Commentary

The Case for (Carve-Out) Personal Accounts

The article originally appeared on Techcentralstation.com on July 5, 2005
Republican leaders in Congress have been struggling to come up with Social Security legislation that will attract the broadest possible support. That’s apparently proving difficult because of lawmakers’ wide range of preferences on retirement policy, private pensions, tax-favored saving plans, taxes and so on. The latest buzz is about restricting personal accounts to just save Social Security’s surplus payroll taxes — by crediting only that amount each year to personal accounts. After the dust settles, we may get a bill that’s extremely complicated and broad, but with very small accounts.

Two things are worth reiterating: First, postponing reforms that fix the system’s financial shortfall would be a mistake. Second, addressing solvency by hiking taxes under the current set of Social Security institutions would be an even a bigger mistake: Those institutions won’t save any additional resources devoted to Social Security. The value of a properly crafted personal accounts system would be in its ability to genuinely save and invest funds meant for Social Security.

The resistance to adopting personal accounts is not just political. Lawmakers appear to believe that the decision to adopt personal accounts is completely separable from the choice about how to fix the system’s insolvency. Some economists argue that carve-out personal accounts — as championed by President Bush — do not contribute at all toward fixing the system’s insolvency. They claim that carve-out personal accounts generate no new savings. That impression, unfortunately, is the result of an inappropriate comparison of the alternatives. Here’s why:

To begin, suppose that mandatory “add-on” personal accounts were introduced to fund that part of scheduled Social Security benefits that are unfunded — that is, benefits promised but not covered by present law payroll taxes. Because workers would own personal accounts, their “add-on” contributions would not appear as additional incentive-reducing taxes and would not reduce labor supply. If borrowing against personal accounts were prohibited, as would be appropriate, they will likely lead to higher national saving and investment. As a result, future output, incomes, and the payroll tax base would all be larger. Therefore, present law payroll taxes would fund a higher level of future Social Security benefits.

This higher level of benefits, funded out of present law payroll taxes under “add-on” accounts, would not be available were we to adopt the “status-quo” alternative of simply hiking payroll taxes to finance presently scheduled but unfunded Social Security benefits. That’s because, today, payroll tax surpluses are turned over to the Treasury and are consumed by the government rather than saved and invested.

Recent studies show that government consumption expenditures increase more than dollar-for-dollar as Social Security surpluses accrue in the government’s coffers. If true, the lower saving and reduced work incentives from higher payroll taxes would shrink national output, incomes, and the payroll tax base, and present law payroll taxes would fund smaller future Social Security benefits.

The difference between the two projections of future benefit levels funded out of present law payroll taxes — higher ones under “add-on” personal accounts versus lower ones under a “status-quo” hike in payroll taxes — constitutes the basic case for “carve-out” personal accounts. How come? If “add-on” accounts to pay for benefits that are promised but unpayable under present law effectively increases saving and investment and preserves work incentives, the (lower) level of payable benefits under a “status quo” payroll tax hike could be financed with a less than 12.4 percent payroll tax rate under the “add-on” policy. That implies room for a “carve out” — that is, for diverting a part of present law payroll taxes into personal accounts.

How large would be the size of a feasible carve out? Would it ultimately completely do away with the need for “add-on” contributions? These are difficult questions to answer. Two considerations suggest, however, that the scope for carve-outs could be large. First, several studies report that payroll taxes add significantly to marginal tax rates — especially for households’ secondary earners — and that labor supply is quite sensitive to higher taxes. Noteworthy here is a recent study by economics Nobel laureate Edward Prescott that attributes the significant decline in European labor supply relative to the United States since the 1970s to higher European social insurance taxes.

Second, loss in annual output because of the savings-reducing impact of the current Social Security system’s pay-as-you-go financing structure is estimated to be of the same size as total current outlays on Social Security. That is, were the existing system based entirely on “add-on” personal accounts, the gain in annual output due to higher saving and capital formation would have been about as large as total current outlays on Social Security.

Introducing personal accounts (“add-on”, or “carve-out”) involves an institutional change in the way Social Security funds are allocated compared to the current system. If conferring asset ownership to individuals rather than to the government can effectively increase national saving and investment without reducing work-incentives, the future benefits funded by present law payroll taxes could be higher or those taxes could be reduced. Hence, separating the issue of fixing Social Security’s insolvency from that of introducing personal accounts is inappropriate. Ownership and management of retirement assets by the government has been shown to be ineffective. It’s time to adopt a new approach.

Jagadeesh Gokhale is a senior fellow at the Cato Institute