No Half‐​way Measures

February 8, 2005 • Commentary

NOW THAT the nation’s pundits are in full cry over Social Security reform, we should not forget that this debate is also taking place around the world. About 130 countries are wrestling with similar demographic challenges to their retirement systems, and how they think through the possible answers to the problem may be instructive.

The optimal solution is to move completely from tax‐​based to market‐​based financing. But this is difficult for politicians, causing them normally to promote interim measures which are easier to sell but which are ineffective. The first two deal with taxes and benefits because the challenge is often thought of as a cash flow mismatch.

Of these two options, the initial choice usually is to raise taxes because there are more workers to tax than there are retirees from whom to cut benefits. Also, given that workers are younger than retirees, they have a longer time to adjust. Like most countries, the United States adopted this strategy; in 1950 the payroll tax rate was 3 percent on a wage cap of $3,000. From then until now the rate has jumped to 12.4 percent on a wage cap this year of $90,000.

At some point the tax increase strategy hits a political wall and plan two is invoked, cutting benefits. This is something people don’t like to talk about. Instead, they use language that can only be understood with the help of a secret decoder ring. They speak of price indexing, moving from a COLA to a diet COLA, longevity indexing, adding a bend point, decreasing the PIA, increasing the NRA, and raising the retirement earnings test exempt amounts. It’s all code for cutting benefits.

Once the benefit‐​cut strategy hits its political wall the real fun starts: “notional accounts.” These come in many forms, but a common variant is offering citizens the right to save and invest in a portfolio of government bonds. Although this may sound secure, keep in mind that the principal and interest when due on government bonds are financed by taxes. The notional account structure closely approximates a tax‐​based retirement system, but it’s gussied up to appear more attractive.

When I was in Moscow advising the Russian Federation on how to reform its Social Security system by investing in wealth‐​producing assets, one Duma member asked me what’s wrong with a notional account. Wanting to be certain that we were thinking of the same structure, I asked if she meant by this that citizens would have individual accounts that were invested in Russian government bonds. She responded yes. I asked her if she agreed that this was basically the same as each citizen owning a government bond outright? She said yes. To answer her “what’s wrong” question I offered the following.

Instead of individuals owning government bonds, why not deliver a government bond to each Russian worker — literally — to his house, farm, or apartment? And let us not be stingy; let’s make each bond worth $1 million. Now, every Russian worker is a millionaire. Except, that is, for one inconvenient fact. We have to pay principal and interest when due on each bond, so we’ll have to tax each worker $1 million. I asked her what we have accomplished? She smiled and responded, “nothing.” After concurring, I took the next step.

Let’s now go to every farm, house, and apartment, collect the bonds, and bring them back to Moscow and deposit them in a portfolio that is managed by a reputable asset manager — the notional account. What have we accomplished? This time, she hesitated. But she then again smiled and meekly asked, “Nothing?” I agreed. Then another member of the Duma said something most insightful: “Yes, but we would have fooled them for a while.” There was laughter. I responded, “You’re probably right. But when they figure it out, you had better get out of town.”

There are at least two lessons from these experiences. The first is that raising taxes, cutting benefits, and then promoting notional accounts consumes valuable time. This is a wasted opportunity because none of the three solves the problem, and the demographics that squeeze pay‐​as‐​you‐​go systems continue their powerful, albeit slow, progression: fewer workers to tax, more elderly to pay benefits.

The second lesson is that these ineffective responses squander political capital. When politicians tell you that they have solved something and they haven’t, the natural tendency is to disbelieve their future promises. Another way of putting it is that pretending to solve the problem makes it more difficult to actually solve the problem.

Our country is now in the middle of the Social Security reform debate. The solution is to reform the system’s finances through market‐​based investing in wealth‐​producing assets. By themselves, tax hikes, benefit cuts, or notional accounts don’t work. If employed sparsely, however, each may play a useful role. Be on guard, however, as to how sparse that role is, because our government has already raised taxes and cut benefits, and some members of Congress are advocating notional accounts. Don’t let them fool us for a minute.

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