Replacing Social Security with a Genuine Trust Fund

June 22, 2000

by James Bradfield

James Bradfield is a professor of economics at Hamilton College, Clinton, NY 13323.

In the numerous discussions in the public press about privatizing Social Security there is one issue that has not received nearly the attention it deserves. The issue is the speciousness of the Social Security "Trust Fund."

Many authors of papers in the Cato Series on Social Security Privatization ¹ clearly understand this issue, and several of these authors allocate some attention to it. But in the popular press there is scarcely any recognition that the trust fund is specious. The typical popular analysis of Social Security in general, and privatization in particular, is misleading, and sometimes incorrect, because it misuses the concept of a trust fund. Indeed, some of the statements on privatization by politicians seem intentionally misleading.

The editor of The Wall Street Journal, Robert L. Bartley ², sought to disabuse the public of the politicians' highly misleading use of the term "trust fund" when assessing the financial viability of Social Security. Mr. Bartley described Social Security as a "pay as you go" system, and then explained how the continuing decrease in the ratio of workers to retirees will soon jeopardize this system.

Perhaps the expression "transfer as we go" is a better description of Social Security. Social Security simply transfers purchasing power from those now working to those now retired. This will remain true in future years when the government calls on future taxpayers to redeem bonds taken from the “trust fund” to cover the shortfall between the social security taxes collected and the benefits paid in those future years. There are no real capital assets to support the government bonds now held in the Social Security "trust fund." These bonds are simply claims against future taxpayers. [There is an exception here. To the extent that the government creates infrastructure by investing the excess of social security taxes collected over social security benefits paid, future taxpayers will be more productive than they would otherwise be.]

Privatization, however, would create a genuine trust fund.

Allowing workers to invest a portion (or all!) of their Social Security taxes in the stock market would increase the stock of real capital assets in the economy. The accumulation of these additions to the stock of real capital would be a genuine "trust fund," because the new capital would enable the economy to increase the production of goods and services throughout the future, including the years during which the workers who would now make the investments will be retired. It is, of course, ultimately real goods and services, not money, that will support retirees.

The new real capital created by the private investment of money formerly collected as Social Security taxes would partly (and potentially fully) obviate transfers from workers to retirees. The retirees’ benefits would be funded by the output of goods and services generated by the additional real capital that would have been created by those same retirees during their working years. ³

Some of the money that workers would invest would purchase existing securities from investors who wish to disinvest, perhaps to finance their own retirements. These investments by current workers would increase liquidity for all investors. But a portion of the inflow of money formerly collected in social security taxes would be used, directly or indirectly, to finance an expansion of real capital goods through the purchase of IPOs and secondary issues of new securities. The new capital goods created would include intangible assets, such as new computer operating systems, as well as tangible assets, such as office buildings, homes, and railroad cars.

Of course, investment in the stock market is not without risks. But these risks are typically overstated by opponents of privatization, who ignore the distinction between short term and long term risks of investment in the stock market. The opponents of privatization also ignore the fact that the current system imposes substantial political risks on workers because they have no property rights to pensions under Social Security. ⁴ Their pensions will be determined by future Congresses, that will be elected in part by future generations of workers. These future workers might not tolerate the increases in taxes that will be necessary if the persons who will then be retired are to receive the same levels of transfer payments that current retirees do.⁵

2 "Economics 101 on Privatizing Social Security," The Wall Street Journal, May 22, 2000, p. A30.

3 For an explicit proposal for privatization that benefits young workers without harming older workers and current retirees, see David Altig & Jagadeesh Gokhale, "Social Security Privatization: One Proposal," Cato Institute Social Security Paper No. 9, May 29, 1997. See also Peter J. Ferrara, "A Plan For Privatizing Social Security," loc. cit. No. 8, April 30, 1997; Neil Howe & Richard Jackson, "The Myth of the 2.2 Percent Solution," loc. cit. No. 11, June 15, 1998 section "The Central Fallacy." For more general information, see Martin Feldstein, "Privatizing Social Security: The $10 Trillion Opportunity," loc. cit. No. 7, January 31, 1997; Karl Borden, "Dismantling The Pyramid: The Why And How Of Privatizing Social Security," loc. cit. No. 1, August 14, 1995; William G. Shipman "Retiring With Dignity: Social Security vs. Private Markets," loc. cit. No. 2, August 14, 1995.

4 See Charles. E. Rounds, Jr., "Property Rights: The Hidden Issue of Social Security Reform," loc. cit., No. 19, April 19, 2000.

5 For a detailed refutation of frequently raised objections to privatization, see Melissa Hieger and William Shipman, "Common Objections to a Market-Based Social Security System: A Response," loc. cit., No. 10, July 22, 1997.

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