Debunking the Social Security Myth

How much will you have to pay in higher taxes to finance Social Security benefits for the Baby Boom generation? If you think this is an unimportant question for a 20-year-old Harvard student, think again. Without any changes, Social Security benefits are projected to exceed payroll tax revenues by approximately $160 trillion from now until 2075. To maintain the exiting system, our generation will have to bear a tremendous burden in the form of higher taxes during our working years and reduced benefits in our retirement years. In fact, economists estimate payroll taxes may have to rise at least 50 percent to finance benefits for our parents' generation.

The problem lies with the "pay-as-you-go" nature of the existing system. In the current system, the federal government collects payroll taxes from worker and firms and immediately uses the money to pay benefits to current retiree. During the past 50 years, this system functioned effectively for three reasons. First, there were a higher number of workers per current retiree. Second, workers' real wages kept rising, and therefore, so did the federal government's payroll tax revenue. Third, Congress repeatedly increased the payroll tax rate (in the past 50 year, it has gone from 2 percent to 12.4 percent). Unfortunately, times have changed. In particular, the number of workers per retiree has decreased dramatically with the aging of the American population. The problem will only get worse when the Baby Boomers begin to retire. To maintain the existing system's solvency, we will have no choice but to increase taxes, reduce benefits, and/or raise the retirement age.

Fortunately, an alternative solution exists: we can move toward a "fully-funded," privatized system. Individuals could direct a portion of their payroll taxes to their own retirement accounts. They would have the opportunity to invest their savings in stocks and bonds. When individuals retire, they would draw their benefits from their own accounts. In other words, retirees would receive a portion of their benefits from their own savings rather than from payroll taxes on younger generations of workers.

As students learn in Ec 10, a fully-funded system has two important advantages over a pay-as-you-go system. First, it has a positive effect on national saving and economic growth. In the pay-as-you-go system, no savings occurs in the Social Security system. Payroll taxes are used to finance current consumption by retirees. Moreover, the expectation of future Social Security benefits discourages workers from saving some of their income for retirement. In the fully-funded system, savings accumulates in each individual's account. Savings is important because it fuels investment in plant and equipment. Additional plant and equipment allows each worker to produce more output. In other words, labor productivity rises, and therefore, national output (GDP) rises.

The second major advantage of a fully-funded system is that it provides individuals with a greater rate of return. A brief example, drawn from work by William Beach and Gareth Davis at the Heritage Foundation, will help me to explain this point. Consider an average household consisting of two 30-year-old working parents with children. In today's dollars, that couple will pay approximately $320,000 in payroll taxes over their lifetime, and will receive $450,000 in benefits during their retirement. This represents an annual rate of return of 1.23 percent. In other words, the Social Security system is equivalent to a bank account that yields 1.23 percent annually after adjusting for inflation. But remember--no such account exists in our pay-as-you-go system! On the other hand, if the couple had, placed that $320,000 in a tax-deferred account, and invested 50 percent in stocks, then they would receive $975,000 during retirement. That represents a real rate of return of over five percent or four times the rate of return that they receive from social Security!

Some bipartisan support has begun to emerge for proposals that move us toward a fully-funded, privatized system. Unfortunately, defenders of the status quo have promulgated a series of myths that undermine efforts to reform the current system.

Myth #1: Privatization plans hurt the poor.

Opponents of privatization argue that the existing Social Security system redistributes income from the rich to the poor, and consequently, is a good deal for most low income families. Nothing could be farther from the truth. According to the work by Beach and Davis, low income families receive only slightly higher returns than the average income household. They earn 1.85 percent on their "investment" in the current system, which is far below the five percent return offered by an investment in a balanced portfolio of government bonds and stocks. Moreover, some minorities earn negative returns in the current system. For example, due to their low life expectancy, African-American single males in their mid-20s should expect to get back less than 88 cents for every dollar of payroll taxes paid during their lifetime.

Myth #2: Privatization will be risky.

Opponents of privatization argue that stocks represent risky investments, and in particular, they point out that the stock market cannot continue its recent record of abnormally high returns. Well, they are correct that individual stocks have more risk than bank accounts or U.S. government bonds, and they are also correct that the stock market in unlikely to maintain its current rate of return. However, they must remember that individuals will be investing for the long haul, and in that case, the risk of losing money in a diversified portfolio of stocks looks mighty small. In fact, stocks rose at a 7.56 percent annual rate, after inflation, over the seventy year period from 1926-1996.

Myth #3: Privatization will have a big impact on stock prices.

Opponents of privatization argue that the sudden increase in stock market investments will cause a dramatic rise in stock prices today. What will follow, they argue, is a big decrease in prices as Baby Boomers withdraw money from their accounts. However, the increased savings resulting from these privatization proposals represents a tiny portion of the total value of U.S. stock and bonds. It is unlikely, therefore, to have any significant impact on stock and bond prices.

As the national debate continues in the coming months, keep in mind the facts behind these myths. In particular, keep in mind that incremental changes to the existing pay-as-you-go system are likely to impose a greater burden on our generation. A fully-funded, privatized system offers an opportunity to avoid tax hikes and benefit cuts while simultaneously increasing savings, investment and economic growth.

Michael Roberto '91 is a former Ec 10 section leader, and is currently a doctoral candidate at the Harvard Business School.