The Case for Pre-Funding Social Security

By Brown, Jeffrey R. | Generations, Spring 2005 | Go to article overview

The Case for Pre-Funding Social Security


Brown, Jeffrey R., Generations


Why 'personal' or 'private' accounts could save the system.

Social security has been one of the most successful government programs in our nation's history. Unfortunately, the basic financial structure of Social security, designed during the depths of the Great Depression, is not well equipped to handle the substantial demographic changes that are under way in the United States. As a result, Social security simply cannot afford to pay currently scheduled benefits in the coming decades without imposing an ever-larger tax burden on younger workers. In the face of this demographic and financial reality, "doing nothing" is simply not a viable policy option. Social security must change if it is to be made financially secure.

This article outlines the basic reasons that the Social security system is in long-run financial distress and discusses the policy options namely tax increases or benefit cuts-available for closing the financial shortfalls within the confines of the existing system. "Pre-funding" Social security-that is, saving more today in order to reduce the burden on future generations emerges as the most sensible way to proceed, with personal retirement accounts (PRAS) constituting a mechanism for saving that is superior to the current system's reliance on "trust funds." Indeed, much of the current opposition to such accounts is based on misconceptions about PEAS as part of a reformed Social security system.

A TAY As You GO' SYSTEM

The U.S. Social security system is not a savings program. Rather, it is an income transfer system that taxes today's workers to pay benefits for today's retirees and other beneficiaries. Economists call such a financial structure a "pay-as-you-go" or "unfunded" system. This is in sharp contrast to die pre-funded nature of most private-sector pension plans in which the money contributed to a worker's pension is invested in real financial assets (e.g., stocks or bonds) that are then used to pay benefits when the worker begins receiving benefits. In economic terms, the primary disadvantage of a "pay-as-you-go" system relative to a pre-funded system is that it reduces national saving, reduces economic growth, and therefore shrinks the size of the economic pie (Feldstein, 1974).

Despite its economic disadvantages, an unfunded, pay-as-you-go system can still work reasonably well when there are a large number of workers paying taxes to support each beneficiary. Back in 1950, for example, there were sixteen workers paying taxes to support each Social security beneficiary. At that time, a payroll tax rate of only 3 percent was sufficient to support the expenditures of the entire Social security program. As the Social security system has expanded and matured, however, the ratio of workers to retirees has fallen substantially, as indicated in Figure i. Today there are only 3.3 workers to support each beneficiary. As a result of population aging, this ratio will fall to just 2 within a generation.1

To put these numbers into perspective, consider the following example. When there are sixteen workers per retiree, as was the case in 1950, then for every $100 that the government pays to the average Social security beneficiary, each worker must pay a tax of $6.25. When the worker-to-beneficiary ratio falls to 3.3, as it stands today, each worker must pay over $30 in taxes to provide a $100 benefit. As this ratio falls to 2, the tax must rise to $50 per worker. Simple mathematics dictates that as the ratio of workers-to-beneficiaries declines, Social security must either raise taxes or reduce benefits in order to keep the system in annual fiscal balance.

While this example is highly stylized, the lesson is very real. Today, employees and employers pay a combined 12.4 percent in Social Security taxes on die first $87,900 in earnings. These taxes, combined with a much smaller amount of revenue obtained from personal income taxation on some Social security benefits, raised approximately $470 billion in 2003. …

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