TCS Daily

Tomorrow's Economy Today

By Peter Ferrara - July 23, 2003 12:00 AM

A new international study published by the National Bureau of Economic Research shows that Social Security causes workers to retire earlier. The retirement age chosen for a Social Security program causes a reduction in labor force participation around that age by one-fourth to one-third. Despite the widely varying retirement ages in the programs of the 12 countries studied, the researchers still found the same work-reducing effect clustered around the program's retirement age in each country.

That is a lot less workers, which translates into significantly less output and overall GDP. The early retirement age under the U.S. Social Security system is 62, and over the years the program seems to have induced a large movement towards retirement in the early 60s. With life expectancy lengthening considerably, and modern medicine likely only to accelerate that trend, such early retirement is unsustainable, absent some massive improvement in overall economic growth.

But this is only one of the relatively minor effects of Social Security in reducing output and economic growth. When all of these effects are considered together, the conclusion is inescapable that Social Security as currently structured has sharply reduced national wealth and income.

About 30 years ago, NBER Chairman and Harvard Economics Professor Martin Feldstein began writing about probably the biggest economically disabling effect of the program -- the program sharply reduces national saving and investment. Workers think they are saving for their retirement with the taxes they pay into Social Security. So those taxes displace retirement savings they would otherwise make.

But Social Security itself does not involve any savings and investment. It operates basically on a pay-as-you-go basis. The taxes paid into the program today are mostly paid out to finance today's benefits. The future benefits of today's workers are then to be paid not out of their savings but out of future taxes paid by workers at the time.

The result is a net loss of savings and investment. With the Social Security taxes that finance retirement benefits currently running at about $450 billion per year, or about one-fourth of total annual private savings, that net loss could be quite large.

The effect can be seen as well by focusing on the benefit side. The worker need not save for the portion of retirement benefits provided by Social Security. Indeed, the worker can reduce retirement saving by the present value of future Social Security benefits. But since Social Security again does not involve any significant savings or investment, the result is a net loss in these critical economic assets. On this analysis, just as the farm programs used to pay farmers not to grow crops, Social Security benefits can effectively be seen as paying workers not to save for their retirement.

Feldstein buttressed his analysis with substantial econometric work concluding that Social Security reduces national saving by 40 percent, or more. Studies by others have varied from finding quite similar effects to finding effects only about half as large. But even at the lower estimates, the loss of savings and investment would reduce national GDP by about 5 percent per year. At Feldstein's original estimates the loss of GDP would be about 10 percent a year. With GDP currently running about $11 trillion a year, we are talking about losses here in the range of $500 billion to a trillion dollars per year.

But there is still more. The payroll tax sharply reduces the net wages workers receive for working. The loss of savings and investment means lower productivity and so less wages as well. This reduces the labor supply and causes other distortions in labor markets. Feldstein estimates that the result is another loss of GDP of 1 percent per year.

However, with a true personal account option for Social Security, these effects can be reversed, producing a large increase in economic growth, national income, and GDP. In a recent study published by the Institute for Policy Innovation in Texas , I proposed a personal account option that would allow workers to shift 5 percentage points of their payroll taxes into the accounts, but on the first $10,000 of wages for each worker this would be doubled to 10 percentage points. With this progressive account, workers on average would be shifting about two-thirds of the current payroll tax for retirement benefits to the accounts.

With workers heavily exercising the personal account option, as they have in other countries, the result would be hundreds of billions in savings and investment pouring into the economy through the accounts. While workers may offset some of this by reducing saving elsewhere, most workers have very little in other savings that they can reduce. Moreover, the accounts represent a new, very large tax-free shelter for saving and investment, amounting to a large tax cut on capital. Workers who exercise the account option also need new savings to replace Social Security benefits through the account. All of these factors indicate the potential for a large increase in savings and investment as a result of the account option.

In addition, the money paid into the account is no longer a tax, but the worker's own money held in his own personal account. The perceived compensation from working would consequently rise. The increase in savings and investment through the accounts would also produce higher wages. Over time, the remaining one-third of the Social Security retirement taxes that workers would not be paying into the accounts can and should be eliminated. The overall result would be a very large reduction in taxes on labor as well, which would eliminate the labor market distortions discussed by Feldstein, and add substantially to the increase in economic growth and national income resulting from the reform.

Finally, workers with the accounts would have considerable freedom of choice over their retirement age. But if they retire early, they would be financing that entirely themselves out of their own account. This should focus the decision more carefully on exactly when workers want to retire. Many workers may well continue to retire in their early 60s from their longtime career, but use their time and accumulated capital to start new, small, self-employment ventures that are well suited to continuing work for many more years. As people live longer and longer, such second careers drawing on the store of experience, contacts, skills and wisdom of older workers may well become the norm. In any event, with the personal accounts, workers who withdraw their productive labor from the economy would at a minimum be replacing it with their productive savings and capital, to maintain their incomes.

Shifting Social Security from a non-saving, simply redistributive, pay-as-you-go system to a fully funded savings and investment system is, in fact, the central linchpin to the development of the modern, 21st century economy. The emerging, cutting edge, advanced technologies of today and tomorrow will require vast amounts of capital for practical implementation. From the medical applications of the new biotechnologies, to deep seabed mining, to space stations and commercial space flights, and so much more, huge amounts of capital will be needed. Fundamental Social Security reform may well be the catalyst that leads to the arrival of tomorrow's economy today.

Peter Ferrara is Director of the International Center for Law and Economics.

Jonathon Gruber and David Wise, Social Security Programs and Retirement Around the World: Micro Estimation, NBER Working Paper No. 9407, July, 2003. The study examined the conduct of workers in 12 countries: the U.S., Japan, the United Kingdom, France, Italy, Germany, Spain, Sweden, Canada, Denmark, the Netherlands, and Belgium.

Martin Feldstein, "The Missing Piece in Policy Analysis: Social Security Reform" American Economic Review, Vol. 86, p.1 (May 1996).

Peter Ferrara, A Progressive Proposal for Social Security Personal Accounts, Policy Report 176, Institute for Policy Innovation, Lewisville, Texas, June, 2003.

For the net increase in savings and investment to occur, the government must also not completely offset it by the means it uses to finance the transition to the new system. In my study for the Institute for Policy Innovation, I propose transition financing that would avoid that problem. Id.

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