TCS Daily

Economics of Social Security Privatization

By Arnold Kling - December 15, 2004 12:00 AM

"To 'work,' privatization must generate more money for retirees than current arrangements. This bonus is supposed to be extra money in retirees' pockets and/or it is supposed to make up for a reduction in promised benefits, thus helping to close the looming revenue gap.

"Where does this bonus come from? There are only two possibilities: from greater economic growth, or from other people."
-- Michael Kinsley

Michael Kinsley is correct to be skeptical that privatization will generate a bonus large enough to eliminate the gap between the promises made to future recipients and the likely revenue to pay for those promises. In that sense, privatization will not "work." Neither will the status quo.

To a first approximation, Social Security's imbalance is not made better or worse by privatization. Instead, economic analysis suggests that the effects of Social Security privatization will be subtle and small relative to the challenges that lie ahead. A much more powerful tool for addressing the problem would be to increase the age of dependency, also known as the Social Security retirement age.

Social Security is a Transfer Mechanism

Contrary to what many people believe, Social Security is not a pension plan, in which your "contributions" go into a reserve fund, to be paid back when you retire. Instead, your Social Security taxes are used to pay current beneficiaries. In return, you receive a promise from the government to tax future workers in order to pay for your benefits.

Social Security's long-term problem is that the ratio of workers to retirees is falling, so that the tax rate on workers must rise. In the near term, some of this drop is due to the aging of the Baby Boomers. However, more fundamentally, it is due to the steady increase in longevity, part of what Nobel Laureate Robert Fogel calls "technophysio evolution."

Compared with the 1930's, when Social Security was enacted, we are living almost 15 years longer, while the Social Security retirement age has been raised only a few years. Because of the failure to index the dependency age to longevity, the ratio of recipients to taxpayers has climbed to levels that are difficult to sustain.

Privatization's Primary Effect

If private accounts were created, then as a worker some of your contributions to Social Security would be diverted from current beneficiaries in order to go into accounts under your control. This would make Social Security more like a pension plan and less like a transfer scheme.

However, if your contributions go into your own account, then payments to current beneficiaries have to come from somewhere else. Chances are, most of the money would be borrowed by the government. This additional borrowing often is referred to as a "transition cost."

The "transition cost" is not a real cost. It is an accounting change, in which off-balance sheet obligations of the government (the promises that are made to you under the current Social Security system) are exchanged for on-balance sheet debt. I have used the analogy that Social Security's unfunded liabilities are like a worn-out roof, and privatization is like paying for a new roof. If you were not counting the worn-out roof as a liability, then it may appear that there is a "transition cost" to fixing the roof. In fact, the cost of not fixing the roof is just as high or higher.

On the other hand, using debt rather than payroll taxes to fund current beneficiaries would have one important real effect. It would shift the overall tax burden away from payroll taxes and toward general revenues, which means primarily income taxes. Thus, the transition toward privatization would make the funding of Social Security more progressive, meaning that relatively more burden falls on the rich and relatively less falls on the poor. In that regard, it is somewhat surprising that the Left opposes privatization and the Right supports it.

Subtle Effects

There are some subtle effects of privatization that might change the accumulation of capital in the United States. The potential magnitude of these changes is difficult to assess.

One effect could be to shift the composition of portfolio holdings so that Americans invest more in stocks and less in bonds. If stocks are under-valued, as they have been historically, this would improve the allocation of capital in the United States. To believe that this will happen, you have to believe that U.S. capital markets are inefficient today, and that their efficiency will be improved by steering more people toward ownership of stocks. Greater efficiency would increase economic growth, which, as Kinsley points out, is a way for privatization to improve the outlook for the future. Conservative economists are inclined to view markets as efficient, so that privatization would not cause such a portfolio shift. Therefore, this is another argument for privatization that is more likely to be supported by the Left (for example, Berkeley economist Brad DeLong) than by the Right.

Another effect could be a shift toward less government spending or higher taxes in the near term, because of Congressional concern with the higher deficits that otherwise would accompany the transition to privatization. If Congress behaves this way, then by the same token in the long term these effects would be reversed. That is, in the long term privatization would reduce the government's Social Security obligations, leaving more room for higher spending or lower taxes.

Finally, privatization could increase the incentives for work and thrift. Under privatization, if you work harder and earn more, this increases the funds in your own account. If you are relatively more dependent on your own saving and less reliant on government support, then you have a greater incentive to save. Anything that increases work and thrift tends to raise economic growth. Harvard's Martin Feldstein has argued that these effects could be quite large, on the order of hundreds of billions of dollars per year in higher national output for a complete transition to privatization.

Social Security threatens to become an increasing tax burden on young workers, primarily because the age of eligibility to receive benefits has lagged behind increases in longevity. Privatization does not alter that situation. It serves primarily to shift the funding mechanism for current beneficiaries, moving it away from payroll taxes and toward personal and corporate income taxes. Privatization may increase economic growth by stimulating work and thrift, and perhaps also by increasing the value of stocks relative to bonds and by putting pressure on Congress to reduce spending or increase taxes in the near term. To the extent that these mechanisms do raise economic growth, the overall burden of Social Security on young workers will be reduced. However, it is by no means certain that the increased growth will be sufficient to make the burden bearable as the ratio of workers to retirees continues to fall.


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