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Steltzer makes sense---not one of the "deficits don't matter" 
pseudoconservatives at the Weekly Standard


The Weekly Standard


Social Security Snares & Delusions
From the January 17, 2005 issue: How not to squander political capital.
by Irwin M. Stelzer
01/17/2005, Volume 010, Issue 17



PRESIDENT BUSH WANTS TO REFORM the Social Security system. He is right 
to want to transform the system into one that meets the needs of an 
America whose economy and demography markedly differ from the day when 
Franklin Roosevelt put this safety net in place. He is right, too, to 
have decided to allow debate on the best way to accomplish this 
transformation to go on for a while longer before he commits himself to 
a particular set of proposals that would significantly change a system 
that many Americans have come to regard as the compassionate face of 
capitalism.

Some Democrats, predictably, have taken to the barricades to oppose any 
change, either out of an attachment to a system that represents one of 
their party's historic achievements, or out of sheer political 
calculation or spite. They are unlikely to be persuaded by whatever 
evidence is marshaled in support of change. But for now at least, even 
centrist Democrats, many willing to consider reforming the system, are 
lining up to oppose the president, as is the supply-side, 
deficits-don't-matter (or not very much) wing of his own party. Former 
House speaker Newt Gingrich and Jack Kemp are warning that the 
president's plan to "reduce benefits" could cost the Republicans control 
of Congress. And while most Republican senators and congressmen of 
course want to be with the president, they are nervous about facing 
political fire without at least a modicum of bipartisan support to 
provide "political cover." So far, that cover just isn't available.

Those of us who know that change is needed are hoping that the 
president's decision to delay specific proposals is not merely intended 
to give his staff more time to hone its presentational skills, but will 
permit a substantive debate that will, in the end, result in 
improvements to the plan now on the White House drawing board. For 
unless the president considers some important modifications of his plan, 
his crusade could become for him what health care reform was for Bill 
Clinton--at least a waste of energy and political capital, at worst a 
political debacle.

How could one reform Social Security in a way that could result in a 
financially sound system, stimulate economic growth, improve the 
fairness of the existing system, and gain support from all save the "no, 
not now, not ever" crowd?

Start with the reason most offered for reforming the system: that owing 
to the impending retirement of the nation's baby boomers, the system is 
on the brink of financial insolvency. Or, if not on the brink, headed 
toward it. That may be, but is not certainly, true: Some estimates show 
that taxes currently earmarked for the program, along with earnings on 
the Social Security Trust Fund (for our purposes let's assume that there 
is such a thing, rather than reopen the tiresome debate about the 
"lockbox") will cover outlays until 2028. Others put the date at which 
the current system will be unable to pay all promised benefits at 2042.

And possibly later. For one thing, if the economy grows more rapidly and 
efficiently than some predictions suggest, the current system might well 
prove capable of meeting all of its obligations. Improvements in 
productivity at rates of recent years, for example, will allow the 
workforce to support a higher ratio of retirees than is now the case; 
more rapid economic growth will generate more revenues for the system 
than some of the middle-scenario forecasts assume.

Besides, we should be careful before spending a great deal of energy 
worrying about the financial condition of retiring baby boomers. This is 
not the 1930s, when even retirees who had worked hard, and scrimped, 
faced a difficult future. This is the 21st century, when many retiring 
baby boomers will have substantial assets that make them less dependent 
on their Social Security checks to make up as high a proportion of their 
retirement income.

Indeed, a case can be made that by putting the issue of Social Security 
reform on the backburner for several years we would not be emulating Mr. 
Micawber but, instead, heeding the interdiction widely attributed to 
Ronald Reagan: "Don't just do something, stand there." After all, in the 
face of the uncertainties surrounding global warming, the administration 
has quite wisely avoided the temptation to join the world in 
overreacting, in "doing something" before it is clear that anything 
needs to be done, or, if it does, just what. What makes sense for 
environmental policy might make equal sense when it comes to social policy.

BUT WE SHOULD NEVER discourage politicians bent on prudence. So let's 
assume that there indeed is an impending problem, and that the president 
is right to contend it is his responsibility to solve that problem now, 
rather than to burden his successors with the chore.

It is, of course, also his responsibility to make clear just what his 
proposed solutions involve. A good beginning would be to abandon the 
argument that no cut in benefits is contemplated. That argument goes 
something like this. One reason the system is in financial difficulty is 
that (here and throughout I am sacrificing a bit of precision in favor 
of a great deal of clarity) the benefits of retirees are being increased 
more or less in line with the rise in wages. Reports are the president 
would change the escalator to the cost-of-living index. That alone, 
estimates Professor Olivia Mitchell of the University of Pennsylvania's 
Wharton School, "would fix the solvency problem without individual 
accounts. Indexing to inflation rather than wages will put it back on 
actuarial balance."

Now, it is possible to make a conceptual argument in favor of either of 
those escalators (such automatic increases are far superior to the old 
system where Congress raised benefits to win reelection). Escalate with 
wages, and you retain the standard of living of retirees /relative/ to 
those of active workers. Escalate with inflation, and you retain the 
/absolute/ standard of living of retirees. Surely a question on which 
reasonable men can differ.

What cannot be argued, at least not while maintaining credibility, is 
that a switch from a wage-based escalator to an inflation-based 
escalator does not result in a reduction in payments to retirees. It 
does, for the simple reason that in an economy in which productivity is 
increasing, wages will, over time, rise faster than inflation. That's 
why proponents of the president's plan argue that using a wage escalator 
places a far greater financial burden on the system than does the 
alternative. But if the current escalator is far more expensive than the 
proposed substitute, then the switch to an inflation index would reduce 
the benefits that would flow from retaining the wage indexation scheme. 
A change to a cost-of-living index would lower the cost of the system 
precisely because it lowers benefits--a good or at least necessary 
thing, perhaps, but a reduction by any other name remains a reduction. 
Meanwhile, payments into the system, being based on a tax on wages, 
would rise faster than benefits paid out, since wages should (one 
trusts) outpace inflation.

True, were we to switch escalators we would be imposing only a reduction 
in an increase, but it is a reduction in a promised increase, an 
increase that is now incorporated in what can be characterized as a 
social contract between active workers and retirees. That is not 
something conservatives should lightly contemplate.

In addition to reducing benefits, the proposal being mooted in the White 
House would allow some portion (one-third is the share recommended by 
the 2001 Presidential Commission on Social Security Reform) of the funds 
now being paid as taxes to support the Social Security system to be 
diverted into personal retirement accounts. The reasons given for this 
change, which polls suggest younger voters see as the only way they will 
ever collect any benefits, are two: It will help to create an "ownership 
society," weaning the individual from dependence on the state; and 
returns on the privately invested funds will in some economically 
meaningful sense be higher than those now being earned by the government 
on behalf of future beneficiaries. Neither reason withstands scrutiny.

No one is proposing to allow participants in the current system to 
invest even a part of their contribution in any way they might choose. 
After all, individuals might make the wrong choices, and find themselves 
less well-off than they would wish when the time comes to lay down their 
tools or attend their last important meeting. So the proposal now on the 
table would have the government limit investment options to stock-index 
mutual funds, bond funds, and cash--the resulting pool to be converted 
into annuities upon retirement. The theory of forced conversion into 
annuities, rather than allowing lump-sum withdrawals, seems to be that 
retirees and their money might otherwise soon be parted, a folly the 
government is honor-bound to prevent. So much for freeing citizens from 
the heavy hand of the state.

A good case can be made, of course, for continued government supervision 
of the private investment of funds destined to support retirees. After 
all, a society unwilling to tolerate an army of penurious retirees--and 
politically unable to do so even if it were inclined to let retirees 
fall where they may--is in a sense the insurer of last resort. Insurers 
impose limits on the behavior against which they will insure. So the 
proposed changes in the system will not really create an army of 
investors freed from dependence on the state. Nor will the reforms in 
any economically meaningful sense increase returns on investment. 
Returns will rise only if the risk to which funds are exposed also 
rises. "Higher returns are not a free lunch," warn economists at Goldman 
Sachs; "workers would take on more risk." Risk-adjusted returns will 
remain unchanged. Private accounts allow their holders to earn more, but 
only by risking more--unless the government is prepared to cover any 
losses incurred by the private investors.

It is true, of course, that the return on investment in stocks has been 
higher over the long run than has the return earned by the Social 
Security Trust Fund. But it is far from certain that the 7 percent 
historically earned on stocks is a sure clue to what the future holds. 
Indeed, with share prices selling at higher multiples than in the past, 
it is not an unreasonable guess that earnings will be closer to 5 
percent. A bit of arithmetic: A portfolio invested 50 percent in stocks 
earning 5 percent, and 50 percent in bonds earning a real return of, 
say, 2 percent, will have an average yield of 3.5 percent. Deduct 1 
percent for management fees (Larry Lindsey thinks this wildly overstates 
the cost), and retirees will net 2.5 percent, not much of a gain over 
what the Trust Fund now earns. Never have so many spilt so much ink over 
so little, or at least so it seems.

PERHAPS MOST IMPORTANT, personal retirement accounts really have little 
to do with the solvency problem, a point made clear by Comptroller 
General David Walker, who commented last month, "The creation of private 
accounts for Social Security will not deal with the solvency and 
sustainability of the Social Security Trust Fund." Which is why Lindsey, 
a supporter of the president in this and other matters, says that 
individual accounts in the absence of other changes "will not fly in the 
bond market." These private accounts, then, are more what /BusinessWeek/ 
calls a "values issue" than a fiscal one.

Then there is the nasty question of what are called transition costs, 
variously estimated at between $2 trillion and $5 trillion, as funds 
previously headed into the system are diverted to private accounts, 
while outlays continue at currently planned levels. No one can deny that 
the president has a point: If returns can be raised sufficiently by 
switching some funds to private accounts, it should be easy to finance 
the transition costs to a new, more productive system. Borrowing in 
order to fund larger reductions in costs is common in the private 
sector, where businesses often borrow money to pay for investments or 
organizational changes that will lower future costs by more than the 
cost associated with the new borrowing. Michael Milken understood that, 
which was why he was able to arrange financing for predators and sharks 
who took over fat-laden companies, then lowered their operating costs, 
repaying loans out of the savings, with something left over to reward 
the predators.

But the government is already running a substantial deficit, and neither 
the president nor the Congress has yet demonstrated the cost-cutting 
devotion that enabled Milken's takeover artists to persuade lenders to 
accept their IOUs. It is not impossible that lenders would see $2-$5 
trillion as too much to swallow, at least at current interest rates. The 
result might then be higher interest rates, renewed pressure on the 
dollar, and other unforeseeable and unpleasant consequences. I say 
"might" because many experts, among them Lindsey and R. Glenn Hubbard, 
two of Bush's favorite economists, contend that the increased debt can 
be financed without seriously upsetting financial markets. Lindsey 
believes that the combination of personal accounts and a switch away 
from wage indexing will be "rewarded by the bond market." And Hubbard 
feels the markets will acknowledge that a diversion of funds to personal 
accounts is "akin to prepaying part of a mortgage."

But in the end no one can be sure of the effect of hitting the markets 
for a few odd trillion more in borrowing. We can, however, be sure that 
there is a risk in doing so, making it reasonable to ask whether that 
risk is worth taking to achieve what seem like the minimal gains in 
freedom and earnings that might flow from individual retirement accounts.

Fortunately, now that the time pressure has been relaxed a bit by the 
president, we can explore better ways of accomplishing his goals. 
President Bush is right to want individuals to have personal accounts, 
but these could supplement Social Security, rather than supplant a part 
of it, thereby avoiding the transition-cost problem. So more power to 
the administration's efforts to devise tax-advantaged schemes to 
encourage personal saving, schemes that do not require any diversion of 
funds now destined to finance Social Security. And with the Social 
Security safety net intact, individuals could be left free to invest 
these added savings in any way they choose--safely, in order to add a 
bit to retirement income, or daringly, in the hope of striking it rich.

The president is right, too, to want to consider a reduction in benefits 
as part of any reform package. And replacing wage-based indexing with 
something related to the inflation rate might be the right thing to do. 
But it is not the only possibility: Surely, extending the retirement age 
to reflect current longevity expectations should also be on the table. 
But in any case, we should keep our word, unmodified, to those who have 
long been part of the current system, and confine reductions in benefits 
to new or relatively recent entrants into the workforce.

Where the president and his team might benefit most from further 
reflection is in the financing of Social Security. The current system of 
levying a 12.4 percent payroll tax gives us the worst of all possible 
worlds. First, it is a tax on jobs--payroll taxes make it more costly 
for employers to hire, and less attractive for workers to work. These 
taxes raise employers' cost of hiring by 6.2 percent, and reduce the 
employees' incentive to work by cutting their take-home pay.

Worse still, the system is regressive. Only salaries up to $87,900 (in 
2004) are taxed, meaning that Wall Street mega-earners pay no more than 
their secretaries. This regressivity is ameliorated by the fact that 
most high earners continue working after the date at which they receive 
retirement benefits, and those benefits are taxed at the high rates that 
apply to all of the income earned by these older but unretired workers. 
Still, not the fairest of systems.

A truly radical reformer would consider alternatives to the 
job-destroying payroll tax system. After all, why tax a good thing, like 
jobs, rather than the many bad things that currently go untaxed? Two 
leap to mind: pollution and imported oil. Surely a reduction in the 
payroll tax, funded by a tax on either of those two items, would do more 
to stimulate economic growth, and to reduce the regressive character of 
the Social Security finance system, than would any of the reforms now 
being considered.

Which brings me to my final suggestion. The president is keen to reform 
the tax system and has announced a bipartisan commission that will 
report to him July 31 on how that might best be done. The question of 
how to finance the nation's retirement program is equally taxing, if I 
might be forgiven a pun, and is not unrelated to the broader question of 
tax reform. Why not charge the new commission with the responsibility of 
integrating reforms for the tax and Social Security systems? These 
reforms could take into consideration the fact that the world has 
changed since FDR first introduced the Social Security safety net; that 
the increase in wealth since the days of the New Deal inevitably changes 
the role to be played by government-funded retirement benefits from 
near-total provision to a supplement to other incomes; that the payroll 
tax is an impediment to more rapid economic and job growth; and that 
experience has taught that it is no bad thing to rely on each new 
generation to fund the retirement of older ones, since newer generations 
are richer than their predecessors.

With an appropriate mandate, this commission could make available to the 
president a more carefully considered set of proposals than he now has 
before him, and provide the basis for greater bipartisan support. And 
with luck, those of us who fear that the president has not been as 
radical as he might have been had he been willing to abandon the payroll 
tax, might carry the day.

Not incidentally, this pause that might refresh would leave President 
Bush free to devote that portion of the time and political capital that 
he is able to spend on domestic affairs to getting his judicial 
appointments approved, and to begin focusing his attention on the health 
care system. According to Goldman Sachs's economic team, "Medicare is 
the much bigger problem. It accounts for more than four-fifths of the 
projected increase in entitlement spending in coming decades, and its 
costs--unlike those of Social Security--are largely immune to an 
increase in retirement age. Indeed, the recently enacted Medicare 
prescription drug benefit by itself is projected to cause a bigger 
spending increase than the entire Social Security system!"

Now there's a problem worth tackling in order to bring the deficit under 
control, while plans for reforming Social Security are, shall we say, 
refined.

Irwin M. Stelzer is a contributing editor to /The Weekly Standard/, 
director of economic policy studies at the Hudson Institute, and a 
columnist for the /Sunday Times/ (London).