Structural Spending Reform, Part 5

The big item in the federal budget is, of course, Social Security. Slated for bankruptcy in a little bit over a decade, Social Security is an ominous symbol for the entire American welfare state. Despite 20 tax hikes in 40 year, taking the Social Security tax from two to over 12 percent, the program is rapidly running out of money.

The same is true for the entire American welfare state. I explained in great detail already in 2012 when I wrote Ending the Welfare State: A Path to Limited Government That Won’t Leave the Poor Behind. In that book I gave five examples of comprehensive reforms to entitlement programs, all of which would:

  • Eliminate the threat of a fiscal cliff,
  • Advance economic freedom, and
  • Protect the poorest among us.

One of the reforms in the book explains how we can save Social Security from bankruptcy. This article is a summary of that chapter; for the sake of brevity I will not explain the details of the algorithm for introducing private accounts. The full technical outline is in the book.

The biggest problem with Social Security is that it has made promises to low-income workers. Thanks to these promises, they have refrained from seeking other retirement security options and therefore become entirely dependent on government. To reinforce this promise profile, the Social Security system allows you to accrue future benefits with a slant in favor of low incomes. In a three-tier formula, taxpayers qualify for benefits equal to 90, 32 and 15 percent, respectively, of their income, depending on how much money they earn.

By contrast, the tax funding Social Security is a flat rate, which means that the program redistributes money on an on-going basis, from higher-earning taxpayers to those with lower incomes.

Herein lies one of the two key design flaws in Social Security: it works if and only if

  1. Overall household income grows at a certain minimum rate per year, and
  2. Income differences remain big enough for a solid transfer of money from those with higher incomes to those with lower incomes.

The second condition depends on the first. Social Security is funded out of work-based income; in a slow-growing economy, work-based income grows more slowly across the board – not just for low- and middle-income families. As a result, tax revenue slows down and the “surplus” tax base, i.e., the higher incomes that fund the benefits redistribution, shrinks.

Since GDP growth has slowed down markedly in the past 20 years, so has growth in personal income – and especially work-based income. Therefore, Social Security is structurally under-funded.

However, there is another design flaw: income migration. This flaw is independent of the rate at which the economy grows over time. At the heart of Social Security lies a discrepancy between the growth rate in benefits and the growth rate in funding. The benefits that each person accrues over his or her working life will, by necessity, grow faster than the incomes out of which those benefits are paid.

Here is how it works. You enter the workforce at a young age, with a wage or salary at the bottom of what is common for your profession. As your career advances, your income increases primarily in three ways: annual raises and seniority; promotions and job changes; and career-advancing training and education. When you approach retirement, you earn a top salary for your profession.

Over the years, your income migrates upward, but it doesn’t just migrate upward with average household income. Thanks to your progress through your career, your earnings outpace the average. But here is also where the problem starts for Social Security: your benefits are accrued based not on average, national household income, but on your individual income path.

Taxes, by contrast, grow with average household income.

To take an example, suppose you enter the workforce at 22. You start out with a salary of $25,000.* Average personal income is $40,000, placing you at 62.5 percent of the average. Over time, average income grows by three percent – new, younger workers enter the workforce at entry-level wages – but due to the three factors behind individual income growth, your income rises faster, say at five percent per year.

By 47, your income will equal the national average; when you retire, you earn 42 percent more than the average.

This example is based on a modest assumption of how individual income outgrows average income. If the growth difference is 2.5 percent per year instead of two percent, in the example above the individual will retire with an income 75 percent above average, instead of 42 percent.

When your individual income grows at five percent per year (with average income growing at three percent) you retire with an individual funding deficit. You have, bluntly, underfunded your own retirement by $216,600.

Over the decades, this underfunding makes the system structurally underfunded. Every retiring generation adds to the funding deficit. I include a calculation in my book, simulating a benefits cap at average income growth (p. 120). Over the 50 years from 1960 to 2010, the benefits cap would have eliminated half the benefits paid out.

The root cause is that Social Security is a pay-as-you-go system. Cash that goes into the system from current tax payments fund cash going out of the system, i.e., current benefits. The individual earns IOUs as he goes, relying on future taxpayers to fund it for him.

It is thanks primarily to 20 tax hikes over a period of 40 years, 1950 to 1990, that the bankruptcy of the system has been delayed.

There have been attempts to solve this problem. President Bush Jr. and then-Congressman Paul Ryan (R-WI) introduced a model for static private accounts where a fixed share of a person’s Social Security taxes would be diverted into a private account. This model delays but does not solve the problem with the structural budget deficit.

Only a model for dynamic private accounts can do this. Referring again to my book for the details, here is the dynamic model in a nutshell.

Instead of diverting a fixed income share, over time the dynamic reform diverts a growing share of a person’s income. The increase in the share is faster for low incomes: they will be the first to get control over their own retirement. Since a private-account model means that retirement is pre-paid, and since individualized retirement builds a more solid structure of benefits upon retirement, this feature of the model guarantees that low-income workers are taken care of before anyone else.

There is another feature of the model that protects low-income taxpayers. The private accounts are phased in, meaning that the accounts slowly, gradually replace Social Security as a national retirement plan. The phase-in period is very long – the algorithm developed in my book is based on a 40-year transition period – which means that the current Social Security system will continue to receive funding for a long time to come. Since current benefits are structured to prioritize low-income workers, this means that those who are too old to benefit substantially from the private accounts, are guaranteed funding of their Social Security benefits.

The phase-in follows a formula (p. 127) where private accounts are rolled in by income quintile. The transition from Social Security taxes to private-account contributions migrates upward through the income layers; the share of the tax that is diverted increases annually.

It takes five years before the highest income quintile is introduced to private accounts. This, again, helps guarantee the solvency of the gradually out-phased Social Security system.

To further guarantee a solvent transition, the expansion of the private accounts takes place in three stages:

  1. The introduction period is 6-8 years long. During this period the share of Social Security taxes that go into private accounts will increase steadily until 30 percent of all Social Security tax revenue goes into those accounts. At that point the transition tapers off and comes to a halt at a 45-percent private account share.
  2. A stabilization period lasts for 10-12 years, during which the private-accounts share remains unchanged. This is to allow for solvent funding of retirement benefits for those who are too old to participate to any substantial degree in the transition.
  3. The final phase, the completion period, is about ten years long. During this phase, the transition is completed into a fully private model for retirement security.

Again, the algorithm developed for this transition (pp. 129-131) is based on a total transition period of 40 years. If GDP growth picks up during that period of time, the transition can move faster and be completed sooner.

The main point with the privatization is, again, to liberate America from one of its most bone-headed government promises – one that was based on embarrassing design flaws from the get-go – and to do so while protecting the poor, the vulnerable and those who have been lured into believing that they can trust government with their own financial future.

We have one more reform model to talk about: income security. Click here and see what happens when we toss out the socialist, relative definition of poverty and replace it with the socially conservative, absolute definition.

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*) The numbers here are hypothetical, but please keep in mind that the statistics used for this privatization model are almost a decade old by now. However, the Social-Security structural problems identified here have not changed. They remain regardless of what actual numbers we plug in.

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  1. Pingback: Structural Spending Reform, Part 4 | The Liberty Bullhorn
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