Grading the Social Security debate

Posted: Jan 13, 2005 12:00 AM

The debate about whether and how to allow young people to invest part of their Social Security taxes in personal accounts is off to a fascinating start. Some initial rhetoric and legislative action have been informative and constructive, but some have been deceptive and destructive. Unfortunately, it is hard to find any middle ground between insightful candor and devious fraud. So, I thought it might be annoyingly useful to take on the role of a grumpy old professor and start handing out grades.

 On this list (there will be others), President Bush gets the only "A" -- for daring to push hard for dealing with a festering problem before it gets really nasty. But not just any Social Security reform bill will do, and most I've seen will earn low grades for a few quirky features. So, the president's grade may yet slip by the time something is signed into law.

  Ignoring Incentives and Markets: D

 L.A. Times editor Michael Kinsley recently wrote that "to work, privatization must generate more money for retirees than current arrangements. ... Where does this bonus come from? There are only two possibilities -- from greater economic growth or from other people."

 The latter "other people" theme was superfluous, but sure to be garbled once he described privatization as "the notion of putting Social Security money into stocks, instead of government bonds, because stocks have a better long-term return." Social Security money is not invested in "government bonds." Ninety five percent of Social Security money, soon to exceed 100 percent, is just a transfer payment from Social Security taxpayers (many of whom are over 65) to retirees (many of whom are under 65).

 In any event, Kinsley envisioned no chance of greater economic growth because, he theorized, "increased growth can come only from higher private investment or smarter private investment." Economists would describe that as a production function with only one factor of production -- privately owned buildings and machines (public schools and highways must be even worse than I thought). There are no workers, managers, students or entrepreneurs in Kinsley's growth model, or their behavior doesn't matter. If that made sense, then it would make no difference to the economy if all U.S. workers, managers, students and entrepreneurs were suddenly replaced with a random assortment of illiterate peasants from Bangladesh or Chad.

 By contrast, Nobel Laureate Ed Prescott finds that "promises of payments to the current and future ... can be honored by reducing the effective marginal tax rate on labor and moving toward retirement systems with the property that benefits on margin increase proportionally to contributions." Putting 12.4 percent of your paycheck into the Social Security slush fund to be redistributed by political whim has a far more demoralizing effect on lifetime work incentives than letting folks put some of that money into assets they really own.

 Kinsley also imagines privatization "can't possibly work, even in theory" because he theorizes that the return on investments must fall whenever there are more investors. "The money newly available for private investment," he says, "would bid up the price of (and thus lower the return on) stocks." If so, the return on stocks should have been falling continually since at least 1980, when IRS Section 401(k) first became effective and the Dow was around 900. In fact, "money newly available for private investment" has been growing since about 1933. Yet stocks continue to do quite well.

 The value of stocks is not determined by the volume traded, but by their expected return (capital gains and dividends) in comparison to many alternative investments. Besides, nobody says personal accounts have to be invested in stocks.

  Proving Social Security Is Risky: D

 Democratic Strategist Bob Beckel recently proposed on Fox News that anyone with an annual income higher than about $50,000 at retirement age should get nothing from Social Security. Could Congress really do that? Yes, it could. Social Security's promises are subject to change without notice.

 Benefits have already been cut by raising the eligibility age to 67 and raising the amount of benefits subject to tax from zero to 85 percent. That was barely a hint of what opponents of private accounts now have in mind. Most are less candid than Beckel, yet they also advise slashing Social Security benefits for those frugal enough to save for retirement or industrious enough to keep working. Most would also increase Social Security tax rates on the same politically disfavored group. If this ever happened, frugality and industriousness would become foolhardy and therefore rare.

  "Saving Social Security" by Peter Diamond and Peter Orszag, for example, relies on increased taxes on higher earners for 42 percent of the hoped-for reduction in unfunded debt, yet benefits to the top 15 percent would also be cut by a third. The other half of their savings comes from "a universal legacy charge on future workers and beneficiaries, roughly half in the form of benefit reductions for all beneficiaries becoming eligible in or after 2023, and the rest in the form of ... increases in the payroll tax from 2023 onward" (forever).

 Even Republican Sen. Lindsey Graham of South Carolina recently told The Hill, "I would support means-testing as a component of reforming Social Security. Means-testing is part of the mix of true reform."

 Graham also proposed raising the income level subject to Social Security tax from $90,000 to as much as $200,000. That is the most dangerous idea so far. Leftists who want no limit at all on annual Social Security taxes would find it much easier to sell Congress on that terrible next step. And that, in turn, could push combined federal-state tax rates on professionals and managers to European levels (above 50 percent) -- with the disastrous economic effects Prescott and others have documented. Western Europeans may enjoy their tax-induced indolence, but it means their governments are running out of suckers to tax.

 "Social Security is the only portion of retirement income that is guaranteed," claims Bill Novelli, the CEO of AARP. Yet these proposals for "saving" or "means-testing" Social Security prove such assurances are a fraud. Market risk from stocks and bonds is trivial compared with political risk of what some future Congress is likely to do to those so-called "guaranteed" benefits and to related taxes.

  Tiny Limits on Contributions to Private Accounts: C-minus

 Several political proposals put a tiny limit of $1,000 to $1,300 on the amount that could be added to a personal account in any year. The rationale may be egalitarian -- holding everyone down to the same low level -- but the effect would the opposite. Any annual limit is hardest on those who start their adult life with a low income, then work their way up by middle age. It is much easier to save after the kids are out of college, when both husband and wife are more likely to be working. A lifetime limit on contributions (such as $100,000) would be a lesser evil.

  AARP Ads Comparing Mutual Funds to Slot Machines: F

 An AARP ad has a couple in their 40s saying, "If we wanted to gamble, we'd play the slots." When AARP recruits employees, on the other hand, it does not describe its own unusually generous 401k plan (since 1998) as "gambling."

 AARP is a big business, marketing insurance and other financial services and receiving only 27 percent of it $770 million income from dues. Among other things, AARP markets Scudder mutual funds to its members. But it does not do so by suggesting such investments are equivalent to playing the slots.

 Like AARP executives, academic critics of privatization also get to choose among retirement funds, often from TIAA-CREF. Over the last 10 years -- a period that included a nasty three-year bear market -- the annual return was 11.7 percent on the CREF stock index fund and 10.7 percent on their mixed stock-bond fund.

 Unlike Ivy League professors and AARP executives, many ordinary workers lack access to such lucrative employer-provided retirement savings plans. But even ordinary workers deserve some chance to "gamble" so profitably -- just as AARP executives and a few academic critics of broader retirement choice have been doing for years.