Commentary

Progress or Surrender?

After losing Republican majorities in both houses of Congress, the Bush Administration is reportedly contemplating abandoning its long-held goal of introducing Social Security personal accounts. Now, chances are that changes to Social Security will include a collection of unrelated measures rather than coordinated structural reforms. The collection of measures being considered by newly elected Congressmen suggests an attempt to co-mingle the objectives of improving Social Security’s finances and increasing national saving. But they are likely to perform poorly on both counts.

Reform discussions appear focused on three main elements. Social Security would undergo a progressive shift from wage- to price-indexing of past earnings when calculating benefits for middle and upper earners. Prices grow slower than wages, so this would result in slower benefit growth. Likely reforms would also increase revenue by raising the taxable maximum payroll ceiling, imposing additional costs on those in the top earnings quintile. The additional revenues would be safeguarded from spendthrift politicians by using them to fund a saving-subsidy for low-income taxpayers — a matching contribution into 401(k)-type accounts whose coverage would be broadened to those currently without access via employment.

These measures might achieve a political compromise, but they are unlikely to achieve their economic objectives. They won’t improve Social Security’s financial health by much, and they probably won’t increase national saving, either. Indeed, introducing personal accounts for one population group and financing them with taxes on another would worsen the link between work and its rewards, thereby adding to the program’s structural shortcomings.

Consider the likely economic impact of such a combination of reforms: The reduction of benefit growth for middle and upper earners may induce them to work more each year and to retire later. In addition, such workers would be induced to save more to make up for reduced future Social Security benefits. But the second measure — subjecting upper earners to the payroll tax — would have a countervailing impact, inducing them to reduce work efforts, retire earlier, and save less for retirement as higher taxes reduce their sustainable consumption levels. Higher taxes would also increase incentives to redefine their earnings — by deferring compensation via stock options and taking in-kind benefits not subject to payroll taxes.

Creating heavily subsidized retirement accounts for low earners and financing them out of the additional payroll taxes also means new revenues won’t be available to pay future Social Security benefits. And progressive cuts in benefit growth alone are unlikely to bring overall benefit obligations within available Social Security revenues.

In addition, low earners would enjoy large net gains from such a combination of reform measures. They would be shielded from cuts in future benefit growth and from payroll tax increases but would receive generous subsidies against retirement contributions into tax-advantaged saving accounts. Such workers have larger consumption propensities but are generally considered less savvy in managing their finances. Chances are, however, that they would eventually learn how to exploit their new retirement accounts to increase current consumption.

One way would be to purchase larger homes with their newfound retirement accounts if those accounts allowed home-purchases as a legitimate reason for pre-retirement withdrawals or loans. And larger homes may trigger larger concomitant consumption expenditures. Alternatively, such accounts may enable their recipients to qualify for more generous credit card and consumer loans. In turn, that may trigger earlier personal bankruptcies or “hardship” withdrawals from retirement accounts instead of generating additional resources for retirement.

In summary, the current clutch of proposals for Social Security reform are motivated solely by the need to find a political compromise, and with too little regard for their eventual economic impact. It would be better for Congress to reform Social Security on its own terms — by retaining personal accounts within the Social Security system and implementing a progressive but linked reduction in benefit growth to reduced payroll taxes for all households. Moreover, increases in retirement ages could be employed to add to the system’s progressivity — by linking the age of retirement with full benefits to total earnings through age 62.

Reduced future benefits and a higher full-retirement age would make larger personal saving desirable, especially for high earners. And lower payroll taxes would make additional saving feasible, especially for low earners. Yet, to ensure increased saving, it may be necessary to mandate that the tax cuts be saved in Social Security personal accounts. Retaining all reform elements within the Social Security system would also provide political cover to impose stricter safeguards against pre-retirement withdrawals from Social Security personal accounts.

Whether or not such reforms achieve full Social Security sustainability, Congress should steer clear from attempting to simultaneously subsidize household saving. Studies in many countries, including the United States, show that existing tax incentives for saving do not generate new saving in excess of their budget costs. Additional saving subsidies are likely to prove ineffective at best and counterproductive at worst. If Congress wants to contribute to higher national saving, the best way would be to reduce government expenditures.

Jagadeesh Gokhale is a senior fellow at the Cato Institute and former senior adviser to the Federal Reserve Bank of Cleveland.