A Mass Delusion

April 21, 2006 • Commentary
This article appeared in TCS​dai​ly​.com on April 21, 2006.

Most have declared the Social Security reform debate dead. But the program still faces financial insolvency, so no action now simply means that the debate is being shifted into the future. Supporters of personal accounts are unlikely to give up their quest so account opponents are maintaining a drumbeat of criticism.

Unfortunately, much of the criticism of personal accounts is based on an incorrect premise — that the accounts’ objective is to put more money into retirees’ pockets. Critics argue personal accounts would deliver this goal only by taking money away from others.

However, the system has another dimension that is a crucial reason personal accounts should be retained as a reform option: Current payroll taxes create entitlements to future benefits. This link leads to a misperception of the risk inherent in retirement financing and harms growth‐​promoting economic behaviors. The misperception and its harmful effects will continue to grow as long as the program remains in its current form.

Nobody really knows the exact size of future obligations created by today’s payroll taxes: Future benefits will be paid under future program rules, and the program’s financial insolvency makes those rules uncertain.

Opponents of personal accounts ignore that uncertainty and continue to proclaim that Social Security constitutes “guaranteed” retirement support. This perception is only reinforced by the Social Security Administration’s regular notifications to participants of future benefits that would be paid under current laws.

Life holds no certainties. But to provide a relatively strong benefit “guarantee,” Congress would have to pass a law requiring a super majority vote to alter the current benefit formula. In that case, recurring financial shortfalls would have to be closed by hiking payroll taxes or otherwise injecting more resources into Social Security. Were that the case, a ballooning cohort of retirees would require repeated payroll tax hikes that would eventually become unbearable.

In reality, there is no strong Social Security guarantee and future electorates are unlikely to acquiesce to exclusively revenue‐​side adjustments. Potential future benefit adjustments should not be ignored, but talk of “guaranteed” benefits misleads people into believing their retirements are more secure than is really the case — a misperception that negatively affects how much they personally save for the future.

Another way that the current Social Security system erodes national saving is by transferring resources from savers to spenders. Studies show that spending rates of American retirees out of their total resources are larger than those of American workers, and retirees’ spending rates have increased over time. That means transferring dollars from workers to retirees via Social Security and other entitlements promotes spending growth and retards national saving.

The savings‐​reducing impact of entitlements would not matter if Americans were saving excessively — like the Chinese do today. However, Americans’ saving rates — never very high historically — have fallen significantly since the late 1970s, causing the United States to rank close to the lowest savers among developed economies.

Social Security also creates labor‐​markets inefficiencies: Financing benefits out of payroll taxes rather than out of prior savings adds to work‐​disincentives arising from income taxes. Studies show that spousal labor‐​force participation is especially reduced by Social Security payroll taxes and dependents’ benefits that accrue despite a lifetime spent out of the labor force. And recent studies have shown that Social Security’s clawback of benefits for working beneficiaries younger than 65 (otherwise known as the “earnings test”) induces people to retire early even when in good health and with undiminished ability to work.

According to a study by Nobel laureate Edward Prescott, high social insurance taxes cause lower labor‐​force participation among Europeans compared to Americans. Thus, a policy of “fixing” Social Security through tax increases would only discourage work and compound the growth‐​retarding impact of low saving and capital formation.

Perhaps most worryingly, economists and social scientists have begun to suggest that the long‐​term fertility decline in developed economies may also be the effect of generous pension and health insurance programs. A recent study shows that a significant portion of fertility declines among developed economies during the 20th century can “be explained” by the generosity of retiree pension and health benefits. In addition, changes in social structures and behavior — women’s economic independence, higher divorce rates, and increasingly separated living arrangements of retirees and their adult children — which are partially wrought by greater economic independence during retirement — may sustain the decline in fertility rates.

Because the existing structure of entitlements weakens important growth‐​promoting economic behaviors — saving, labor‐​force participation, family cohesion, and potentially even procreation — finding a way to provide retirement security that reverses or minimizes them in the future is obviously important. Simply assuming that future benefits would be paid through higher taxes and ignoring the risky nature of Social Security’s “intergenerational compact” appears to be a sure recipe for disaster.

Personal accounts cannot solve Social Security’s cash flow shortfalls, but they could help to eliminate the mass delusion about retirement security that the current program creates.

About the Author