Originally Published in THE NEW REPUBLIC
April 6, 1998
A new plan to rescue Social Security.
By Martin Feldstein
President Clinton was right when he called on Congress to use projected budget surpluses to save Social Security and protect future retirement incomes. Congressional leaders in both parties are now responding with proposals to turn that idea into reality. Among them are Daniel Patrick Moynihan, the ranking Democrat on the Senate Finance Committee, and the committees Republican chairman, Bill Roth. Republicans Phil Gramm of Texas and Judd Gregg of New Hampshire, and Democrat Bob Kerrey of Nebraska, also have plans, as do Bill Archer, chairman of the House Ways and Means Committee, and John Kasich, chairman of the House Budget Committee.
What these proposals have in common is that they use federal budget surpluses--which the White House and Congress say will continue through the second decade of the next century--to finance a new kind of universal individual account similar to existing IRA and 401(k) accounts. These individual accounts would supplement traditional pay-as-you-go Social Security and would do so without raising taxes, incurring a budget deficit, or making individuals tighten their belts. Other countries have already done it. Sweden recently enacted a plan to put 2.5 percent of each workers wages into an individual account. Australia developed a system in the 1980s. England has been developing one for more than a decade.
Heres how it might work in the United States. Each year, you could put two percent of your annual earnings (up to the Social Security maximum earnings limit, now $68,400) into a Personal Retirement Account and get a dollar-for-dollar tax credit for the amount you deposited. For those who pay little or no income tax, the PRA tax credit would be converted into a cash rebate.
The PRA deposit would thus cost those who participate nothing. In effect, you would get a tax cut of two percent of earnings (up to the $68,400 limit) on the condition that the tax cut is deposited in the PRA. Since the amount of earnings eligible for the two percent credit is equal to about 40 percent of gross domestic product, the PRA deposits would end up costing the government about 0.8 percent of GDP per year, less than the projected annual budget surpluses. To be sure, when the projected budget surpluses end around 2015, the 0.8 percent of GDP would have to be generated through new tax revenue or reduced spending. But this is not an impossible task in an economy in which federal taxes and spending account for more than 20 percent of GDP.
The government could regulate PRAs as it does existing IRA accounts to prevent them from being risked on such speculative investments as puts and calls or collectibles. It might even impose more stringent regulations requiring, for example, that the funds be invested in diversified mutual funds or bank deposits. At retirement age, you could use your accumulated balance to buy an annuity, or you might be allowed to withdraw them gradually subject to age-related restrictions.
If you work for a large employer, your firm might assist by using payroll deductions to direct the two percent of earnings into PRA accounts. You would still be free to opt out of the employers PRA plan and put your two percent into any alternative approved investment. Or you could use your annual tax return to designate a bank, mutual fund, or insurance company to which the government would then send two percent of the past years earnings. For those who make no other choice, the funds would go to a government-sponsored account like the Federal Employees Thrift Plan. With these three options, every wage-earner would participate, and administrative costs would be low.
In such a system, PRAs would accumulate substantial retirement benefits. Even before the sharp market rise of the past three years, a conservative portfolio with 60 percent in a diversified stock fund and 40 percent in bonds earned a long-term average return of 5.5 percent after inflation. That means that somebody who earned $30,000 a year (at 1998 prices) and put two percent of his earnings from age 25 to age 65 into a PRA would accumulate more than $80,000 by age 65, more than double his annual preretirement income. The retiree could use that $80,000 to fund a $6,500 annuity from ages 65 to 85, more than 20 percent of the $30,000 preretirement income. Such a PRA-financed annuity would also be a substantial add-on to ordinary Social Security benefits. Under the current system, somebody with constant real earnings of $30,000 a year would receive benefits of about $13,000 a year. With a PRA annuity that person would have 50 percent more retirement income.
But there is an even better way to use the PRA dollars to protect Social Security and reduce future payroll tax increases. Individual PRA withdrawals could be integrated explicitly with Social Security benefits in a way that would improve the financial viability of the existing Social Security system--and hence obviate much or all of the future increases in the payroll tax that Social Security actuaries now consider necessary to finance the future retirement benefits promised in current law.
For example, a 50 percent integration of PRA withdrawals with Social Security benefits would mean that each dollar of retirement income that you withdraw from a PRA would reduce your Social Security benefit that year by 50 cents. If you take $6,000 from a PRA, you would forgo $3,000 in Social Security benefits. With such an integration, individuals with above-average investment experience would give up more Social Security benefits, while those with below-average investment experience would get more from Social Security. But, for everyone, the combination of Social Security benefits and the PRA withdrawals would exceed Social Security benefits alone.
The reduced payout of benefits that would result from such a system would also contribute substantially to the financial health of the Social Security system. The trust fund would no longer be exhausted in 2029 as Social Security actuaries now project. Benefits specified in current law could be paid, while keeping the payroll tax rate below 15 percent, instead of raising it to 18 percent as is currently projected.
Raising the integration factor to 75 percent--in other words, decreasing your Social Security benefits by 75 cents for every dollar you take from the PRA account-- would completely eliminate the Social Security funding shortfall. More specifically, with a 75 percent integration, the tax rate required to finance the benefits specified in current law would never have to be raised above the existing 12.4 percent. The combination of net Social Security benefits and the PRA withdrawals would eventually be about ten percent higher than the Social Security benefits projected in current law.
In addition to protecting Social Security benefits, by increasing retirement income and substantially lowering payroll taxes, the system of individual accounts would increase the national savings rate above what it would otherwise be. This is true for two reasons. Because most Americans have few financial assets, they would be unable to offset their PRA savings by increasing their consumption elsewhere. Also, its a safe bet that the government surpluses that would be used to fund the PRAs would not otherwise be used to pay down the national debt. Politics being what it is, that money would go to current consumption in the form of tax cuts or spending.
Some have advocated transferring the surpluses into the existing Social Security trust fund and allowing the government to invest those funds in private stocks and bonds. But individual accounts are preferable for three reasons. First, a plan to transfer budget surpluses to the trust fund could easily degenerate into giving the trust fund whatever happens to be left of the surplus after new government spending and new tax cuts--and that is likely to be less than the two percent of payroll mandated under the PRA plan. Second, even if the actual surpluses are invested in private securities in the trust fund, nothing is really achieved if the government then turns around and increases other spending or cuts taxes. Either way, the country would forfeit the increase in national savings it would achieve with PRAs.
A third problem with investing the budget surpluses in private securities is that it would radically change the governments role in the economy. Nearly $1 trillion of projected surpluses would be invested by the government in private stocks and bonds. Over time, these investments would grow larger as share prices rise and dividends and interest are reinvested. There would inevitably be strong political pressures to influence how those funds are invested; for example, Congress might try to steer funds to companies in favored parts of the country, just as defense contracts are now parceled out to each member's congressional district. The result would be a reduced return on the investment funds and an unwelcome interference by the government in the private sector.
Committing the projected budget surpluses to PRAs would raise the real incomes of all employees and eventually all retirees. Integrating the PRA withdrawals and Social Security benefits could maintain Social Securitys solvency without reducing projected benefits or increasing the payroll tax. Limiting the future payroll tax to the current 12.4 percent, instead of increasing it to the 18 percent as required by the current system, would be an enormous benefit to working Americans. I can think of no other policy that would do more to raise permanently the real income of low- and middle-income families.
President Clintons call to use the projected budget surpluses to save Social Security could be the first step toward securing his economic legacy. Now he needs to join with congressional leaders in both parties to find the form of PRA that can turn his initiative into a reality.
MARTIN FELDSTEIN, a former chairman of the presidents Council of Economic Advisers, is a professor of economics at Harvard.