Capital Formation Newsletter
January-February 1996, Vol. 21, No. 1


Social Security Reform and U.S. Economic Growth

Mission '96: ACCF and ACCF Center for Policy Research

Social Security Reform and U.S. Economic Growth

Introduction

The debate about reforming the U.S. social security system has changed. No longer is this issue confined to academics or a few farsighted politicians. Social security reform and privatization are now being discussed actively by the presidential candidates and by President Clinton's Advisory Committee on Social Security. Even after the conclusion of the presidential campaign, the growing concerns of the baby boomers and the younger generation that social security will not "be there for them" when they retire is likely to keep a spotlight on the issue.

Middle-aged and younger workers are rightly concerned about the stability of our social security system because it is funded on a "pay-as-you-go" basis, in which current payroll taxes are used to pay benefits to today's retirees and to offset the federal deficit through purchases of government bonds. Many scholars, including John Shoven, Dean of Stanford University's College of Arts and Sciences and member of the ACCF Center for Policy Research Board of Scholars, have focused on the fact that our current unfunded system will run out of money to pay benefits to the then-retired baby boomers sometime around 2030 (see Figure 1). The looming bankruptcy of the social security system, absent sharp increases in payroll taxes or equally sharp cutbacks in benefits, is a serious threat to U.S. political and economic stability.

Economic Effects of the Current System

New research by National Bureau of Economic Research President Martin Feldstein highlights several critical economic problems caused by the present unfunded system, in addition to the fact that the system, as presently structured, will have a zero fund balance around 2030 and will be unable to pay benefits to the retired baby-boomers.*

Central to Dr. Feldstein's analysis is the notion of "social security wealth," which he defines as the present actuarial value of the social security benefits to which the current adult population will be entitled at age 65 (or are already entitled to if they are older than 65) minus the present actuarial value of the social security taxes that they will pay before reaching that age. Social security wealth has now grown to about $11 trillion, or more than 1.5 times the GDP (Gross Domestic Product). Since that is equivalent to more than $50,000 for every adult in the country, the value of social security wealth substantially exceeds that of all other assets for the vast majority of American households. In the aggregate, social security wealth exceeds three-fourths of all private financial wealth as conventionally measured.

Social security wealth is, however, not real wealth but only a claim on current and future taxpayers. Instead of labeling it social security wealth, it could be called the nation's social security liability, observes Dr. Feldstein. Like ordinary government debt, social security wealth has the power to crowd out private capital accumulation. Social security wealth will continue to grow as long as our current unfunded system remains unchanged, displacing an ever-larger stock of capital. According to Dr. Feldstein, this causes two main economic impacts. First, workers will earn a much lower rate of return than if their payroll taxes were invested in the private sector. Second, national saving and investment rates are lower than they would be under a funded system invested in the private sector, resulting in slower growth in GDP. (For a comparison of the real rate of return on social security payroll tax payments for currently retired couples, who are benefiting from the sixfold rise in payroll taxes since 1940, versus what those still in the workforce will receive, see Figure 2.)

Impact of Social Security on U.S. Private Saving and Economic Growth

The impact of the United States' unfunded social security system on national income and economic welfare, notes Dr. Feldstein, depends on how individual saving responds to social security taxes and benefits and on how the government acts to offset the reductions in private saving.

Under our current system, an individual with average earnings during his entire working life who retires at 65 with a dependent spouse now receives benefits equal to 63 percent of his earnings during the full year before retirement. Since the social security benefits of such an individual are not taxed, those benefits replace more than 80 percent of peak preretirement net-of-tax income. Common sense and casual observation suggest that individuals who can expect such a high replacement rate will do little saving for their retirement. Such saving as they do during their preretirement years is more likely to be for precautionary balances to deal with unexpected changes in income or consumption. Not surprisingly, the median financial assets of heads of households aged 55 to 64 was only $8,300 in 1991, substantially less than six months' income. Looking beyond financial wealth alone, the median net worth (including the value of the home) among all households under 65 years of age was only $28,000.

To get a sense of the magnitude of the annual loss in national income, Dr. Feldstein notes, it is helpful to begin with the simplest case in which each dollar of social security wealth reduces real private wealth by a dollar. Since the foregone private wealth would have earned the marginal product of capital (private investments have averaged a 9.3 percent pretax return over the past 35 years) while the unfunded social security system only provides a return equal to the growth of the social security tax base (2.6 percent per year), the population incurs an annual loss of real income equal to the difference between those two returns. With a marginal product of capital of 9.3 percent and a social security return of 2.6 percent, the annual loss of real income is 6.7 percent of social security wealth. The social security wealth of $11 trillion in 1995 implies an annual loss in that year of around $730 billion, or more than 10 percent of total GDP.

The key issue for the U.S. economy, Dr. Feldstein states, is the extent to which social security wealth actually substitutes for private real wealth accumulation. The empirical evidence from his analysis, as well as that of other scholars, is that each extra dollar of social security wealth replaces about 50 cents of private wealth accumulation. He concludes that the social security program causes each generation to reduce its savings substantially, thereby incurring a large loss in real investment income. As a consequence, annual GDP is about 5 percent lower than it would have been without our current, unfunded retirement system.

The Potential Gain from Privatization

Could the United States realize a large gain in economic welfare and GDP by shifting to a funded retirement system? Dr. Feldstein notes that several governments around the world are following Chile's example and making such a transition by privatizing their social security programs. Although the details differ, the essential feature of a privatized system is that each employee or his employer must make regular contributions into the employee's own retirement account that are then invested in stocks and bonds. The government recognizes its obligations to existing retirees and employees at the time of privatization by depositing in these retirement accounts new government bonds equal to the present value of the benefits to which the individual is then entitled on the basis of past contributions to the unfunded system. Funds in these new retirement accounts can be used to purchase annuities, or withdrawn gradually when the individual reaches retirement age, or bequeathed to a spouse or other heirs.

A skeptic might ask what this really accomplishes, since it merely converts the existing unfunded social security obligations into explicit government debt with the same present value, Dr. Feldstein notes. That skepticism would be warranted in a static economy, but is not appropriate when economic growth is continually enlarging the size of the social security liability. Shifting from an unfunded program to a funded one applies the general principle that when you discover you are in a hole, the first thing to do is stop digging. Shifting to a funded system eliminates the future losses associated with future increases in the size of social security wealth.

In the first year after the privatization of a pay-as-you-go system, capital stock does not increase because the government must borrow all of the mandatory saving to pay benefits to existing retirees. But as time passes, the amount of net capital investment grows (because the mandatory saving rises with the number of employees and their average incomes) while the net social security debt that is explicitly recognized at privatization remains constant. As a result, the capital stock grows and with it the incremental income.

If the capital stock grows by the amount of the mandated saving (in excess of the initial social security wealth), the present value of this gain at the time of privatization, using a 6.4 percent risk-adjusted return on capital, a 2.6 percent return on social security, and a 4 percent discount rate, is nearly twice the current value of the unfunded program, observes Dr. Feldstein. Approximating the current value of the unfunded program by the social security wealth implies a potential present value gain of nearly $20 trillion. Even if the increase in the capital stock that results from shifting to a funded program is substantially less (because individuals reduce some private saving or because the mandated saving is less than the existing payroll tax), the potential present-value gain could easily exceed $10 trillion.

While it is hard to put such a large sum in perspective, Dr. Feldstein finds it helpful to note that, with the assumed discount rate and GDP growth rate, present-value gain from privatization is equivalent to about two percent of GDP in perpetuity.

This is just the gain from increasing real capital accumulation. In addition, as noted above, the shift to a funded program would also reduce the losses now caused by a payroll tax that distorts labor supply and the form of compensation, e.g., workers receive more nontaxable benefits such as pleasant working conditions than they would in the absence of a payroll tax. This $68 billion loss for 1995 corresponds to an additional one percent of GDP.

Because privatization reduces the loss due to distortions in the labor supply in perpetuity (by one percent of GDP) and provides individuals (after the first generation) with an opportunity to earn a higher rate of return on their mandatory retirement saving, it is possible to design a transition to a funded program that leaves each generation better off than it would be with the existing program, notes Dr. Feldstein. This can be done by using additional debt to smooth the cost of the transition over more than one generation. Although each of the transition generations would pay more in a combination of taxes and mandatory saving than under the existing laws, the improved return on their funded accounts and the resulting reduction in labor market distortions would leave them better off.

Conclusions

Reform of the social security system is both urgent and enormously important, concludes Dr. Feldstein. Each generation now and in the future loses the difference between the return to real capital that would be obtained in a funded system and the much lower return in the existing unfunded program, as well as losses caused by dollar market distortions. Conservative assumptions imply a combined annual loss of more than four percent of GDP as long as the current system lasts. Although the transition to a funded system would involve economic as well as political costs, the net present value of the gain would be enormous.

The rapidly deteriorating financial position of social security will eventually force politicians to deal with the problem of social security reform. The adverse impact of the current system on a wide variety of groups, including two-earner couples, the young, and the poor, may embolden some politicians to go beyond patching up the solvency of the current system to propose fundamental reform.

Mission 96: ACCF and ACCF Center for Policy Research

The American Council for Capital Formation and its public policy think tank, the ACCF Center for Policy Research, have undertaken a unique mission in 1996-to help define and restructure U.S. tax, regulatory, and environmental policies so that this country can increase the pace of economic growth, provide high-quality jobs, and compete effectively in world markets.

The ACCF and the Center will pursue their mission in three ways:

• First, the ACCF is a recognized participant-not a bystander-in U.S. economic policymaking on Capitol Hill and in the corridors of the White House.
  
  
• Second, the ACCF Center for Policy Research brings to the policymaking process research by some of the nation's most credible economic and regulatory policy scholars and analysts.
  
  
• Third, the ACCF and ACCF Center for Policy Research are highly regarded resources for journalists and editorial boards on sound tax, regulatory, and environmental policies.
  
  
• Over the past year, the ACCF and the ACCF Center for Policy Research made significant contributions to the economic policymaking process through their work on strategies for increasing saving and investment, and through a pioneering research project on the economic consequences of proposals to address climate change.
  
  Throughout 1996, the ACCF and ACCF Center for Policy Research will carry out their mission by educating policymakers, the media, and the public on the importance of sound tax, regulatory, and environmental policies to long-term economic growth. Recognizing the need for tax initiatives to promote strong and sustainable economic growth for our children's future, the Center will sponsor a blue-ribbon forum, "Tax Policy for the 21st Century," which will feature provocative new research on current tax policy issues facing policymakers. To continue its 1995 climate change program, the Center will sponsor a project on "Environmental Policy, Regulatory Reform, and U.S. Economic Growth." With their high-profile forums, both research programs will provide important new information to help shape the election-year debate in a pro-capital formation direction.

The Center's 1996 programs will be augmented by briefings for Hill staff and publication of special reports and books based on the research presented at the forums. Center-sponsored research will be available on the Internet and the Center is planning to produce videotapes on selected tax and environmental issues.

For more information on the 1996 programs of the American Council for Capital Formation and the ACCF Center for Policy Research, please contact Mark Bloomfield, president, American Council for Capital Formation, 1750 K Street, NW, Suite 400, Washington, D.C. 20006-2300; 202/293-5811; 202/785-8165 fax.