Social Security "Add-On" Accounts with Benefit Offsetrevised September 27, 2004 --
a minor editorial correction.
Many Republicans favor personal Social Security accounts that are “carved out” of current payroll taxes. But Republicans have not come to terms with the increased taxes or reduced spending needed to finance the “transition costs” of carve-out accounts.
Most Democrats reject carve-out accounts. But Democratic leaders have yet to outline an alternative set of tax increases or benefit reductions sufficient to balance Social Security's revenues and costs in the long run.
Social Security "add-on" accounts might help break the impasse. Add-on accounts could give future retirees the benefits of personal accounts without the transition costs associated with carve-out proposals.
Alternatively, add-on accounts could be used in combination with larger reform packages, including carve-out proposals. The add-on would allow larger accounts without extra costs.
Outline:
Add-On Social Security Accounts
Some Pros and Cons
Perspective -- A Bipartisan Breakthrough?
Add-On Social Security Accounts: Personal add-on accounts in Social Security would be funded by additional payroll taxes paid by workers.
A worker would literally pay for his or her own Social Security account. Over time, retirees would use the funds in their accounts to compensate for reductions in regular Social Security benefits. Because, current payroll taxes would not be diverted, there would be no transition costs to worry about.
By contrast, most Social Security reform proposals would redirect a portion of existing payroll taxes to new personal accounts. In Social Security jargon, these proposals are called "carve-out" plans.
However, redirecting payroll tax revenues to personal accounts creates a budgetary hole -- we still need to pay benefits for current retirees. Moreover, no Social Security reform proposal would dramatically cut benefits for workers now nearing retirement. We would need sufficient tax revenues to pay for current retirees and near-retirement workers for several decades.
This transition cost problem looked solvable in the late-1990s. By channeling budget surpluses to Social Security accounts instead of tax cuts or spending increases, Congress could have paid for the transition costs of Social Security reform while keeping the overall federal budget roughly in balance.
But times have changed. The recession of 2001, three large tax cuts, dramatic increases in national security spending, and steady non-defense spending have turned budget surpluses into deep deficits.
Although the economy is now recovering, annual budget deficits are likely to stay around $300 or $400 billion for several years. Continuing tax cuts and defense needs, a new Medicare drug benefit, and the necessity of fixing the Alternative Minimum Tax (AMT) will keep deficits high throughout this decade. (Assuming Congress makes many of the tax cuts permanent after 2010, the deficits will soar in the next decade, when the baby boomers start to retire.)
To be sure, even unfunded Social Security reforms might be better than doing nothing. Borrowing several trillion dollars now to pre-fund Social Security would be preferable to borrowing many times that amount in the future.
However, with the budget deficit continuing to worsen, Social Security reforms with large unfunded transition costs are increasingly implausible.
Instead of shunting a portion of current payroll taxes to an account, the add-on approach would leave current payroll taxes to fund current benefits. With add-on accounts, workers would pay an additional percentage point or two in payroll taxes, and only that money would fund their Social Security accounts.
To save Social Security costs in the long run, add-on accounts would be coupled with an offsetting benefit reduction. Social Security's regular benefit would be reduced by exactly the amount each worker would be expected to receive from his or her account, assuming a standard interest rate associated with "safe" investments in government bonds. In Social Security jargon, this is called a "benefit offset" corresponding to an individual's account.
Figure 1 shows the impact on Social Security's long-run deficit of a 1 percent or a 2 percent add-on account, with corresponding benefit offsets. Assuming a "real" or inflation-adjusted interest rate of 2 percent for the benefit offset, the 1 percent accounts would reduce the Social Security deficit by about 0.5 percent of GDP in the long run. A 2 percent add-on account with corresponding benefit offset would reduce the Social Security deficit by about twice as much, roughly 1.0 percent of GDP.
Figure 1.
Figure 2 (below) illustrates the same two options from a different point of view. Since the payroll tax add-on of 1 or 2 percent exactly equals the amounts placed in workers' accounts, there is no net cost to the government. New revenues from the extra percent or two of payroll exactly equal the amount of new outlays going to fund the accounts.
Therefore, Figure 2 shows the underlying improvement in Social Security costs from the benefit offsets alone. Netting out the funding for the account itself, a 1 percent account with benefit offset would reduce Social Security's benefit costs by about 0.5 percent of GDP. A 2 percent add-on account would reduce Social Security's benefit costs by 1.0 percent of GDP.
Figure 2.
Importantly, add-on accounts are not really a substitute for a fuller reform package. By themselves, add-on accounts of 1 or 2 percent of earnings with a benefit offset would not reduce Social Security's costs by nearly enough to close the program's long-term deficit. (Larger add-on accounts would be impractical -- the drain on workers' earnings would be quickly become difficult to bear.)
However, add-on accounts wouldn't worsen our budget problems in the short run.
Table 1 (below) shows the budgetary cost of several Social Security reform proposals, including a 2 percent add-on account with benefit offset. (The various proposals are explained in a little more detail below.)
Congressional budgeting is usually done in ten year blocks, and total spending or revenues are commonly cumulated over the entire period. By this measure, a two percent add-on account with corresponding benefit offset would save a small amount -- about $1 trillion -- cumulatively over the next 30 years. (Budget accounts are displayed in "current" dollars, so $1 trillion cumulated over the next 30 years really isn't that much.)
However, plans with large carve-out accounts are unambiguously expensive. A plan proposed by anti-tax advocate Peter Ferrara would cost about $9 trillion over the next 20 years, and almost $14 trillion over the next 30 years.
Unlike most Social Security reform proposals, the add-on concept saves the government money during both the transition period and the long run.
Table 1.
| Cost Comparisons (in Trillions of Current Dollars) |
|
|
| |
|
Current Law |
|
Ferrara |
Graham |
Kolbe-Stenholm |
2% Add-On Account With Benefit Offset |
Diamond-Orszag |
| |
|
|
|
|
|
|
|
|
| Budgetary Cost (+) or Savings (-): |
|
|
|
|
|
|
|
|
| 2005-2014 |
|
N/A |
|
3.6 |
1.5 |
0.8 |
-0.0 |
-0.5 |
| 2015-2024 |
|
N/A |
|
5.3 |
2.1 |
0.6 |
-0.2 |
-1.0 |
| 2025-2034 |
|
N/A |
|
4.9 |
1.1 |
-0.8 |
-0.9 |
-2.2 |
| |
|
|
|
|
|
|
|
|
| Total, 2005-2034 |
|
|
13.8 |
4.7 |
0.6 |
-1.2 |
-3.7 |
| |
|
|
|
|
|
|
|
|
| Source: Centrists.Org |
|
|
|
|
|
|
| Notes: Calendar Years; Budget Estimates Not Adjusted for Inflation. |
|
|
Although it is not used in budgetary calculations, a more comprehensive measure of the long-run impact of Social Security reform ideas is the present value of all future Social Security deficits and surpluses.
There are many ways to compute net present values of future liabilities. Figure 3 (below) uses a very simple method, the net present value of Social Security operating liabilities (costs less tax revenues) in current dollars, discounted at a flat rate of 6 percent a year between 2004 and 2078.
By this measure, the 2 percent add-on account with a benefit offset would reduce Social Security's long-run liabilities by almost as much as the carve-out bill introduced by Representatives Jim Kolbe and Charlie Stenholm, and by more than Senator Lindsey Graham's Social Security reform bill.
Figure 3.
Some Pros and Cons: To be fair, the 2 percent add-on idea with a benefit offset is not really sufficient to put Social Security on a permanently sustainable path. It would not reduce the program's long-run deficit to zero. After 50 years, Senator Graham's plan, which would eliminate the Social Security deficit after 2050, performs better (see Figure 4, below).
However, add-on accounts idea do not need to be considered in isolation. Add-on accounts could be used in combination with larger reform packages, including carve-out proposals. The add-on would allow larger accounts to be created without extra transition costs.
Figure 4.
Some conservatives would deride the add-on idea as a tax increase. Of course, that's true. Social Security would be compelling people to save more, in effect, by shunting an additional percent or two of payroll earnings into their Social Security accounts.
But from an economic point of view, this sort of "forced savings" would have beneficial effects. As a tax increase, it would be unlike any other -- the funds would be in people's personal accounts, not the Treasury's. The accounts would probably increase national savings and investment.
Moreover, any government spending must ultimately be covered by taxes. Politicians who say "deficits don't matter" are just lying. When taxes aren't high enough to cover government spending, governments must borrow, and government borrowing must ultimately be repaid.
Although governments routinely run deficits to fight recessions, all government debt carries a price in the long run, either via interest costs, reduced private investment, or higher inflation. A large amount of government borrowing almost always eventually has adverse economic consequences.
Finally, borrowing from the next generation (by forcing future workers to pay interest and principal on money the government borrows now) defeats one of the main purposes of Social Security reform: preventing future generations from crushing tax burdens.
Figure 5 (below) shows how the budgetary costs of a 1 percent add-on account with a benefit offset would work out under standard budget rules. Like Figure 2, this chart shows the savings from the benefit offset corresponding to the accounts. But unlike Figure 2, it also shows the absolute revenue increase associated with funding the accounts, as well as the cost increase associated with putting those very same dollars in people's accounts.
For practical purposes, add-on accounts wouldn't greatly affect the date when Social Security benefits exceed revenues. (That date is currently projected to be about 2018 -- it is the date when the revenue and spending lines cross in Figure 5.) It takes a long time for the savings from the benefit offset to kick in.
But in the long run, even accounting for the extra funds flowing into accounts, Social Security's overall cost as a share of the economy would be reduced.
Figure 5.
Perspective -- A Bipartisan Breakthrough? "Pre-funding" future Social Security benefits using personal accounts could permanently solve the program's budget problems. Personal accounts would allow Social Security's standard benefits to be trimmed back to their current levels as a percentage of the economy, even as the population aged 65 or over doubles during the next 35 years.
Personal accounts have other advantages. They could increase younger workers' confidence in the Social Security system. They would allow low-income workers to build a modest amount of wealth, which they and their families would control.
Finally, personal accounts have the potential to be more popular and politically palatable than alternative Social Security reforms that would simply cut benefits and raise taxes. For example, a non-account proposal put forward by left-of-center economists Peter Diamond and Peter Orszag was met with a resounding silence among Democrats.
The Diamond-Orszag proposal was straight-forward -- it laid out the tax increases and benefit cuts that would be necessary to close the Social Security deficit in the long run without using personal accounts. But when it was unveiled, most Democratic elected officials ran for the hills.
Most Republicans have been just as cowardly. Republicans pushing personal accounts have mostly shied away from addressing the transition costs of their proposals.
To his credit, Senator Graham -- whose reform bill is a close proxy for President Bush's approach -- has offered to rescind some tax cuts if the money went to pay for Social Security accounts instead.
But President Bush and Congressional Republican leaders have not come close to endorsing Sen. Graham's all-too-reasonable offer.
Making matters worse, several Republicans in the House are pushing "free lunch" proposals with large personal accounts and no plausible accounting for the huge transition costs. These "large account" proposals would make Social Security more expensive, not less, for the next 30 years.
For centrists, the bipartisan reform plan introduced by Representatives Kolbe and Stenholm contains tough, specific benefit and budget cuts to reduce its transition costs to a relatively small and manageable amount.
But tough choices are not fashionable in Congress these days. That is why we have record budget deficits. Politically, it is always easier to pass tough decisions on to the next Congress, or the next generation.
The bottom line? We need a breakthrough idea on Social Security reform.
As stands now, Democrats aren't willing to endorse the benefit cuts and tax increases necessary to eliminate future Social Security deficits without pre-funding through personal accounts. And Republicans aren't willing to pay for the transition costs of their personal account proposals.
Add-on accounts might be a tolerable middle ground. On one hand, they could be considered as a starting point in the move toward pre-funding Social Security. Alternatively, they could be added to carve-out proposals, a zero-cost way make personal accounts bigger and more attractive.
Links:
Centrists.Org CBO's New Estimates of Social Security Reform Proposals (July 23, 2004)
Centrists.Org Testimony: Comparing Social Security Reform Proposals (June 15, 2004)
Centrists.Org CBO vs. Trustees on Social Security: A New Model Tells A Similar Story (preliminary June 14, 2004)
Centrist Policy Network Kerry Talks Social Security (April 9, 2004)
Centrists.Org Transcript: Addressing Greenspan's Challenge on Social Security and Savings: Views from an Emerging Generation of Political Leaders (revised April 2, 2004) Transcript of a discussion on Social Security reform held on March 25, 2004 with Senator Lindsey Graham and Rep. Harold Ford, moderated by Morton Kondracke of Roll Call.
Centrists.Org The Kolbe-Stenholm Social Security Reform Plan (revised February 14, 2004)
Centrists.Org Detailed Issue Summary: Social Security Reform (updated January 5, 2004)
Centrists.Org Budgetary Effects of the Diamond-Orszag Social Security Proposal (revised December 31, 2003)
Centrists.Org Unfunded Transition Costs of the Ferrara Social Security Proposal (revised December 10, 2003)
Centrists.Org A Preliminary Analysis of Sen. Graham's Social Security Proposal (revised December 14, 2003)
Centrists.Org Raising the Cap on Payroll Taxes Doesn't Solve the Social Security Problem (November 17, 2003)
