Originally published in THE WALL STREET JOURNAL

Tuesday, November 4, 1997

Don't Waste the Budget Surplus

By Martin Feldstein

Board of Contributors

"The projected surpluses should be used for a tax cut to fund a system of Personal Retirement Accounts modeled on the very successful and widely used 401(k) plans."

The federal budget surpluses now projected for the coming years provide an unprecedented political opportunity for fundamental reform of Social Security. That reform would cut taxes now for every working person while laying the foundation for a more secure retirement.

First some budget facts. Lower defense spending, limits on the growth of nondefense outlays, and the surging tax revenue that has resulted from strong economic growth have combined to cut the budget deficit for the 1997 fiscal year, which ended in September, to only $22 billion -- about 0.25% of gross domestic product. The Congressional Budget Office projected earlier this year that the budget would be in surplus by 2002 and would remain there for the rest of the decade. The strong growth and high tax receipts of the past few months are now likely to require a revised budget forecast that accelerates the surplus, probably to the current fiscal year.

A decade of budget surpluses would be a welcome change after decades of budget deficits. Surpluses would automatically shrink the national debt, which has grown to nearly $4 trillion. A smaller national debt would mean lower future taxes to meet government interest payments. Budget surpluses would also automatically raise the national saving rate. That would finance increased investment in plant and equipment, raising productivity and real wages. And the higher national saving rate would make the U.S. less dependent on capital inflows from abroad.

A Better Alternative

But despite these desirable effects of potential budget surpluses, Congress and the Clinton administration are unlikely to let them last very long. Thats because while there is broad public support for the goal of a balanced budget, there isn't broad support for running budget surpluses in order to shrink the national debt. So Washington is already talking about new spending initiatives and special-interest tax breaks that would eliminate those surpluses. Fortunately, there is a better alternative that should have enough popular support to make it politically viable: using the projected surpluses to fund a system of mandatory Personal Retirement Accounts modeled on the very successful and widely used 401(k) plans. A system of PRAs would achieve the same gain in national saving that budget surpluses would. It would also have the popular appeal of a personal tax cut and yet the long-term benefit of more reliable retirement income with lower future taxes.

Heres how it would work. Two percent of the earnings of each employee and self-employed person (up to the maximum earnings covered by the Social Security payroll tax, currently $65,100) would be sent to a PRA rather than to Social Security. The employee would invest those dollars in stocks, bonds and mutual funds. Each individual would automatically receive a dollar-for-dollar tax credit (or tax rebate) for these PRA deposits. The PRA deposit would therefore be costless to the individual and his employer. Each workers PRA investment earnings would accumulate tax free at the private financial institution of his choice. At retirement age, he could withdraw his PRA balance as an annuity or by gradual payouts.

For the individual taxpayer, this plan would mean a substantial tax cut. A married couple with a combined wage and salary Income of $60,000 would get a $1,200 annual tax reduction. While they wouldn't get that $1,200 in cash immediately, the $1,200 would unambiguously be theirs. And since the funds would be invested in a 401(k) type account in which investment income accumulates tax free, this tax cut would actually be more valuable than cash to anyone whose tax-favored saving is now limited by the maximum on Individual Retirement Account and 401(k) contributions.

The tax cut would be equivalent to cutting the payroll tax rate by two percentage points -- to 13.3% from the existing 15.3% employer-employee rate. That would increase incentives to work and to take compensation in taxable form rather than as fringe benefits or enhanced working conditions. Those favorable supply-side effects would mean more real income for individuals and increased tax receipts for the government.

The funds that accumulate in the PRAs would be a valuable and substantial supplement to future Social Security benefits. Even before the financial markets boom of the past few years, funds invested 60% in stocks and 40% in bonds earned an average real return of 5.5% a year during the 50 years through 1994. A couple that saves $1,200 a year in a PRA from age 30 to age 65 and earns that 5.5% rate of return would accumulate more than $120,000 by age 65 (in constant dollars) and be able to finance a 20-year annuity paying more than $10,000 a year in order to supplement their retirement income.

If Congress and the President would otherwise use potential federal budget surpluses to finance new spending and tax cuts, shifting those dollars to PRA accounts would be a net addition to the national saving rate. But even if Washington would otherwise exercise the self-discipline to keep the budget surplus, the PRA plan would just change the form of national saving as the PRA tax cuts are channeled into PRA saving accounts.

Of course, some high-income individuals might reduce other financial assets to offset the accumulation of funds in their Personal Retirement Accounts. But few Americans have enough discretionary financial assets to do that. Even on the verge of retirement, the average family has net assets equal to only about six months of income, much less than the amounts that would accumulate in PRAs. And since the existing funds have generally been accumulated to deal with "rainy days" and financial emergencies, they will not be spent just because expected future retirement income has increased.

The 2% of earnings that individuals contribute to their PRA accounts is only a small part of the incremental national saving in those accounts. Even more important is the investment return that would be earned on those accumulated funds and that would be retained in each individuals PRA until that individual retires. Although the couple that adds $1,200 a year to their PRA accounts for 35 years contributes a total of only $42,000, the accumulation of investment earnings brings their account balance to $120,000 at the end of those 35 years and allows them to take out more than $200,000 in retirement income.

Exceeding Tax Reduction

If the budget forecasts that point to near-term surpluses are too optimistic, the PRA tax credits could push the budget into deficit. But even if a deficit occurs, national saving would be higher with the PRA plan than without it because the combination of new PRA saving and the accumulating investment income in the PRA accounts would exceed the tax reductions. And if Congress responds to any potential deficits by further steps to achieve budget balance, national saving would be even higher.

In the longer term, the aging of the population means that the currently projected Social Security pensions and government health spending are sure to outstrip the growth of tax revenues at existing tax rates. The tax increase required to finance the currently projected benefits in 2030 would be equal to about 8% of GDP, essentially the equivalent of doubling all personal income-tax rates. The only way to prevent such a devastating tax increase would be to switch from the present pay-as-you-go method of financing retiree benefits to a system of prefunding based on individual accounts like the PRAs. The current fiscal situation offers a golden opportunity to begin that important process.

Mr. Feldstein, former chairman of the President's Council of Economic Advisers, is a professor of economics at Harvard University.