“Shooting from the Hip” on Social Security Reform

September 14, 2004 • Commentary

National newspapers have reported that President Bush’s Social Security plan would involve a “huge cost‐​up to $2 trillion.” Those claims need careful scrutiny.

In the first place, President Bush has not offered a detailed plan but has only outlined the principles he would follow in designing one. How can anyone cost out a plan whose details aren’t even specified?

But let’s assume that one of the plans outlined by the President’s Commission to Strengthen Social Security might become the president’s own proposal.

Take the most often referenced Plan II of the Commission’s alternatives. Under it, those who choose to participate would be allowed to divert a relatively small portion of their payroll taxes into private, individually owned and controlled accounts.

Note that it is very difficult to interpret the meaning of a 2 trillion “transition cost” for an individual accounts system. Media references to such costs are rarely properly sourced or explained. Neither the most recent Economic Report of the President nor the President’s Social Security Commission’s report confirm a 2 trillion “transition cost.” However, for the sake of argument, we’ll assume that the 2 trillion refers to the present discounted value of additional explicit annual deficits over the next 75 years that would arise from implementing Plan II. But, as explained below, these are not “new” deficits.

Along with guaranteeing the benefits of current retirees and those close to retirement, Plan II would also reduce the growth of benefits for future retirees. This would be accomplished by modifying the formula applied to workers’ past earnings for calculating benefits. “Reducing the growth” in benefits is not the same thing as “reducing benefits.” So, future retirees who choose to remain under the current Social Security system can expect to be just as well off as today’s retirees under this plan.

Those who participate in Plan II’s individual accounts are likely to be better off: Their account balances would face somewhat greater market risk, but they would be subject to a much smaller risk of arbitrary future tax and benefit changes by Congress‐​a risk that is substantial today and growing.

Under the current system, future tax/​benefit changes could take the form of increases in the retirement age, subjecting benefits to additional income taxation, higher payroll taxation or higher income taxation to finance needed general revenue transfers toward Social Security. And such changes are surely inevitable if we retain the current system’s financing structure.

Under Plan II, those who chose personal accounts could tailor their retirement finances to suit their needs‐​by exerting greater choice in purchasing guaranteed annuities or retaining their assets and leaving them to their children. These benefits of reform are rarely, if ever, included in cost estimates.

But here’s the main point: The so‐​called “costs” of reform are already there. They’re part of the current system and will continue to grow unless reforms take them fully into account. The full, official measure of the government’s commitment to pay future retirement benefits in excess of future payroll taxes amounts to $12 trillion (in present value terms) under the current system. And, just like debt, this cost grows with interest as time passes. Those who say Social Security doesn’t need reform need to specify where that $12 trillion is going to come from.

Under the current system of budget accounting, all of this cost remains hidden. Indeed, because the Social Security trust fund currently holds government IOUs, many believe that Social Security is well funded and not in trouble; and this partly explains the eye‐​widening reaction when someone suggests that the “transition cost” of a reform plan is $2 trillion.

Few people appreciate that the amount of those Trust Fund IOUs is insufficient to pay more than 3 years’ benefits to current retirees. The remaining years’ benefits must come out of current payroll taxes paid by workers‐​which implies those funds won’t be invested for their own future retirements.

Hence, transforming the system by introducing personal accounts won’t create “new” costs. It will only make existing costs visible. But Plan II also reduces the system’s overall costs by slowing future benefit growth.

In effect, the 2 trillion estimate (if correct) reflects the amount of the existing system’s shortfall that remains after the full impact of Plan II’s is accounted for. Indeed, because this estimate is based on an accounting of Plan II’s impact only over the next 75 years, it surely understates the true size of the cost savings that would be implemented were we to adopt Plan II.

Finally, anyone suggesting that the reform plan will “cost” 2 trillion has the story exactly reversed. The correct interpretation is that Plan II goes a long way toward dealing with the current system’s resource shortfall‐​it addresses about $10 trillion of the existing system’s $12 trillion shortfall.

At the same time, Plan II will probably improve the economy’s efficiency because workers will view their contributions to individual accounts as their own savings rather than as a tax. Indeed, Plan II represents a huge improvement over the “do nothing” option which leaves a $12 trillion wide river of of red ink untouched.

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