Social Security Reform and Tax Reform: Is One Possible without the Other?
by Aldona Robbins on 02/12/2002
24 Pages
In a few more years, when the baby boom generation (those born between 1946 and 1963) begins to retire, Social Security is projected to face ever-widening deficits: up to one-fifth of benefits in 2020, rising to almost one-third by 2075, according to a 2001 report by the Social Security Trustees. To handle projected deficits under the current system, those who favor the status quo respond with a mixture of tax increases and benefit reductions. This response, however, just perpetuates the problem of financing Social Security by the pay-as-you-go system, in which benefits are paid from tax revenues collected in that same year.
This paper examines how true reform of Social Security and fundamental tax reform go hand in hand. First, moving away from pay-as-you-go financing and toward personalized prefunding is a Social Security reform long overdue. That means establishing individual accounts owned by workers, funded with payroll taxes and invested in real assets.
How much of the payroll tax should go to individual accounts? If 2 percentage points of payroll taxes (2 percent of wages) were saved each year starting in 2002, the asset buildup in individual accounts would be substantial. More sweeping reformers advocate a higher contribution rate for individual accounts. Allowing for the progressive benefit formula and special categories of benefits leaves slightly more than half of the original OASDI payroll tax rate (6.3% of wages) to fund individual retirement accounts.
Even if larger contributions are allowed, how closely could private accounts mimic the redistribution of the current Social Security system? For political viability of reform, the proceeds from private accounts earning the average return plus remaining Social Security benefits must leave beneficiaries at least as well off as they would be under current law. That is where tax reform comes in.
For individual accounts to work as envisioned, two things must occur. The funds saved must represent new saving and that saving must translate into new U.S. investment. Under current tax treatment of saving and investment, this is not likely to occur. First, unless the return to saving goes up, households will simply rearrange their portfolios to offset the funds going into the individual accounts. The other danger is that new saving, should it occur, will translate into foreign investment unless the rate of return to plant and equipment sited in the United States also goes up.
Reducing the bias against capital in the current tax system will raise the return to U.S. saving and make domestic investment more attractive compared to the rest of the world. The combination of new savings generated through Social Security reform and increased growth made possible through tax reform increases the likelihood that the economy will be able to produce sufficient output to satisfy workers and retirees.
The surest way to Social Security reform is through tax reform. There is no question that a faster-growing, lower-inflation economy would lessen the financial strain imposed by Social Security.
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