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Introduction

privatization seems worthwhile. If not, then the

argument for reform is less persuasive. The

One of the more common concerns about

starting point to determine which system is

transforming Social Security's pay-as-you-go

superior is Social Security's financial future

financing into a market-based structure is the

under present law, which is detailed in the 1998

transition cost. Critics claim that people would

Trustees Report.3

be unduly burdened because they would have to

The term privatization should be used with

pay twice--once for their own retirement and

caution. The term is now so liberally employed

once for those already retired. This double

that quantifying the price of getting there is a

expense would be so prohibitive, it is argued, as

matter of much interpretation. Different privati-

to warrant rejecting the idea of privatization

zation plans can produce entirely different

even if it were meritorious on other grounds.

results. This paper, therefore, presents a frame of

However, the transition cost need not be pro-

reference that is useful in estimating the costs of

hibitive or even greater than the benefits from

making the transition to specific market-based

the new system. Theoretically, a net saving rela-

structures. The analysis will show that moving

tive to what the future holds under today's law

toward market-based financing does not neces-

could be realized. An illustration is the tradeoff

sarily incur a cost over and above present law,

in refinancing a home mortgage. Costs, such as

and may produce a saving.

points, title insurance, title search, attorneys'

fees, credit report and the like, are associated

Social Security Today:

with achieving a lower interest rate. The deci-

The transition

sion to refinance includes not only the lower

Deep in Debt

interest rate, but these transaction costs as well.

cost need not

Social Security comprises two different

If the present value of the costs and the lower

be prohibitive

programs: Old-Age and Survivors Insurance

interest expense is significantly less than the

(OASI) and Disability Insurance (DI). Com-

or even

present value of the existing mortgage interest

bined, they are called OASDI. This paper con-

expense, then there is a net benefit from refi-

greater than

siders OASI only but not the taxes paid to or the

nancing even though costs were incurred to

the benefits

benefits received from the Disability Insurance

achieve it.

program.

from the new

The home mortgage paradigm is useful in the

In the OASI program one pays a payroll tax

Social Security reform debate. The cost of the

system.

during working years and receives a monthly

present system is the forgone consumption,

benefit check during retirement years. It is a sys-

either by individuals or the government, neces-

tem of money in and money out and can be

sary to pay future promised benefits. The cost of

compared with other money-in, money-out

getting to a market-based structure is the for-

systems.

gone consumption required to invest in markets

Actuaries estimate OASI's long-term finan-

and pay some payroll tax.1 If the latter is less

cial health over a 75-year period.4 They project

than the former, then there is a net saving during

annual revenues and expenses and adjust each

the transition, even though costs were incurred

for expected inflation. The difference, expressed

to achieve it.

in today's dollars, is how much the system is

If the forgone consumption were in the form

funded or unfunded. Projections assume three

of a reduction in government spending, then

different economic and demographic scenarios:

there would be an added benefit, which is the

optimistic, pessimistic, and middle of the road.

efficiency gain from this choice. Although inde-

terminate, this gain may be significant.2

This paper compares privatization with the mid-

dle-of-the-road scenario, formally referred to as

Whichever path the country ultimately takes, the

the Intermediate Assumption.

timing of the decrease in consumption can be

managed through deficit finance, but it cannot

Cash Flows: OASI derives revenues primarily

be avoided.

from a payroll tax. The payroll tax started in

One significant advantage of a privatized sys-

tem is the greater retirement income earned

1937 at 2 percent up to $3,000 of wage earnings

and is now 10.7 percent up to $68,400.5 The

from investing in markets. If this income, taking

into account the cost of achieving it, is greater

maximum tax, therefore, has gone from just $60

than Social Security's retirement income adjust-

to $7,319 in 61 years, about a 950 percent

ed for the cost of maintaining it, then the goal of

increase in real terms. (Economists agree that

2