TCS Daily

Four Myths About Social Security

By Arnold Kling - October 27, 2004 12:00 AM

"No matter what plan he chooses, any privatization would also come with so-called transition costs, the initial increase in the gap between worker contributions and retiree benefits that would result as workers send part of their payroll taxes into private accounts.

"Estimates of the gap vary -- it's the '$2 trillion hole' that Kerry refers to in his speeches -- but there's no question that money would have to be moved into the system to make up for the money moved into private accounts.

"The bottom line? In the end, whether it's now or later, a generation of Americans has to pay."
-- CNN/Money

The transition cost myth is one of four Social Security misconceptions that I want to address here. The others are the misconception that Social Security is a pension, the misconception that the Baby Boom is the main problem with Social Security, and the misconception that Medicare is in worse shape than Social Security. Although there is an element of truth behind each of these misconceptions, what is reported in the press and believed by the general public is more myth than reality.

The Pension Myth

The central myth of Social Security is that it is a pension plan. This myth keeps the vast majority of the public completely in the dark as to what the issues are relative to Social Security.

Real pension plans pay benefits out of accumulated funds, known as reserves. As workers contribute to a pension plan, the funds are invested, growing into reserves. To be actuarially sound, and legal, a pension plan must build up enough reserves to pay its obligations to retirees. In a defined-benefit plan (meaning that the company providing the pension promises a given level of benefits regardless of investment performance), if there is a shortfall in reserves the company must supply more funds to make up the difference. Under no circumstances is it legal for the company to raid the contributions of its current workers in order to pay current retirees.

Defined-contribution plans, in which a worker's contributions are held and invested in a separate account until retirement, are even more strictly protected from transfers between employees and retirees. Your account is your account, and the funds in it could never be used to pay for someone else's retirement benefits. Any attempt to do so would constitute theft.

What would be considered theft in a private pension plan is the standard operating procedure for Social Security. That is, benefits paid to retirees come from the taxes paid by current workers. As a worker, you have no assets in your Social Security "account." Nor are your tax payments being used to build up reserves. All you have in return for your Social Security "contributions" is the promise of the government to pay your benefits in the future out of someone else's taxes.

The Transition Cost Myth

If Social Security were a pension, then the transition to private accounts would be simple. One day, at the stroke of a pen, the government would transfer the funds that had accumulated in your Social Security account into a personal private account, and the transition would be complete.

However, everyone who really understands Social Security knows that there are no funds accumulated in your Social Security account, or in anyone else's. Since Social Security cannot stop paying benefits, particularly for people already retired, there is a "gap." That is, if we reduce Social Security taxes on a young worker by $1000 in order to allow her to invest the money in her own account, then the government has to find another source for that $1000 in order to pay current retirees. Multiply this by hundreds of millions of taxpayers for a couple of decades.

In practice, the government would have to borrow hundreds of billions of dollars in order to fill this "gap." Opponents of private accounts call this the "transition cost" and flaunt this cost as a barrier to privatization. Senator Kerry used the term "catastrophe" to describe the transition cost.

The transition cost is a myth. In economic terms, the transition cost is zero.

From an economic perspective, the transition exchanges an off-balance sheet obligation of the government for an equal-value on-balance sheet obligation. It makes government accounting more honest, without changing the underlying debt structure.

When your Social Security taxes are reduced by $1000, the government will reduce its obligations to pay you Social Security by an equivalent amount. That is what partial privatization means -- you have to take that $1000 and invest it yourself, because the government is reducing its future payments to you.

Partial privatization means that you have more disposable income now, but the government is going to give you less later. Conversely, it means that the government must borrow more now, but it will owe you less later. These effects would wash out if the accounting were done correctly.

One way to eliminate the "transition cost" to partial privatization would be to first undertake a transition to better accounting. If the government were to put future Social Security obligations on its balance sheet as debt, then the accounting would be accurate. To borrow a locution from Warren Buffet, if promises to make Social Security payments are not a financial obligation of the government, then what are they? And if a financial obligation of the government is not debt, than what is it?

If unfunded liabilities to make future Social Security payments were counted as debt, then partial privatization would be nothing but a debt swap. The government would increase ordinary debt and reduce unfunded-liability debt by an equal amount. The transition cost would be zero.

(This debt swap might have economic effects, for a variety of subtle reasons. For example, myopic consumers might spend too much in the short run and save too little for retirement. Or myopic politicians might reduce government spending in the short run because the traditional deficit measure would be higher in the short run -- and lower in the long run.)

(Other economic effects are microeconomic. It might shift more funds from bonds to stocks, which could reduce an allegedly excessive risk premium for stocks, a point made by Brad DeLong and one which is much more subtle than the "stock market scenario" that I dismiss -- a scenario in which stocks are assumed to earn 7 percent real returns forever, magically bailing out Social Security. Most importantly, by better connecting effort to income, private accounts could reduce the disincentives to work and thrift of government retirement systems, a point spelled out by Alex Tabarrok.)

The Baby Boomer Myth

Because Social Security is a transfer mechanism and not a real pension, the critical driver of its financial condition is the ratio of workers to retirees. If that ratio is high, so that there are plenty of workers relative to retirees, then the system can be funded at a low tax rate. However, if the ratio of workers to retirees is low, then the workers have to be taxed heavily in order to fund the system. The trouble is that high tax rates create a wedge that could drive too many workers out of the paid labor market.

As I pointed out in a TCS article here, the Baby Boom raises the ratio of workers to retirees while the Boomers work, and then lowers it when we retire. So the Baby Boom does indeed affect the key ratio of the Social Security system.

However, as these charts show, even after the Boomers die off, the ratio of workers to retirees is not expected to recover. In the United States, this ratio, which is over 4.5 today, is projected to decline to just about 2.5 by 2030 or so, and then to level off thereafter. In Europe and Japan, the ratio is declining faster and will fall farther, making their retirement systems even more unsustainable than ours.

Our population is reproducing slowly and getting older. As these charts illustrate, we are extending the lifespan for people over the age of 65. This improvement in medical care, combined with a fixed retirement age, serves to increase the ratio of retirees to workers.

The bottom line is that Social Security faces a demographic challenge that goes beyond the Baby Boomer retirement issue. The retirement age has not kept up with gains in longevity, which means that the system is getting more and more out of balance as health care and technology improve.

The Medicare Myth

Another myth is that Medicare is a bigger problem than Social Security. This myth is based on two truths. The first truth is that spending on Medicare is rising faster than spending on Social Security. The second truth is that the excess of future obligations over future tax receipts is higher with Medicare than it is with Social Security.

However, from an economic point of view, what matters is the total amount of money needed to fund Social Security and Medicare, and the tax burden that this total implies. The fact that Social Security is less insolvent than Medicare reflects nothing other than the fact that Social Security taxes are much higher than Medicare taxes.

Because Social Security taxes already are high, we can "solve" Social Security with a relatively small tax increase. It takes a larger tax increase to "solve" Medicare. However, from an economic perspective, what matters is the total taxes needed to "solve" both. And in that regard, Social Security obligations loom large. Social Security outlays are still more than double the outlays for Medicare.

To put this another way, we could "solve" Medicare by shifting a large portion of Social Security taxes to pay for Medicare. However, we cannot do this, because the money is needed to pay Social Security.

The bottom line is that we need to deal with both Social Security and Medicare. The government has limited tax-raising capacity. Both programs use up a lot of that capacity. Projections are that by the middle of the century, they will use up more than 100 percent of our tax-raising capacity. To point the finger at Medicare as a justification for leaving Social Security alone completely misses that point.


My view has always been that the crux of the issue in Social Security and Medicare is the ratio of beneficiaries to taxpayers. The implications of this are:

1. Privatization is not a panacea. I think that privatization is a good idea, but the benefits from privatization will not be sufficient to rescue Social Security.

2. The retirement age is the most logical and effective policy lever. See Phase Out Medicare and the other essays in the last part of my book.

For the public, I recommend keeping in mind the main lessons of this essay. Social Security is a transfer scheme, not a pension plan. The economic effects of a transition to privatization would be subtle and small, probably beneficial, and certainly not catastrophic. The demographic problems with Social Security go well beyond the Baby Boom retirement bulge. Finally, the fact that Medicare's obligations are rising faster relative to Medicare's smaller tax rate does not imply that Social Security's imbalances are minor.


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