TCS Daily


Social Security's Worn-Out Roof

By Arnold Kling - December 2, 2004 12:00 AM

"I've always been a great believer in Samuelson's great comment that any concept in economics that you could not explain to your father in law would eventually be proven wrong. Would you explain the difference between 'economic costs' that you say do not exist and 'cash flow costs'"
-- spencer

I cannot vouch for whether Paul Samuelson ever made the comment attributed to him by this chap spencer (it doesn't sound to me like something Samuelson would believe), but I am willing to take up spencer's challenge of explaining Social Security privatization costs clearly.

Let me start with an analogy. Suppose that your house has a very dilapidated roof. The next big winter storm is likely to cause huge damage unless it is repaired. So you borrow $20,000 and fix the roof.

What is the cost of this transaction? The "cash flow cost" is that you have to pay back the loan. Until you complete the payments, you will have less money available to buy a fancy home theater system or a new Jacuzzi.

The economic cost of this transaction may be zero. In an economic sense, you have exchanged a certain, visible cost -- the cost of repaying the loan -- for an uncertain, invisible cost -- the cost of trying to get through winter with a dilapidated roof. Chances are, if you did not fix the roof, you would still not be able to afford the home theater system or the Jacuzzi, because a storm could cause water damage and force you to pay huge repair bills.

Another way to put this is that the dilapidated roof is an off-balance-sheet liability. It does not show up in your statement of net worth, but the liability is there nonetheless. When you pay to repair the roof, you eliminate the off-balance sheet liability. However, you acquire a new liability -- the $20,000 loan. That new liability is on your balance sheet.

Social Security's Worn-Out Roof

Social Security's dilapidated roof is its unfunded liability. As I have pointed out before, your Social Security "contributions" do not go into a reserve account. Instead, they are used to pay for the benefits of current retirees. What you get in return for your contributions is the government's promise to tax future workers to pay for your benefits. That promise is the unfunded liability. Like the dilapidated roof, it is a liability that does not show up on the balance sheet.

Suppose that we want to reform Social Security so that your contributions go into a reserve account. One particular form that this reserve account could take would be a savings account in your name and under your control (within limits). That is called "privatization." But any reform that creates a reserve will have the effects discussed in the rest of this article.

Your contributions that go into a reserve account cannot be used to pay benefits to current retirees. The government will have to borrow additional money in order to meet its obligations. However, by the same token, because of the reserve account, when you retire the government will not have to find as much money to pay for your benefits. The additional borrowing in the short term is like taking out a loan to repair the roof. But just as the new roof reduces future maintenance costs, putting your contributions into a reserve fund reduces the government's future cost of providing Social Security benefits.

If "privatization" or a similar reform were to be enacted, the government would have to borrow more money. That would be the "cash flow cost." However, the economic cost is zero. The government is extinguishing an off-balance-sheet liability (unfunded promises to pay benefits) and creating an equivalent on-balance-sheet liability (new debt). To put it another way, the government's "cash flow cost" incurred today will be offset by a "cash flow benefit" many years from now, as you receive lower tax-financed benefits and instead live off your reserve account. The net effect is essentially a wash.

Alternatives to Borrowing

Just because you could borrow $20,000 to fix the roof does not mean that you should do so. It might be better to pay some of the cost in cash, even if that means working harder or cutting back on spending.

Similarly, the government has other options for dealing with the transition to "privatization." Jose Pinera recently described how Chile achieved its successful reform.

"We used five 'sources' to generate that cash flow: a) one-time long-term government bonds at market rates of interest so the cost was shared with future generations; b) a temporary residual payroll tax; c) privatization of state-owned companies, which increased efficiency, prevented corruption and spread ownership; d) a budget surplus deliberately created before the reform (for many years afterward, we were able to use the need to "finance the transition" as a powerful argument to contain increases in government spending); e) increased tax revenues that resulted from the higher economic growth fueled by the personal retirement account system."

For the United States, the relevant options are listed below, along with their drawbacks.

Option

Drawback

Status Quo (no reform)

Passes Cost to Future Generations

Borrow

Passes Cost to Future Generations

Raise Taxes

Could Discourage Work, Thrift, and Risk-taking

Cut Social Security Benefits

Hard to do fairly

Cut other government spending

Drawback depends on your point of view

It is important to understand that, to a first approximation, there is no difference between maintaining the status quo and undertaking privatization that is financed entirely by borrowing. Either way, future generations have a liability. Under the status quo, that liability is off the government's balance sheet, like the dilapidated roof. Under privatization, the off-balance sheet liability is extinguished in exchange for debt that appears on the balance sheet.

As I have pointed out elsewhere, privatization financed by borrowing would have some advantages relative to the status quo. In particular, it would create a "lockbox" that would keep government from adding to the disconnect between its promises and the ability to find tax revenue to make good on those promises.

However, if I were advising Congress, I would not recommend borrowing 100 percent of the money needed to fund the transition. Instead, what I would recommend is using all four methods for funding a transition to privatization: borrowing, raising taxes, cutting Social Security benefits, and cutting other government spending. For example, the government could borrow 70 percent of the necessary funds, and obtain the remainder in equal amounts from the other three methods.

The drawback to raising taxes is that taxes tend to discourage the activities that create wealth. The desire to minimize this drawback explains why TCS contributor Lawrence Kotlikoff, among others, links tax reform with Social Security reform. One idea is to introduce a value-added tax, as I discussed here.

Cutting Social Security benefits is difficult to do in a fair way. One approach, advocated by Tyler Cowen, is "means testing," which would maintain benefits for seniors who most need the income but reduce benefits for wealthier seniors. Another approach, which I have advocated, is indexing the retirement age to longevity. In that essay, I also discuss the idea of limiting benefit increases to the rate of inflation, as recently advocated by Republican Congressman John Kasich. Both the retirement age proposal and the inflation-indexing proposal are suited to gradual, long-term reductions in benefits. If we want to cut benefits for today's seniors, then only means-testing would appear to be palatable.

A final element in funding the transition to private Social Security accounts is reducing government spending on other programs. From some people's point of view, spending cuts would be "painful." But what others would see as difficult I would see as painless, even pleasurable. In fact, I've got a wish list of programs that I would like to see terminated -- Amtrak subsidies, agriculture subsidies, energy programs, etc.

Fix the Roof

There are serious decisions to be made concerning the best mix of methods to finance the transition that extinguishes Social Security's unfunded liability. Borrowing all of the money to fund the transition is probably not the best choice. But the economic costs of the status quo are, if anything, worse than a transition financed 100 percent by borrowing. If spencer or his father-in-law were to complain about the cost of fixing the roof, I would remind them that the cost of not fixing the roof is at least as great.


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