[CC] Issue in Focus: The Real Problem with the President's Social Security Plan

Issue in Focus: The Real Problem with the President's Social Security Plan

The President's New Fiscal Strategy - Still Out of Balance

Re-elected presidents rarely propose a turnaround in
fiscal policy. But President Bush says he's trying.
While during his first term Bush opened the floodgates on
federal spending and set deficit records, during his second
term he is announcing a new theme of "spending restraint"
and says he will take "the steps necessary to achieve our
deficit reduction goals." Unfortunately, this hype is not
backed by much substance. Yes, the new Bush promises
more than what the old Bush delivered. But that's a low
hurdle to clear. The new Bush's fiscal policy remains seriously
out of balance.

On the positive side, the 2006 Budget shows that this
administration is willing at last to stand up to powerful
spending constituencies, from the farm lobby to the vet
lobby. The White House is daring to earmark 99 programs
for elimination and another 55 for major reductions. It is
talking tough to state governors about Medicaid spending.
And it should be commended for trying to focus public
attention on Social Security's long-term cost growth, an
issue most Democratic leaders have ritually ignored.

That said, the administration's overall fiscal strategy
shows a striking absence of balance, candor, and long-term
realism. Take balance. More than two-thirds ($138 billion)
of all the five-year cuts are supposed to come from the 18
percent of outlays that are "non-security" domestic discretionary
spending, everything from training and transportation
to NASA and national parks. By 2010, this part of the
budget is slated to shrink by 16 percent in real dollars.

Much less ($39 billion) is being asked of the 55 percent
of outlays that are "mandatory" entitlements. Indeed, the
same President who has yet to veto a single spending bill
has declared he would never agree to pare back the massive
prescription drug add-on to Medicare he pushed through
Congress last year (at a 10-year cost of $724 billion). And
nothing at all, of course, is being asked on the revenue side,
where the administration insists on extending its whole
range of tax cuts (at a 10-year cost of $1.1 trillion). Although
it wants to reinstitute the congressional pay-go rule,
it would rewrite it to exempt tax cuts from the same procedural
safeguards that would apply to spending hikes.

So lopsided is this corner-squeezing exercise in fiscal
restraint that it does not do much to reduce the deficit.
Even with a growing economy to fill its sail, the plan can
"cut the deficit in half" only under an arbitrary set of assumptions
(requiring us, for example, to ignore the certain
cost of the war on terror and the near-certain cost of providing
Alternative Minimum Tax relief). Realistically, the
plan will never pull the deficit under $300 billion by 2010.

Further out, in a future deliberately veiled by the administration's
short 5-year horizon, the deficit will balloon
as the Boomer retirement starts pushing the growth of
Medicare, Social Security, and other health and pension
payments into high gear. By 2025, the White House's own
long-range model projects that the government will be borrowing
from the rest of the world to afford a budget that
spends 85 percent of its outlays on retirement, defense, and
interest. The White House lacks candor not just for its
near-term smoke and mirrors, but for obfuscating what the
2006 Budget itself confesses -- that "our greatest fiscal challenges
are the long-term unfunded liabilities of our entitlement
programs." This is a vast challenge. It cannot be met
by zeroing out energy labs or teacher workshops.

To be sure, the President has issued a bold proposal
for reforming Social Security. But as yet his proposal includes
no measure that addresses what he himself agrees is
the real problem, namely, the growing future gap between
program receipts and expenditures. Instead, he has focused
on ways to divert payroll taxes into personal accounts, an
idea which might be part of an effective reform plan that
also included some new contributions or a pay-as-you-go
benefit cut. Alone, however, personal accounts will probably
make the problem worse. (See the following essay.)

The White House may have hoped that the public
would be strongly attracted to the implied prospect of a free
lunch. If so, it miscalculated. Many Americans have reacted
with puzzlement, others with the suspicion that the
White House is trying to play bait-and-switch, inventing a
fictional "crisis" in order to get personal accounts.

The President's defenders say critics just don't appreciate
his reform's cultural message -- how his personal accounts
will create "a society of owners." But what about
creating a society of savers? Let's be honest. We Americans
have no problem owning stuff. The real problem is -- from
our houses to our cars and now to our retirement funds --
we are in hock for everything we own. Paying off our debts:
Now that would be a cultural message worth listening to.

The Real Problem with the President's Social Security Plan

Face to face with the greatest fiscal challenge of the new
century -- coping with the projected cost explosion in
Social Security and other senior entitlements -- both political
parties are practicing a game of denial and diversion.

Many Democrats argue that Social Security requires
only minor adjustments. They are wrong. According to the
official report of the Social Security Trustees, America's age
wave is about to push the program into an inexorable slide
toward bankruptcy by the time today's thirty year-olds retire.
Long before then, Social Security will become a
mounting burden on the budget and the economy.

To their credit, the President and a few GOP leaders in
Congress have taken the lead in pointing out the urgent
need for Social Security reform. Unfortunately, the President's
only concrete proposal -- a debt-financed personal
accounts "carve out" -- would do nothing to solve the problem
he outlined in his State of the Union Address. Indeed,
it might even make the problem worse.

That problem is closing the long-term gap between
what Social Security is promising in benefits and what it can
afford to pay. Addressing it will require that retirees take
less out of the system or that workers put more in. As now
formulated, the President's plan would do neither.

Wading out to the Sandbar

The President would give workers the option of carving
out 4 percentage points of the current Social Security
payroll tax and diverting it to a new system of personal accounts
that would be invested in private financial markets.
In exchange, workers would forgo a portion of their traditional
Social Security benefit equal, in present value terms,
to their carved-out FICA taxes. This benefit offset only
serves to keep the carve out from digging a deeper hole. It
does nothing to fill the hole we are already in -- that is, it
does not reduce by one dime the future debt Treasury
would have to issue in order to honor Social Security's
benefit promises.

There are other serious problems with this proposal as
well -- starting with the massive borrowing it requires. For
every dollar that workers put into their accounts, Congress
will have to borrow a dollar to replace the lost FICA revenue,
at least until the benefit offset begins to kick in. According
to the administration, the plan would add $754
billion to the federal debt over the next decade. This figure,
however, is deceptively low, since the personal accounts
won't go into effect until 2009. Over the first ten years the
plan is actually in operation, net new borrowing would
come to roughly $1.5 trillion, assuming two-thirds of eligible
workers participate. Over the first twenty, it would
come to roughly $5.0 trillion.

The administration tries to downplay the significance
of the borrowing by maintaining that it doesn't really constitute
an extra cost at all. According to this argument, the
President's plan would not be creating new debt. It would
merely be translating a portion of the federal government's
implicit debt to future Social Security beneficiaries into explicit
debt to the public.

The administration is correct -- and that's precisely the
problem. To the extent that the President's plan translates
implicit Social Security debt (which has no constitutional
protection) into formal Treasury debt (which does), it in
effect renders future Social Security benefits unreformable.
The economy might collapse or the nation go to war, but
short of default on the national debt Congress would have
no way to reduce Social Security obligations.

Keep in mind that the cost of servicing the new Treasury
debt would be immediate and certain, while the offsetting
savings in implicit Social Security debt would be
anything but. It will be a few decades before the benefit
offsets become significant -- if indeed they occur at all.
What if the personal accounts fail to perform as advertised,
creating pressure for future Congresses to scale them back?
From Medicare to military retirement, the history of entitlement
reform is one of back-ended benefit cuts that are
rescinded as soon as they begin to bite. Betting on debtleveraged
personal accounts is a bit like wading out into the
surf to reach a sandbar. You risk drowning before you get
there.

Many proponents of the carve-out approach believe
that leveraging the transition to a personal accounts system
is worth the risk because the long-term rate of return on
stock-heavy accounts is sure to be higher than the longterm
rate of return on the federal debt. There you have
it -- the free lunch in a nutshell. By financial alchemy, a lot
more benefits are supposed to come out of the system
without anyone putting anything more into it. Some GOP
members of Congress actually believe that higher returns on
personal accounts will not only enrich account holders, but
will allow the government to pay off Social Security's liabilities.

If this sounds too good to be true, that's because it is.
Very few economists believe that you can generate new
wealth simply by shuffling assets from one financial instrument
to another. Think about it this way: If this kind of
large-scale financial arbitrage could work, why should government
stop at putting a thousand borrowed dollars per
year into each worker's personal account? Why not, in the
first year, put a million borrowed dollars into each account?
Forget Social Security reform. We've just come up with a
way to turn every American into "Joe Millionaire."

In fairness, the administration itself does not claim it
will be able to cash in on the spread between stocks and
bonds. The administration, however, wants it both ways.
To the public, it implies that the personal accounts will
more than make up for the reductions in traditional benefits
-- which is another way of saying that stocks will outperform
bonds. To the experts, it denies that its plan depends
on the spread. But if the administration thinks that workers
will lose as much in traditional benefits as they gain in their
personal accounts, what's the point? Building an "ownership"
society is all well and good, but in and of itself it does
nothing to solve the Social Security problem.

The Missing Ingredient

Does this mean that personal accounts are a bad idea?
Not at all. It simply means that the President's proposal is
missing the essential ingredient -- net new savings.

The case for transitioning at least in part from today's
pay-as-you-go Social Security system to a funded system is
compelling. At the macro level, genuine funding translates
into higher productivity, higher wages, and higher national
income. At the micro level, it can offer workers larger benefits
for any given level of contributions. Why? Because in a
funded system, worker contributions generate a return
equal to the rate of return on capital, which is typically
much greater than the return on contributions in a pay-asyou-
go system, especially when the population is aging.

Although funding can in principle be accomplished
collectively through public budgets, in practice government
funding doesn't work. So long as Congress owns worker
contributions, Congress can spend them, which is precisely
what it has done with the existing Social Security trust fund.
In the end, personal accounts may be the only "lock box"
that no politician can pick.

Genuine funding, however, requires genuine resource
trade-offs. To save more, we must consume less -- at least
until we begin to enjoy the productivity benefits of the
higher savings. This in turn means that workers must contribute
more, beneficiaries must receive less, or some combination
of the two. The administration acknowledges that
this is indeed the central challenge of Social Security reform --
but it decided to punt rather than face the challenge
head on.

Many of the criticisms of the President's personal accounts
proposal are misplaced. Workers' account balances
would not be eaten up by pricey broker fees. The system
the President proposes would be highly regulated, with
workers required to choose from a small number of lowcost
generic stock and bond portfolios. Nor would workers
be at risk of a sudden market down turn just before retirement --
at least not if they choose the administration's default
"life cycle portfolio" that automatically shifts assets
from stocks to bonds as workers age.

The problem with the President's plan is more fundamental:
Debt-leveraged accounts do not add to national
savings -- and so will not leave society better off.

The Obvious Alternative

The obvious alternative to a personal accounts carve
out is a personal accounts "add-on." Instead of diverting
existing FICA contributions to personal accounts, the addon
approach would fund the accounts partly or wholly from
new worker contributions. It offers a way to ensure the
adequacy of future benefits without recourse to financial
arbitrage or budgetary shell games.

Let us be clear. Raising payroll taxes to extend Social
Security's pay-as-you-go chain letter is not a viable option.
Young workers would ask why they must pay more than
today's midlife Boomers for the same (or worse) benefits.
And middle- and low-income workers, who bear most of
the burden, would ask why they must pay more to subsidize
the high-income old. Some advocate getting the wealthy to
contribute more by levying payroll taxes on all earnings,
without a limit on income. But eliminating the "max cap"
would destroy the whole presumption of a contributory
system -- that what people get back in benefits be at least
somewhat proportional to what they pay in. In any case, it
wouldn't come close to generating enough new revenue to
close Social Security's gaping long-term cash deficits.

Worker contributions to add-on accounts would have
none of these drawbacks. They would constitute personally
owned property and be bequeathable to heirs. As such,
government could not spend them. And as such, they
would not constitute a tax -- or at least they would not
function like one.

Again, let us be clear. We are not talking about some
new-fangled IRA. To work, the personal accounts add-on
would have to be part of an overall Social Security reform
plan that cuts back unsustainable pay-as-you-go benefit
promises. It would also have to be mandatory. Many reform
proposals, including the President's, call for voluntary
personal accounts. This is a big mistake. Society has an
interest in ensuring that people do not under-save during
their working lives and become free riders on the meanstested
safety net in old age. "Choice" is besides the point in
a compulsory floor-of-protection program whose main purpose
is to protect people against poor choices.

A Grand Compromise

The kind of add-on approach we have outlined could
appeal to both sides in the debate. It would allow Democrats
to say that they have preserved Social Security's solvency
without "gutting the trust fund." And it would allow
Republicans to say that they have introduced personal accounts
without raising taxes.

Yet if there is to be a grand compromise, both sides in
the debate will have to rethink the positions they have
staked out. Democrats will have to stop circling around the
trust fund and acknowledge that the current system is fiscally
unsustainable and generationally inequitable. Republicans
will have to begin to think of personal accounts as a
means instead of an end -- and recognize that issuing debt
to finance the transition to a funded Social Security system
undermines the whole purpose of reform.

Political leaders in both parties are hesitant to compromise
for fear of losing political advantage. It's time --
while there's still time -- to rise above partisan politics. It's
time to recognize that, unless we enact genuine Social Security
reform soon, the real losers will be our children and
grandchildren.

 

Concord Coalition have a done a good, nonpartisan job of laying out the troubles each party has with its apporach with SS. CC has even put forward a strawman solution. I actually do not like their solution but will freely admit that it is a solution viz-a-viz Bush's private accounts and the Dem's bandaid approach.