Social Security Privatization

Testimony of Michael Tanner
Director of Health and Welfare Studies, the Cato Institute

1994-95 Advisory Council on Social Security

March 8, 1995

Mr Chairman, Distinguished Members of the Advisory Council on Social Security:

According to a recent public opinion poll, more young Americans believe in UFOs than believe they will receive their Social Security benefits. The unfortunate fact is that, while their views on extraterrestrial visitation may be problematic, their opinion on Social Security may be perilously close to correct.

Recently, the government's own actuaries lowered the date at which the Social Security Trust Fund goes bankrupt from 2036 to 2029. This represents the sixth time in seven years that the government has revised downward the bankruptcy date.

However, this estimate itself may be unduly optimistic because the Social Security Trust Fund is really little more than a polite fiction. For years, the federal government has used the Trust Fund to disguise the actual size of the federal budget deficit, borrowing money from the Trust Fund to pay current operating expenses and replacing the money with government bonds. The real crisis starts, therefore, not when the trust funds run out, but when they peak and start to decline. At that point the trust funds must start turning in bonds to the federal government to obtain the cash needed to finance benefits. But the federal government has no cash or other assets to pay off these bonds. It can only obtain the cash by borrowing and running a bigger deficit, increasing taxes, or cutting other government spending.

We should have learned by now that increasing the deficit is no longer a viable option. At the same time, Congress is already struggling with spending cuts. Making additional cuts in the future will be very difficult. In the past, Congress has resorted to increasing the payroll tax to postpone Social Security's financial reckoning. However, there are limits to how high the already burdensome payroll tax can be raised. Some estimates indicate that by 2040 a combined employer-employee payroll tax of 40 percent could be required to pay benefits.

However, I am not here today to talk about Social Security's financing problems. Others on this panel will do a far better job than I in addressing that looming crisis. I want to make another point -- that, even if Social Security's financial difficulties can be fixed, the system remains a bad deal for most Americans, a situation that is growing worse for today's young workers. Payroll taxes are already so high that even if today's young workers receive the promised benefits, such benefits will amount to a low, below-market return for those taxes. Studies show that for most young workers such benefits would amount to a real return of one percent or less on the required taxes. For many, the real return would be zero or even negative. These workers can now get far higher returns and benefits through private savings, investment, and insurance.

In a forthcoming study for the Cato Institute, financial analyst William Shipman considered the potential investment return under a variety of scenarios. The results are illustrated in the chart attached to this testimony. Mr. Shipman considered the examples of both high and low income wage earners born at three different dates (1930,1950, and 1970). Shipman then compared the social security benefits that the individual would receive with the potential return that the individual would have received if he or she had been allowed to invest an amount equivalent to the payroll tax in either stocks or bonds.

As you can see, the results are striking. In every case but one Social Security's benefits are below those earned in the capital markets.

If, as is likely, the system's impending financial crisis forces reforms such as raising the retirement age, means-testing benefits, or increasing the payroll tax, Social Security will become an even worse investment for today's young workers.

In 1981, Chile faced the same difficulties as presented by the U.S. Social Security system today. In response, the government allowed each worker the freedom to save and invest for his retirement in a private investment account, similar to an IRA in the U.S., rather than Social Security. Workers could also buy private life, disability, and health insurance through the accounts to replace public insurance, disability, and health benefits. Workers already in the old system at the time of the reform received government bonds for their past taxes that can be used to fund part of their future retirement benefits.

These reforms have been wildly popular, with more than 90 percent of workers choosing the private investment system. Required contributions are nearly 25 percent lower than under the old Social Security system. Yet, because the retirement funds earn full market investment returns, the new system is projected to pay much higher benefits. In addition, because the private system is backed by fully-funded investments, it stops the massive accumulation of long-term debt under Social Security and eliminates long-term funding deficits. Moreover, Chile's government credits the private retirement system with generating huge amounts of increased savings and investment, sharply increasing economic growth in that country.

Chile's reforms are seen as such a huge economic and political success that countries throughout Latin America, including Argentina, Bolivia, Columbia, and Peru, are beginning to implement similar changes. Mexico has implemented a new privatized Social Security system operating alongside its old state-run system. In Europe, Britain has allowed some people to opt out of its upper tier of benefits and Italy has begun to privatize some aspects of its Social Security system. Such reforms would ultimately be quite popular in the United States as well.

Senator Robert Kerrey and former Senator John Danforth recently suggested the first steps toward the privatization of Social Security in their recommendations as co-chairmen of the Bipartisan Commission on Entitlement and Tax Reform. They proposed that individuals be allowed to shift approximately 10 percent of their Social Security taxes to individual investment accounts. While this proposal does not go as far as I would like, it represents a sound first step on the road to reform.

It is time to recognize that Social Security is not a government pension program offering retirees reasonable benefits in return for their taxes. It is a coercive intergenerational transfer tax that relies on unrealistic assumptions and pays unreasonably low benefits.

Reform is long overdue. It may be too late to fix things for my generation. But if we fail to act soon, our children will be the next victims.