigenerational and only functions if the current working cohort provides enough in taxes to support the old age dependent population (Stephenson, Horlacher, and Colander, 1995).
From a social standpoint, a public pay-as-you-go system has the advantage of avoiding failure of private insurance markets. In contrast, a private actuarially based system would not be able to guarantee funds in the event of mass unemployment and business failure. In addition, a private system cannot offer appropriately priced annuities that provide a lifetime of specified real income. A private Social Security system also eliminates the sharing of risk between generations unlike a public pay-as-you-go system (Stephenson, Horlacher, and Colander, 1995).
Despite the advantages of a publicly funded pay-as-you-go Social Security system, America’s Social Security system has been criticized as being financially unsound as the demographics of the United States change and the worker to retiree ratio falls making the system unable to self-sustaining. In addition, the system has been criticized for its comparatively low rates of return and for lowering the national savings rate, which can ultimately lead to a lower standard of living (Stephenson, Horlacher, and Colander, 1995).
When America’s Social Security system transitioned from a fully funded scheme to a pay-as-you-go system with a 1939 amendment, benefits increased but contributions did not increase. Initially, in a time of rapid economic growth and small pensioners cohorts, benefits increased more than contributions. However, as the baby-boom generation becomes part of the old age dependent population in America, contributions to Social Security will eventually be too low to support all benefits (Johnson and Falkingham, 1992). It has been projected that OASDI funds will fall below safety level by 2030, and the HI Trust Fund will fall below the safe level in 2002 (Gramlich, 1996). To temporarily avoid the issue of being under-funded, the 1983 amendment to the Social Security Act raised the pension entitlement age from 65 to 67 over a period of time (Johnson and Falkingham, 1992).
Martin Feldstein (1974) addressed the macroeconomic consequences of America’s public Social Security system and argued that it had the effect of lowering the economies long-run rate of growth. He argued that the public Social Security system caused working adults to decrease their savings knowing they would be secure once retired. This has an effect of lowering overall personal savings. All else equal, this in turn causes real interest rates to increase which causes investment to be lower. Lowered investment equates to a lowered rate of growth. However, considering behavioral effects, one would see no changes in the savings rate because as current generations save less to finance old age, they save more to compensate successor generations for increased tax liabilities. On a microeconomic level we are seeing an increase in the old age dependency rate in America affecting Social Security (Johnson and Falkingham, 1992). It is this demographic transition that has lead to a discussion of whether or not America’s Social Security system should be privatized.
It has been argued that privatization may better deal with the decrease in the worker to retiree ratio, particularly when the baby-boomer generation reaches retirement. In 1995, the worker-retiree ratio was 1:3. At this level, the pay-as-you-go system ran a surplus and could support the old age dependent population. However, the ratio is projected to fall to 1:2 in which case no surplus would be seen and the system could not provide benefits as it does today. With the projection that the OASDI Trust Fund will fail after 2030, one must consider alternatives to today’s system. An increase in women and child participation in the labor force would temporarily delay the exhaustion of the OASDI Trust Fund, but would not solve the fundamental issue of a steadily declining worker-retiree ratio (Stephenson, Horlacher, and Colander, 1995).
While this is the main concern with America’s current system of retirement security, other issues exist as well. Social Security offers pensioners a rate of return on their investment of 1 to 2%. This is well below the rate of return on private capital. Peter Ferrara (1986) calculated that if a person invested their share of Social Security in individual retirement accounts (IRA’s) at a 6% real rate of return, they would see a return three to six times that of Social Security while still matching other Social Security benefits. Even an investment at a 4% real rate of return would receive two to three times the return seen through the public pay-as-you-go system. (A 6% rate of return is less then the average stock market return from 1935-1995) (Stephenson, Horlacher, and Colander, 1995).
With all of the issues surrounding America’s public pension program, two cases for reform of the system are generally made. One is a claim that strong work disincentives and increased labor costs arise from the high marginal tax rates on workers. This may reduce international competitiveness and dynamics of developed countries. The second argument is that Social Security pensions are unstable as the worker-retiree ratio falls.
Several proposals have been made to create a Social Security system that is more adept to support retirees. Gramlich puts forth three proposals for addressing the issues facing today’s system. The first proposal calls for increased taxes on social security benefits and investment of the Trust Fund in equities. The second approach would create individual accounts in addition to the present system. The third approach calls for a large move to privatizing Social Security. is this approach that America has begun to take with its Social Security system (Gramlich, 1996).
Despite this move to a partial funding, it is uncertain if the goal of reducing future tax/contribution liabilities of workers will be met. To do so, capital accumulation and economic growth must be spurred by the fund; however, the fund is used to finance public debt. In practice putting Social Security trust fund finances into real capital accumulation is difficult. A complete shift to privatization and a fully funded system would reduce political interference, a major deterrent to achieving real capital accumulation (Johnson and Falkingham, 1992).
Martin Feldstein claims that the financial problems of America’s Social Security system are very serious. One problem the current system faces is that contributions to the fund are real taxes with a very high deadweight loss. A second is the welfare loss of reduced national savings. Social Security affects public and private savings; the affect on private savings, however, is much greater. Because Social Security can represent a substitute for private wealth accumulations, economic growth is decreased (a decrease in overall savings leads to an increase in real interest rates which causes investment to fall) (Feldstein, 1996).
Stephenson, Horlacher, and Colander present the Perez Proposal that would allow the Trust Fund to purchase nongovernmental securities, and the Porter and Ferrara Plan’s that calls for IRA’s to replace Social Security.ez and Irene Hammerbacher recommend a change in America’s Social Security system to allow the Trustees of the Social Security Trust Fund to increase the rate of return earned on the Trust Fund by using modern asset allocation techniques. oing so would allow the date of exhaustion on the Fund to be pushed back or be indefinitely extended. Arguments against the proposal question the stability of investment in stocks. Allowing the purchase of nongovernmental securities using the Trust Fund could impact the national savings rate only if federal fiscal policy is altered. Following the Perez Proposal would raise government financing but would likely not significantly alter interest rates on federal securities. In addition, financial markets would likely not be disruptive. However, Perez and Hammerbacher (1993), along with Carolyn Weaver (1990), suggest the Trust Fund be invested in a broad market index to avoid bias or conflict of interest (Stephenson, Horlacher, and Colander, 1995).
The Porter Plan, proposed by Congressmen John Porter (IL), calls for partial privatization of Social Security with workers maintaining the current payroll tax payments. The difference would lie in a portion of their FICA taxes going to IRA-type accounts instead of to the Trust Fund. This shift would take place over a period of decades so that current obligations of the Social Security system would still be met. The Ferrara Plan, proposed by Peter J. Ferrara of the National Center for Policy Analysis, calls for the full Social Security tax paid by workers to be maintained. owever, workers would have the option of substituting “Super IRAs” for part of their Social Security. Additional amounts could be contributed to a worker’s IRAs and that worker would receive 100% income tax credit equal to the amount of those contributions (Stephenson, Horlacher, and Colander, 1995).
Johnson and Falkingham, in “Public Pensions, Government Expenditure and Intergenerational Transferes,” (1992) describe three types of proposed reform for public pension systems. These are 1) reducing benefits; 2) increasing the retirement age; and 3) moving from a pay-as-you-go to a partial funded system (Johnson and Falkingham, 1992).
Any proposal to privatize America’s Social Security system works must take into account the impact on the transition generation to insure that they do not bear a double burden of financing the current old age dependent’s insurance in addition to their own. Gramlich suggests that all workers over some age remain on the present system while all workers under a certain age be put on the new system. Workers between the set ages would get benefits in two tiers. One would consists of benefits from the existing system and the other would be the return from their personal accounts of the privatized system (1996).
Arguments for the privatization of America’s Social Security system are numerous. Investment in private securities would likely reduce the volatility of the stock markets if the government were investing finances of the Trust Fund (Stephenson, Horlacher, and Colander, 1995). A shift to a funded system would eliminate losses that could be experience in the future due to increases in the size of Social Security wealth. The shift would also reduce deadweight losses that are currently caused by payroll taxes (Feldstein, 1996). In addition, funding costs may be reduced. At the same time, some of the principle purposes of retirement security may be undermined. Certainly a funded system has the weakness of not being able to affectively insure against risks as a multigenerational system can (Johnson and Falkingham, 1992). It is unlikely that the private sector would replace insurance against benefits. The loss of intergenerational risk sharing could not be replaced under privatization. In addition, the redistributive property of the current system would be weakened under privatization (Mitchell and Zeldes, 1996).
Deciding to privatize America’s Social Security system is not an easy task. The current pay-as-you publicly funded system offers many things a private system could not. Yet the current system will not be able to support the old age dependent population in the near future. Therefore some changes to the system must be made soon. Perhaps privatization is the answer despite some of its shortcomings and weaknesses. Perhaps a reform of the current system or a change to a partially public and partially private system is better. The only certainty is that some change must be made if we are to continue to provide retirement security in America.
Blinder, A.S. 1990. “Political Effects of the Social Security Surpluses.” In C. Weaver (ed.),
Social Security’s Looming Surpluses: Prospects and Implications. Washington, DC: The
American Enterprise Institute, pp. 79-82.
Feldstein, M. 1996. "The Missing Piece in Policy Analysis: Social Security Reform", American
Economic Review, Vol. 82, No. 2. pp. 1-14.
Ferrara, P.J. 1986. “Intergenerational Transfers and Super IRA’s.” Cato Journal 6 (1, Spring-
Summer): 195-220.
Gramlich, E.M. 1996. "Different Approaches for Dealing With Social Security", The Journal of
Economic Perspectives, Vol. 10, No. 3. pp. 55-66.
Johnson, P., and J. Falkingham. 1992. "Public Pensions, Government Expenditures and
Intergenerational Transfers" in Ageing and Economic Welfare, Sage Publications, Newberry
Park, California. pp. 124-151.
Makin, J.H. 1990. “The Ineffectiveness of Trust Fund Surpluses.” In C. Weaver (ed.), Social Security’s Looming Surpluses: Prospects and Implications. Washington, DC: The American Enterprise Institute, pp. 39-42.
Mitchell, O.S., and S.P. Zeldes. 1996. "Social Security Privatization: A Structure for Analysis"
American Economic Review, Vol. 82, No. 2. pp. 363-367.
Perez, R. and I. Hammerbacher. 1993. “Looking Towards a Sounder Social Security System.”
Review of Business 14(3, Spring): 30-34.
Stephenson, K., D. Horlacher, and D. Colander. 1995. "An Overview of the U.S. Social
Security System: Problems and Options" in Social Security Time for a Change, edited by
Kevin Stephenson, JAI Press. pp. 3-23.
Weaver, C. 1990. “Social Security Investment Policy.” Testimony before the Social Security
Advisory Council, March 9.