TCS Daily


Demography, Disaster and Destiny

By Megan McArdle - October 21, 2003 12:00 AM

Last week, I wrote a column arguing that Social Security and Medicare are about a decade away from turning into the sucking chest wound of the Federal Budget. I pointed out that the day is rapidly approaching when the benefits we've promised beneficiaries start to exceed the amount we're collecting in payroll taxes: Medicare starts running a deficit in 2013 and Social Security four years later. When that happens we'll be faced with four options: cut benefits, raise taxes, cut other spending, or borrow money (which itself only defers the need to do one of the first three.)

 

But all of these options are so unpleasant. Isn't there some other way?

 

The answer is that there's no easy way to fix our pensions problem, though there are several things we ought to do to make our retirement system more sustainable.

 

Demography Is Destiny

 

To understand exactly why Social Security is so troubled, it's helpful to stop thinking about our looming fiscal crisis, and think instead about the demographic problem that's causing it. For all the exhaustive arguments about tweaking benefit levels, changing the structure of FICA, or raising taxes, the main problem with social security is devastatingly simple. While there are currently 3.3 workers in the workforce supporting every retiree, in the 2040's -- when the Social Security Administration's projections show the program falling off the cliff into insolvency -- there will be fewer than 2, due to a combination of falling birth-rates and longer lifespans. Any long term solution, therefore, must do one of two things: increase the ratio of workers to retirees, or increase the productivity of the workers so that they can support themselves, and the retirees depending upon them, in the style to which everyone has become accustomed.

 

Changing the ratio of workers to retirees is probably easier. Increasing the number of workers, indeed, could be a lot of fun; the most obvious way to do it is to make more babies. Barring that, we can import more workers. Social Security is basically a Ponzi scheme; we could keep it going for an indefinite period of time by adding fresh victims to the bottom of the pyramid.

 

But while opening up the floodgates to immigrants who can staff our old-age homes and geriatric wards while shoring up our retirement funds may be necessary, it will not be sufficient. Even if we can muster the political will to let in more immigrants (which is by no means a foregone conclusion), most immigrants admitted under our current policy have fewer skills, and are therefore less productive, than American workers. It might take two poor Guatemalan farm girls to replace every retiring American payroll manager.

 

Even if you are unfazed by the moral implications of importing workers to America so they can take care of Mom while you fleece them of their payroll taxes, we would quickly run out of space to put them all in, and they would put considerable strain on our service infrastructure. Moreover, birth-rates are falling everywhere, not just in America; as developing economies improve, and their populations begin to level off, the supply of immigrants will eventually dry up.

 

If we can't increase the size of the workforce that much, what about shrinking the number of retirees? Certainly, that would help. Various groups have already suggested two ways we could do this: means-testing benefits, so that the rich are disqualified; and raising the retirement age.

 

Of these, pushing up the age at which people leave the workforce is less politically attractive, but more effective. People are living longer and healthier lives than ever; there's no reason that a medically advanced post-industrial society should cleave to a retirement age set in an era when most people made their living by gruelling manual labor. We can almost surely raise the retirement age to 70 with minimal problems -- except, of course, for the mob of angry seniors marching on Washington.

 

At some point, however, this strategy will cease to work. Medical advances will likely continue to expand life-spans, even as birth-rates keep dwindling. How far can we raise the retirement age? 80? 90? Eventually, we will reach a point where the majority of people in retirement are simply unable to work; if they are pushed off Social Security, we will have to support them on some other program, such as disability, or let them starve. This is not a net savings.

 

Means testing is likewise an incomplete solution. A paper from the Bureau of Labor Statistics puts the percentage of elderly households with incomes above $100,000 at less than 5%. We could certainly save the system some money by eliminating their benefits, but getting rid of less than 5% of the beneficiaries is not going to make the system solvent. And means testing faces vehement political opposition from senior citizens groups who believe -- correctly -- that tampering with the universal coverage of Social Security will erode its support among the electorate.

 

Furthermore, talking about means testing and the various other benefit tweaks that have been proposed to eke out a few more years of life for the system ignores the more fundamental problem of demographic change. For a minute, let's ignore cash flows -- hard though your payroll taxes may seem to ignore -- and just think about the limited supply of goods and services we, as a society, can produce. If we think about consumption, rather than cash, it doesn't matter whether wealthy retirees get their retirement money from a government check, or a dividend payment. Either way, they are expecting to live off the efforts of an ever-shrinking pool of workers. Just bouncing rich seniors off Social Security doesn't change the fact that they are consuming considerable quantities of goods and services, without producing any.

 

At this point, you may be wondering -- if the shrinking workforce is such a problem, what does that mean for privatization schemes, like the one President Bush proposed for diverting 2% of a worker's income from the Social Security system into private accounts? If what we really need to worry about is consumption rather than cash flows, does that mean that privatization is useless?

 

The Role of Privatization

 

Absolutely not. Privatization will be a major component of any long-term solution to the Social Security crisis. Why? Because private accounts increase our national savings. Unlike money given to the government, which overwhelmingly goes into current spending, money invested in the private sector is used to do new research, invent new products, and buy new facilities and equipment -- all of which will eventually make our future workers more productive. When we've gone as far as we can go towards changing the ratio of retirees to workers, privatization can take us the rest of the way by increasing the output of the workers we have left so that both workers and retirees can continue to live in comfort. It can also improve the efficiency of our economy by stopping the Social Security surplus -- which people think is being saved for their retirement -- from being funnelled into wasteful spending by legislators, on things they presumably wouldn't fund if they had to beg their constituents for the tax increases to pay for them.

 

But privatization is risky, say advocates of the status quo. And of course, that's true to some extent, but right now, we have a choice between private sector risk, and the 100% certainty of demographic and fiscal disaster. And there are a number of ways to mitigate the risks of private accounts, such as requiring that a certain percentage be invested in index funds or bond portfolios.

 

But privatization is expensive, say those selfsame advocates. And there they have a better argument; while privatization will be effective, it will not be painless. Andrew Biggs of the Cato Institute estimates that the kind of really ambitious program we want -- one that reserves 5% of a worker's salary (out of the 12.4% payroll tax) -- would increase the unified budget deficit by approximately $200 billion a year for the next 40 years. That's 2% of GDP, a big number, though the other elements of reform I've discussed -- means testing, raising the retirement age, and increasing immigration to grow our labor pool -- could lower it substantially.

 

Faced with allocating 2% of national income merely to making Social Security solvent -- and being asked to delay our retirement to boot! -- it's tempting to do what we've done in the past: put it off for another couple of years, hope for a miracle, and try not to think about what will happen if one doesn't materialize. But as I pointed out in last week's column, it's too late for that. One way or the other, the bill for our changing demographic is going to come due, and soon. We can bite the bullet now, and restructure our retirement benefits so that the system is sustainable -- or we can continue to dance on the edge of disaster for a little while longer, hoping to foist the bill on our grandchildren.

 

Morally, I'd say the choice is clear. But pragmatically, too, it behooves those of us who plan on sticking around for a while to invest in the future. Otherwise, we risk being among the dancers who get crushed when Social Security finally falls over the cliff.

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