Social Security Privatization: Balancing Efficiency and Fairness

By Garner, C. Alan | Economic Review - Federal Reserve Bank of Kansas City, Third Quarter 1997 | Go to article overview

Social Security Privatization: Balancing Efficiency and Fairness


Garner, C. Alan, Economic Review - Federal Reserve Bank of Kansas City


rowing public awareness of future pressures on Social Security is eroding many Americans' confidence in this key retirement program. These pressures are nearly certain in the next century, stemming from the retirement of the large baby-boom generation, longer average life spans, and lower projected fertility rates. To meet such pressures, various reforms of Social Security have been proposed, ranging from simple repairs to the current system all the way to full privatization. In this context, privatization usually means moving the public retirement system toward a set of individual accounts with the workers' funds invested partly in private securities and with workers having some measure of control over investment allocations.

Choosing among the competing reform proposals is a daunting task. Supporters of privatization believe such reforms would boost economic efficiency, resulting in higher real output per worker and helping the nation cope with the future pressures from population aging. Supporters also believe privatization would produce a retirement system that treats different generations more fairly. Critics fear, however, that the privatization of Social Security would produce a more unequal income distribution for retirees and expose them to greater investment risks.

This article examines these fundamental issues of economic efficiency and fairness that should be weighed when considering Social Security privatization. The first section summarizes the challenges to the current system and outlines various options for reform. The second section explains how privatization could improve economic efficiency, and briefly considers the difficult issue of the transition costs in moving from the current system to full privatization. The third section discusses important issues of fairness within and across generations. Any decision to privatize Social Security will require balancing the likely gains of greater real output and fairer returns to younger generations with the possible adverse effects of a more unequal income distribution among retirees and greater investment risks. This balancing must occur through the political process because fairness is a matter of values rather than economic analysis.

I. THE GROWING INTEREST IN PRIVATIZATION

The many achievements of Social Security should not be forgotten in discussing possible reforms. Social Security has provided a secure retirement income for millions of Americans, lowering poverty rates among the elderly and protecting working families against the disability or premature death of a breadwinner. Moreover, such Social Security benefits are not currently in jeopardy because the system faces no immediate problem in meeting its financial obligations. Recent interest in privatizing Social Security comes, instead, from a growing awareness of the pressures that will emerge in the early decades of the next century, along with some long-standing issues about how to balance economic efficiency and fairness.

Financial challenges

Social Security is essentially a pay-as-you-go retirement system in which most of the payroll taxes paid in by employers and current employees are immediately paid out as benefits to retirees. An estimated 144 million people paid contributions to the old-age and survivors insurance and disability insurance (OASDI) trust funds in 1996, with the combined tax rate on employers and employees being 12.4 percent.1 Benefits were paid to almost 44 million people at the end of 1996, with initial benefit levels depending on the workers' earnings histories and changes in national average wages. After retirement, benefit levels are adjusted upward to reflect changes in the consumer price level.

Despite the existence of the OASDI trust funds as an accounting device, Social Security is really unfunded in the sense that there is no portfolio of private securities backing the program that could be sold to maintain future benefit payments. …

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