March 15, 2005 | Volume 2, Issue 1
Policy Viewpoint: Against Privitization of Social Security
The Problem
The Social Security program is facing a long-term deficit—the projected payroll tax revenues will be insufficient to pay all benefits promised under the current law in the next seventy-five years. While everyone agrees that there is a need for some sort of corrective policy reform, there exist wide differences on the nature of that policy reform. The proposal to divert a part of payroll taxes to private accounts has sparked a great deal of discussion. On one hand, supporters of private accounts argue that private accounts would give workers ownership and control over their retirement funds, which will not only provide workers with higher benefits but also restore Social Security to longterm solvency. On the other hand opponents of private accounts argue that carving out payroll taxes to deposit in inherently risky private accounts undermines the assured income that the Social Security provides.
Solution
My policy position is to restore the actuarial balance of the system through a balanced package of adjustments to both the benefits and revenue sides, but without disturbing the program’s basic structure. The following are the possible adjustments:
- On the benefits side, the retirement age could be suitably raised for white-collar workers.
- On the revenue side, the maximum taxable earnings base could be raised suitably and state &
local government workers could be brought into the program coverage; and
- The estate tax could be reformed rather than eliminated entirely, and some of the revenue
could be dedicated to Social Security.
Justification for policy position
The basic objective of Social Security systems, whether public or private, is to provide financial security to the elderly, their dependents, and to those unable to work due to disability. The three key objectives1 of any Social Security system are:
- Providing a savings vehicle (to allow individuals to redistribute across their own lifetime to avoid
poverty in old age)
- Redistribution (from the rich to the poor to prevent poverty in old age);
- Social insurance (providing a social safety net for those who become unable to work).
The analysis below shows that introduction of private accounts significantly dilutes all of the above objectives.
Objective 1: Providing a savings vehicle
The current system provides an equitable savings vehicle for all workers and ensures that each worker who participates by paying payroll taxes is entitled to an assured level of base income on retirement. This base income is, in fact, the main source of income for over 28 million people, including 8 million people for whom it is the only income. Privatization destabilizes this savings vehicle and undermines the value of the base income in the following ways:
- It exposes the base income to the vagaries of the financial market, subjecting the base income
to risk of erosion. Fluctuations in the financial market are a reality that could severely
undermine the base income. Moreover, these financial fluctuations can be sudden and
unpredictable. For instance, in the aftermath of the Internet bubble burst in 2000–01, the
NASDAQ fell more than 7%. In case of privatized accounts, such a meltdown would mean a
catastrophic drop in the value of base income.
- In particular, if the private accounts are to be financed by diverting payroll tax revenue away
from the Social Security trust fund, the immediate effect would be an increase in the deficit
within Social Security. The transition to private accounts is estimated to increase the fiscal
deficit by over USD 2~3 trillion.2 This may slow down the economy, leading to increasing
unemployment and further undermining the savings potential of the workers.
Objective 2: Redistribution
The current Social Security system is progressive in nature, as it replaces a large share of previous earnings for lower earners than it replaces for high earners. Such progressivism in Social Security system helps reduce poverty and narrow income inequalities. Privatization will reduce the redistribution effects of the current system in the following ways:
- With the introduction of private accounts the said replacement rates, rather than being
progressive, would be proportional to the earnings within a cohort, thereby reducing
the ‘inherent’ progressivity of the system.
- In the case of private accounts, benefits during retirement depend on the how ell the individual
has invested. The higher income groups with access to sophisticated financial information are
more equipped to make investment decisions as compared to lower income groups. This
information divide further reduces the progressivism of the system.
Objective 3: Social Insurance
In addition to basic retirement income, the current system provides social insurance in the form of benefits like disability benefits and pension to survivors. Privatization restricts the social insurance function of the system in the following ways:
- In private accounts individuals would have unrestricted access to their accounts through loans or
early withdrawals as in case of 401k plans.3 This not only undermines the preservation of a
base income but also undercuts the protection available for the individual’s survivors. Given that
the American society has a traditionally low savings rate, the feature of current system entitling
individuals to benefits only upon retirement is crucial to preserve basic sustenance income.
- In a private account system it would be financially unviable to integrate such benefits, especially
disability benefits. Moreover, Social Security in its current form is designed to protect retirees
and the disabled from inflationary pressures. Individual accounts are unlikely to have inflation
protection, and the lack of inflation protection could severely undermine the quality of life of the
poorer section of society.
Other issues—Increase in administrative costs
A system of individual accounts would create an enormous administrative burden. Instead of the current centralized trust fund accounts, the government would need to establish and keep track of many small accounts. Ensuring workers have adequate financial education to manage their individual accounts will be expensive. These additional expenses would eventually translate to lower benefits for the workers.
Conclusion
To sum up, the proposal to divert part of Social Security taxes to private investment accounts will destroy the very edifice of a time-tested and well functioning system by adversely impacting the core principles of redistribution, promoting savings and providing social insurance. The existing individual accounts like 401k plans, which already provide an extremely useful supplement to Social Security, can be improved, expanded and encouraged. But carving out payroll taxes to deposit in inherently risky private accounts undermines the assured base income that Social Security provides. In the interest of millions of Americans who depend on Social Security, we must adopt a composed approach to restore the balance of the Social Security system by a combination of benefit and revenue side reforms while preserving its current structure.
Contact Information
For additional information, or to set up an interview with a member of the Heinz School Review staff, please contact us by telephone at 412–268-1610, or by sending email to heinz-journal@andrew.cmu.edu.
1 World Bank Pension Home Page : World Bank in Pensions http://wbln0018.worldbank.org
2 The Century Foundation, Social Security reform â Guide to the Issues, 2002 http://www.socsec.org
3 Brookings Institution: Brooking Briefing â Reforming Social Security, Jan 2005 http://www.brook.edu