A. Modifying the Existing System

2. One approach to reforming the Social Security system would retain the basic features of the current system, but alter some of its parameters—payroll taxes, benefits, and/or the retirement age. The 1998 Trustees’ Report estimated that over the next 75 years, the system’s imbalance between income and expenditure could be eliminated through measures on either the revenue or benefit side equivalent to a payroll tax increase of about 2¼ percentage points, provided these changes were enacted soon.

3. To solve the system’s financial problems by raising payroll taxes alone would not be desirable. An increase in the payroll tax has the effect of reducing the net-of-tax wage, which could induce individuals to reduce the amount of time spent working. The magnitude of this effect will depend on the elasticity of labor supply with respect to after-tax real wages. Most empirical estimates of this elasticity fall well below unity, suggesting that the effect would not be large.² Feldstein (1996) maintains, however, that the payroll tax is more distortionary than is usually thought, because Social Security forces individuals to accept a rate of return on their contributions that is far below the estimated real before-tax return on capital.³ He argues that in addition to reducing hours worked, the payroll tax distorts occupational choice, location of work, work effort, and the form in which individuals choose to receive compensation (providing an incentive to receive compensation as untaxed fringe benefits). Taking these factors into account, Feldstein estimates that the deadweight loss from the Social Security tax is about 2.4 percent of the tax base, equivalent to about 1 percent of GDP.⁴ However, the disincentives to work may be considerably mitigated to the extent that the payroll tax for Social Security is considered to be a pension contribution or payment for the insurance that Social Security provides against poverty in old age, which is available only to those that actually work.⁵

4. Alternatively, benefits could be cut to deal with the long-term financial imbalance in the Social Security system.⁶ The level of pension benefits could be cut directly or indirectly by altering the earnings-based formulae for computing benefits or by providing for less-than-full indexation of benefits. In addition, the normal retirement age could be increased.⁷ In cutting benefits, care would have to be taken to ensure that the success that the program has had in reducing old-age poverty is not undone.

5. Diamond (1996) asserts that the effect of raising the retirement age on benefit outlays may be offset by an increase in disability payments, as there would be a greater incentive to apply for disability benefits, which are not subject to age-related reductions. Rust (1997) notes that raising the retirement age may engender other federal outlays to provide the additional training and health care benefits that may be needed to extend the average working life. Gruber and Wise (1998) report evidence that Social Security provisions have contributed to a decline in labor force participation of older workers, reducing the productive capacity of the labor force.

6. While the details of the actions that should be taken to address the financial problems of Social Security need to be worked out carefully in light of these and other considerations, if actions are adopted soon the magnitude of the problem is such that a combination of a relatively small increase in the payroll tax and reductions in benefits would be sufficient to restore the long-term financial viability of the system. Such a combination of measures would not likely seriously undermine work incentives or risk contributing to an increase in elderly poverty.

B. Fully Funding the System

7. Making small changes to Social Security entails partial funding of the current, defined-benefit system, since net assets are allowed initially to build up to meet, at least part of future obligations. In this way, the burden of dealing with the long-term financing problems of the current system can be spread across generations. Whether this partial funding of Social Security results in an increase in national saving depends on the response of individuals. Faced with an increase in mandatory savings through the Social Security system, individuals may simply reduce other types of savings. Leidy (1997) points out that national savings could decline with the implementation of a credible plan to meet Social Security’s needs because concerns that the system would not be able to meet its future obligations (which may be boosting private savings at present) would diminish.

8. While making small changes to the parameters of the existing Social Security system addresses the demographic problem associated with the aging of the baby-boom population, at the end of the day (i.e., in 2070), it would leave the system on a pay-as-you-go basis, and as such it would remain vulnerable to future demographic shocks. To deal with this problem, the existing defined-benefit system could be shifted to a fully funded basis (i.e., the assets of the system would be built up until they are equivalent to the present value of future obligations). The necessary increases in contribution rates (or cuts in benefits) to fully fund the system would increase national savings to the extent that individuals do not reduce their other savings (as discussed above). Because these increases are larger than those required to keep the system on a pay-as-you-go basis, national savings would be expected to rise by more, which would stimulate significant increases in the capital stock and output.⁸

9. In the end, it is not clear whether the social welfare gains from removing demographic effects on the current defined-benefit system and raising national saving are sufficient to offset the additional substantial up-front cost of moving to a fully funded system. Mitchell and Zeldes (1996) point out that the cost of transition is likely to offset much of the increase in savings resulting from a shift to a funded system.⁹ They also note that the increase in capital formation reported in simulations by Feldstein (1997) is largely due to his assumption that fiscal policy changes to finance the shift to a fully funded system, and this effect is independent of a decision on how to address the long-term financial problems of Social Security. Kotlikoff (1996) shows that the welfare effects of a shift to a fully funded system are very sensitive to the method chosen to finance the transition. For example, if a consumption tax is used, the change can benefit all generations. Alternatively, if an income tax is used then early generations will loose.¹⁰

10. If small changes were made to the parameters of the existing Social Security system or if a fully funded approach were adopted, the system would build up a large stock of assets in the early decades of the next century. It is argued that investing these assets in private securities could significantly raise returns and provide resources to meet the system’s long-term funding needs, Feldstein (1997) estimates that over the last four decades, the real return on private investments has averaged a bit more than 9 percent, while the return on contributions to the Social Security system is currently about 1.5 percent. Therefore, he concludes that Social Security forces workers to save inefficiently, which would argue at a minimum for investment of the system’s assets in private securities. Leidy (1997) demonstrates, however, that, in the absence of an increase in national saving, investing Social Security assets in private securities simply involves a reallocation of financial assets. Shifting trust fund assets to private securities requires an offsetting adjustment in the structure of private portfolios, which would tend to be more heavily invested in lower-yielding government bonds. Thus, while the average return on Social Security assets would rise (and the longer-term financing needs of the system might be met), the average return on other private assets would decline. Funding the system in this manner would be equivalent to levying a tax on current wealth holders.

C. Privatization

11. Once consideration is given to moving to investing in private securities, a more fundamental question arises as to whether Social Security should be privatized. Privatization refers to an increase in the degree of private sector involvement in the provision of Social Security.¹¹ This could be accomplished by crediting individual contributions to personal accounts rather than to the account of the system as a whole, and by providing individuals with some degree of control over how these funds are invested. The establishment of individual accounts would mean that Social Security would become, at least in part, a defined contribution system rather than a defined benefit system as it is now.

12. Proponents of privatization cite a number of advantages to adopting a plan with individual accounts that are privately managed. Mitchell and Zeldes (1996) note that moving to a private system reduces the risk that future retirees’ benefits will be altered by congressional action, pointing out that the government has made changes to the tax and benefit structure of Social Security in the past. Feldstein (1997) maintains that a large and growing publicly owned or managed retirement fund could weaken the resolve of government to reduce its budget deficit, since the retirement fund’s assets could be used to finance the budget. Consequently, national savings could be reduced, hurting future growth prospects.¹²

13. It is also argued that public managers investing Social Security funds in private securities might be subject to political interference. This problem could be addressed by having the government invest the funds in a passive way, for example, by holding a portfolio that would replicate the stock market’s overall performance. However, the large size of the funds to be invested might affect market outcomes, and it might be difficult to invest in a diversified portfolio without the government holding a major stake in some companies. In addition, it can be argued that a mandate to replicate the performance of broad market indices could undermine effective resource allocation. Feldstein (1997) suggests that one of the virtues of a privately managed system is that private fund managers have an incentive to outperform the market, by investing in companies that perform well and selling shares in enterprises that perform poorly. Nevertheless, actual historical experience indicates that, on average, activist fund managers do not do as well as the market.

14. An important argument in favor of maintaining a public system is that a private system would have difficulty in dealing with the problem of annuities. Typically, the most desirable form in which to receive retirement income is an annuity, which provides a given level of income until death. A private system may have difficulty in converting the savings accumulated in the personal pension accounts into an annuity when individuals retire. Problems of adverse selection arise because individuals who have longer life expectancies would be more inclined to purchase annuities. As Diamond (1996) notes, no country has successfully organized a well-functioning annuity market and individuals who have chosen to purchase annuities have done so at high prices.

15. According to Diamond (1998), another important advantage of a publicly managed system is that it would likely entail lower administrative costs, compared with a privately managed system. Administrative costs for the privatized system in Chile are estimated to be 3 percent of the wage bill, which are higher than the approximately 1 percent of the wage bill it costs to administer Social Security in the United States. Mitchell and Zeldes (1996) suggest that these extra costs may be justified to the extent that private plans provide a wider range of services than Social Security. They argue that an arrangement, whereby individuals with different preferences can select the portfolio that is best for them, would be inherently superior to the current Social Security system. However, the choice of potential portfolios may need to be restricted in order to ensure that individuals invest prudently. If so, then the opportunity for product differentiation in the management of private funds could be limited. The primary vehicle for investing government-mandated pension contributions would be indexed funds, which would tend to be similar.

16. In Chile, the type of investment that can be undertaken with the individually owned and privately managed retirement funds is limited by regulators. Diamond (1998) suggests that the extra costs associated with the private management of the Chilean system may not result in substantial benefits for workers. For example, private providers of retirement funds and annuities incur advertising costs in an attempt to differentiate what may be essentially standardized products.

17. Diamond (1998) also points out that a publicly managed collective fund has the advantage of being able to spread the risk of market declines across different generations by borrowing or lending across time. For example, if current retirees were unfortunate and retired when stock prices were low, a publicly managed fund could subsidize their pensions, incurring a liability which could be paid by future retirees who retire when prices are high. This kind of risk sharing is obviously open to abuse, but it is a form of risk sharing that only the public sector can undertake because private agents cannot write contracts with unborn generations.¹³ A downside of this approach is that it breaks the link between individuals’ contributions and their benefits. This may be a price worth paying, however, for the increased insurance that would be provided against adverse market outcomes which could occur.

18. Proponents of private ownership maintain that the creation of individual accounts would reduce disincentives to work by making the system more transparent. With individual accounts, the link between an individual’s contributions and benefits becomes direct and obvious. With a publicly owned system, the link is not as strong or clear.¹⁴ Thus, the work disincentives of a privatized system would be less than under a publicly owned system. The counter argument is that a system of individually owned accounts would substantially weaken the redistribution in favor of low-wage workers that is a feature of the current Social Security System. In order to address this issue and to provide a secure, stable benefit to retirees, all privatization plans include a minimum benefit. However, once an element of redistribution is introduced into the system, an element of taxation also is necessarily introduced. The link between total contributions and total benefits is broken (at least at the margin), and disincentive effects reappear. It is not immediately obvious, therefore, that the taxation element, and the associated work disincentives, would be lower in the case of a privatized system than in the case of the current system.