Martin Feldstein (1)
I believe that President Clinton made a very positive contribution to the development of Social Security reform even though he failed to achieve any Social Security legislation. In contrast, his tax policy had a quite negative effect as a result of one of the few significant pieces of legislation that he did succeed in enacting. I will begin by discussing Social Security and then turn to fiscal policy.
Social Security Reform
President Clinton performed a great service by alerting the American public that Social Security faces a long-run financing problem that is the inevitable result of the aging of the population, by establishing the goal of "saving Social Security" without increasing the payroll tax rate, and by proposing a role for equity investments in achieving that goal. The several policy options that he considered were all based on the correct idea that increasing national saving now, with the accumulated assets devoted to future pension benefits, would permit lower taxes later; in the language of economics, such a policy provides a favorable tradeoff although not an intergenerational Pareto improvement.
The Clinton speeches and the official national education campaign that he launched moved the discussion of investment-based Social Security reform away from an ideological debate about the merits of government versus private systems to the more technical issues of how to design a mixed system that includes both pay-as-you go benefits and investment-based defined contribution annuities. (2)
The specific Clinton administration proposals used the same key building blocks as the plans that were being developed by Congressional Republicans including Bill Archer, Phil Gramm, Newt Gingrich, John Kasich, Clay Shaw, and others. These building blocks included individual accounts, a freeze on the current payroll tax rate, maintenance of the same future expected benefits, and the use of equity investments. Although the way in which these building blocks were used differed between Republicans and the President - for example, making the individual accounts part of Social Security or supplemental to Social Security - the common building blocks provided a clear basis for a compromise in which Democrats and Republicans could both claim that the resulting plan reflected their own principles. (3) (4)
It is a great pity that this initiative failed. Such a Social Security reform would have been an extremely useful contribution to the long-term fiscal health of the nation and would have been a major political legacy for an administration that is short on bragging rights.
The failure to reach an agreement did not reflect irreconcilable differences between the president and the Congressional Republicans. Instead, according to knowledgeable Clinton administration officials, after the House Democrats provided the votes to prevent President Clinton's impeachment, the president acceded to their wish to drop Social Security reform so that they could use it as a negative issue in the upcoming Congressional elections.
But despite his failure to enact any Social Security legislation, President Clinton did change the debate (5), making it easier for George W. Bush to advocate a mixed Social Security program with investment-based personal retirement accounts during his presidential campaign. Bill Clinton had turned off the power on the "third rail of politics" that had previously prevented rational political discussion of Social Security reform.
Nevertheless, the partisan attacks on the Bush proposal during the presidential campaign now threaten to offset the fact that such a plan has much in common with what President Clinton and his team had developed. I hope that, after the bipartisan Social Security Commission reports later this year, Congressional Democrats will focus on the Clinton administration's contribution to these ideas rather than on the negative rhetoric of the election campaign.
In thinking about the Clinton and Bush proposals, it is interesting to ask why we in the Reagan administration did not offer a similar proposal in the early 1980s when a Social Security financing crisis occurred. (6) The Social Security Trust Fund was then about to hit zero and annual payroll tax revenue was not enough to finance benefit outlays. The Greenspan Commission proposed and Congress enacted a combination of higher payroll taxes and cuts in the benefits of higher income retirees (by subjecting benefits above a relatively high income exclusion to the personal income tax and injecting that extra tax revenue into the Trust Fund). Congress also voted to increase the normal retirement age from 65 to 67, but only after a delay of two decades. But there was no serious consideration of an investment-based solution.
President Reagan was very unhappy with the Commission's recommendations but was persuaded by political advisers that any proposed general reduction of benefits (through reduced inflation indexing or changes in the benefit formula) would be unsuccessful in the Congress and would be a long-term burden on future Republican candidates. The result was an immediate rise in taxes with the prospect of further tax rate increases in the more distant future.
I recall a meeting in 1982 at which President Reagan asked if there could be some alternative to tax increases or benefit cuts, some more fundamental reform of Social Security that would avoid the ever increasing tax burden that was already projected at that time. We had nothing to recommend.
Why didn't we propose investment-based accounts? There were two reasons. First, because the trust fund was empty and the overall budget was in substantial deficit, starting to fund investment-based accounts would have required a tax increase or an even larger overall budget deficit. What makes the current (and recent past) situation a unique opportunity for investment-based Social Security reform is that the Trust Fund now has substantial accounting reserves, the payroll tax revenues are much more than the amount needed to pay current benefits, and the overall budget is in surplus. (7) Ironically, the Reagan Social Security reforms produced the current large Social Security surpluses and the Reagan tax policies stimulated the growth and current tax revenues that together with general spending restraint in the 1990s provided the potential financing for the Clinton (and now Bush) investment-based Social Security options.
The second and more fundamental reason that we didn't propose an investment-based plan is that we did not understand that the tax increase needed to start such a plan is very small. We were put off by the common argument that the transition to an investment-based system (even a partially investment-based mixed system) would require the transition generation of employees to "pay double," i.e., to pay for the pay-as-you-go benefits of the current retirees and for their own account accumulation. It was only many years later, after research that I did with Andrew Samwick, that I realized that even a complete transition to an investment-based system can be done with annual additional contributions of less than one percent of GDP. (8) Unfortunately, we will never know how President Reagan would have responded if he had been given such an option.
I can speak more briefly about the fiscal policy of the Clinton years because not very much happened. The key fiscal action was the 1993 tax increase in which the top marginal
statutory personal tax rate rose from 31 percent to 42 percent (including the effect of eliminating the ceiling on income subject to the 2.4 percent Medicare payroll tax ) and the Alternative Minimum Tax (AMT) expanded . Both changes were in principle aimed at collecting more revenue and doing so from high income taxpayers. There was no fundamental improvement of the tax system comparable to the Tax Reform Act of 1986 which redefined taxable income, changed the tax rules relating to business investment, and slashed personal tax rates.
The primary fiscal development during the Clinton years was the shift from a sizeable budget deficit to large budget surpluses as tax revenue rose rapidly. Although it is tempting to think of these budget surpluses as a deliberate policy of national debt reduction, I think the reality is simply that Republicans in Congress blocked spending increases that would have dissipated these increased tax funds while President Clinton blocked Republican initiatives to cut taxes. (9)
The extra tax revenue that contributed to the budget surpluses was not the result of the Clinton tax rate increases. The Congressional Budget Office estimates imply that only about one-fourth of the increased tax revenue was due to the Clinton statutory tax changes, with the rest coming from economic growth and increases in taxable incomes at each level of GDP. But even this one-fourth estimate is misleading because it assumes that the higher marginal tax rates had no adverse effect on taxable income. Common sense and past experience show that the opposite is true. High marginal tax rates reduce taxable income by reducing labor supply, shifting income into nontaxable forms, and encouraging increased tax deductions. (10) Taking these behavioral responses into account would substantially reduce the estimate of the revenue increase due to the Clinton statutory rate changes and might even show that the increase in the high marginal tax rate actually lowered tax receipts, leaving the changes in the AMT as the only statutory source of additional revenue. (11) The real source of the extra revenue that was the primary source for eliminating the budget deficits was the increase in economic growth driven by the new technology that raised taxable personal incomes, corporate profits, and capital gains.
The fiscal legacy of the Clinton policies was therefore neither a significant increase in revenue nor a reform of the tax system. Rather it was an increase in marginal tax rates that substantially exacerbated the inefficiency - i.e., the deadweight loss - of the income tax system.
1. Professor of Economics and President of the National Bureau of Economic Research. These remarks were prepared for presentation at the Harvard University conference on "Economic Policy in the 1990s", June 29, 2001.
2. In such a mixed system, retirees receive a combination of the traditional tax financed pay-as-you-go benefits and the annuities that result from accumulating assets in personal retirement accounts. Andrew Samwick and I calculated that personal retirement account contributions of 2 percent of covered earnings would produce an annuity which, in combination with the benefits that can be financed in each future year with the existing 12.4 percent pay-as-you-go tax, could equal or exceed in each future year the benefits projected in current law. Thus total benefits could be maintained by shifting to a mixed system with the existing payroll tax and a 2 percent personal retirement account contribution rather than continuing a pure pay-as-you-go system financed with a payroll tax of about 19 percent. This calculation assumed a 5.5 percent real rate of return on the stock-bond portfolio, about 1.5 percent less than the 50 year average return through 1995 on a portfolio of 60 percent stocks and 40 percent corporate bonds. The 1.5 percent difference provides an allowance for administrative costs and a margin for risk. See M. Feldstein and A. Samwick, "Potential Effects of Two Percent Personal Retirement Accounts," in Tax Notes, Vol. 79, No. 5, May 4, 1998, pp 615-620. An updated version based on more recent actuarial assumptions is available as, "New Estimates of the Potential Effects of Two Percent Personal Retirement Accounts," NBER Working Paper 6540.
3. I developed this idea in "Common Ground on Social Security, " New York Times, March 31, 1999.
4. One of the key issues in designing a mixed system is the risk inherent in investing personal retirement account assets in a portfolio of stocks and bonds. One option is to guarantee that the combination of the two types of benefits is at least as large as the benefits projected in current law. This can be done by allowing the retiree to keep the full investment-based annuity but reducing the traditional pay-as-you-go benefit by a fraction of the annuity that the individual receives, a method that is unfortunately described as a "clawback." An equivalent alternative that avoids this appearance is to supplement the annuity with a conditional pay-as-you-go benefit that compensates for poor overall stock and bond market performance during the individual's working and retirement life. Elena Ranguelova and I examined a variety of approaches to risk in several papers, including "Individual Risk and Intergenerational Risk Sharing in an Investment-Based Social Security Program," NBER Working Paper No. 6839, a portion of which appears in "Individual Risk in an Investment-based Social Security System," American Economic Review, forthcoming (available as NBER Working Paper 8074.) An NBER project on this subject resulted in the volume Risks Aspects of Investment-Based Social Security Reform, (John Campbell and Martin Feldstein, eds) Chicago: University of Chicago Press, 2001.
5. The earlier Clinton proposal for health care financing reform and the ensuing public and Congressional discussions also changed the future policy debate, although in a quite different way, by ending any serious political interest for at least a very long time in such ideas as national limits on private health spending, mandatory employer premium payments that imply very high costs for each additional insured individual, and phase-out rules for subsidized insurance that raise implicit marginal tax rates dramatically. It was a health policy and an associated implicit tax policy that deserved to fail.
6. For some earlier thoughts on these events, see my introductory chapter in M. Feldstein, American Economic Policy in the 1980s (Chicago: Chicago University Press, 1993), pp. 1-80.
7. I made this case in 1997 when the possibility of future budget surpluses began to emerge; see M. Feldstein, "Don't Waste the Budget Surplus," The Wall Street Journal, November 4, 1997.
8. See Martin Feldstein and Andrew Samwick, "The Transition Path in Privatizing Social Security," in M. Feldstein, Privatizing Social Security, Chicago: Chicago University Press, 1998, and "The Economics of Prefunding Social Security and Medicare Benefits" in NBER Macroeconomic Annual 1997. These papers describe a gradual transition to a system that is completely investment based. A more realistic mixed system that retains a pay-as-you-go system financed by the current 12.4 percent payroll tax and supplements it with an investment based component is discussed in M. Feldstein and A. Samwick, "Potential Effects of Two Percent Personal Retirement Accounts," in Tax Notes, Vol. 79, No. 5, May 4, 1998, pp 615-620. An updated version based on more recent actuarial assumptions is available as, "New Estimates of the Potential Effects of Two Percent Personal Retirement Accounts," NBER Working Paper 6540.
9. In addition, Medicare payments to providers were substantially reduced as part of a policy of protecting the Medicare Trust Fund.
10. Several studies have shown the substantial cumulative size of this effect. See for example Martin Feldstein, "The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act," Journal of Political Economy, June 1995, (103:3), pp 551-72. and John Gruber and Emannuel Saez, "The Elasticity of Taxable Income: Evidence and Implications," NBER working paper 7512, forthcoming in the Journal of Public Economics.
11. See M Feldstein, "Clinton's Revenue Mirage," The Wall Street Journal, April 6, 1993