Saturday, February 19, 2005

A simple illustration of how private accounts in Social Security can provide benefits as described by Alan Greenspan, despite the objection of Paul Krugman.

[An illustration for the accompanying post.]

Let's say you are a typcial 32-year old male, working hard, paying 12.4% Social Security tax on your earnings, and expecting the 0% return promised by Social Security to those like you on your contributions. That is, for every $1 in tax you pay today, 35 years now from at retirement age you will receive a benefit worth $1.

[Caldwell et. al.]

(In reality your statutory benefits under the status quo are 25% underfinanced, so if the program remains as-is you will receive a benefit worth only 75 cents for your dollar -- but we'll forget that for the moment.)

Because the status quo is system unfunded, 35 years from now the government will have to tax somebody $1 (or borrow $1) to pay your Social Security benefit of $1 to you.

Now let's imagine that you have the alternative option of investing your $1 today in a private account in the Social Security system.

The Social Security actuaries estimate that private accounts will earn an average of 4.6% annually after expenses. At that rate 35 years from now you'll have $4.83 in the private account for your $1 contribution today.

But under the status quo the government has already made plans to currently spend every cent of the Social Security tax you pay, upon one thing or another. So if it doesn't act to reduce its spending (which certainly would be the desireable option!) then if you shift $1 into your private account it will have to borrow an extra $1 dollar today to maintain its spending.

The actuaries estimate government bonds will pay 3% in the future, so as a result 35 years from now the government will have to tax somebody (or borrow) $2.81 to pay off that borrowed dollar.

Of course, you can't expect the $1 you shift from regular Social Security into your private account to earn regular Social Security benefits too. So your regular benefits must be reduced by some amount, correspondingly.

The current White House proposal would reduce regular benefits by $1 compounded at 3%, the federal bond rate, until retirement age for every $1 shifted into a private account. So your $1 contribution to a private accound will reduce the value of your regular benefits received 35 years from now by $2.81.

The end result to you is that when you retire you have $4.83 in your private account while your regular benefits are reduced by $2.81 -- so you end up with a net benefit worth $2.02 compared to only $1 under traditional Social Security.

And, of course, you own the $2.02, giving you much more power to use it as you wish -- and securing it from the whims of future voters who may feel, for example, that they are overtaxed to fund transfers to seniors, resulting in actions to reduce such transfers.

The final result to the government is that the reduction in its future liabilities for regular Social Security benefits exactly covers the earlier cost to it of borrowing the $1 -- so 35 years from now the transaction ends up a wash to it. Funding the private account changes the current value of the government's total liabilities by exactly $0.

However, the timing of the payment of the goverment's liabilities is changed. The government's cost of financing regular, traditional Social Security retirement benefits that it owes to you will begin 35 years from now, when you reach retirement age, and last the rest of your life from then.

The government's cost of financing your contribution to a private account begins today when you make your contribution and it must thus borrow $1 to maintain its spending, and ends 35 years from now, when you reach retirement age and its borrowing is paid off. From that point on your retirement benefits are funded with savings in your private account, at no further cost to the goverment.

Thus, while the net present value of government liabilities changes by $0 as a result of you putting your $1 in your private account, compared to the status quo they will be reduced after 35 years pass, while until the 35 years pass the government's debt will be increased. In effect, the payment of the government's liabilities is moved forward in time.

In addition, your $1 contribution to your private account in the end creates a benefit to the nation in the fact that national savings are increased, which as Greenspan emphasized in his testimony is essential to increasing the future productivity of the nation to meet material needs -- especially those of future retirees. Your investing $1 in the private account in the end increases national savings by up to $2.02 -- your final $4.83 in the private account when you retire minus the government's $2.81 of offsetting borrowing then.

Summing up, the net results of your placing that $1 in a private account in Social Security instead of in the traditional program are ...

* You wind up with $2.02, rather than $1, in benefits at retirement age.

* You own that $2.02. So you have much more freedom to do with it as you wish, can bequeath it, and -- not least, considering the government's projected finances -- aren't going to have it reduced by any future government cutback in regular Social Security benefits that is forced by a future fiscal crisis.

* The government incurs $0 net cost total. The arrangement is a wash to it (except to the extent it collects income tax on your net increase in benefits of $1.02 -- a modest fiscal benefit that we'll ignore.)

* National savings are increased -- from $0 under the status quo to as much as $2.02.

* The "extra debt" of $1 that must be incurred up front is actually a benefit -- because it is not extra debt at all, but only pre-funding for a liability that will be much harder for the government to finance after 35 years from now through either borrowing or taxing.

Defenders of the status quo keep willfully ignoring this last point. But you should remember that in 2040 either the annual deficit will be reaching 20% of GDP -- equalling the size of the entire federal government today -- or income taxes will have to be increased by more than 80% from today's level (and will still be rising) to cover the cost of retiree benefits -- both Social Security (those trust fund bonds don't pay themselves off!) and Medicare.

Or, some other major cost-saving measures will have to be taken -- such as cutting Social Security benefits!

Prefunding your benefits today will reduce this future fiscal pressure on the government because it leaves the benefits payable to you after you retire already funded with savings -- eliminating the need to tax or borrow to pay them then, when it may be extraordinarily more difficult to do so than today.

In short, the so called "transition cost" we always hear of regarding private accounts consists only of prefunding benefits when rates are low -- and that's a benefit!

So the five bullet points above give us four solid benefits and a wash from private accounts, compared to the status quo.

Now let's add another fact to the scenario...

Let's say that at the time these private accounts are first set up, Social Security has already promised $10 trillion more in benefits than it has the resources to pay ... or $100 trillion more ... or $1 quadrillion more -- it doesn't matter, Congress can promise any level of future benefits without providing the means to pay them, creating a financing gap of arbitrarily large size.

Thus, at the time private accounts are created, Social Security faces a future financing gap of $X trillion.

What is the effect of private accounts on this funding gap?

Well, we know from the points above that private accounts net out as a wash to the government in the end. Thus, the answer is $0 -- private accounts have zero effect on the original financing gap.

The original pre-existing inability of the original system to pay all promised traditional benefits remains, exactly unchanged. Under the status quo this financing gap of $X will have to be closed with either higher taxes or cuts in traditional benefits or both, and after the introduction of private accounts this fact remains exactly unchanged.

So we have a fifth bullet point:

* The effect on private accounts on Social Security's financing gap is $0 -- it remains unchanged from what it is in the status quo.

Now, what does Krugman do? He looks at this one last bullet point, says only closing the financing gap matters, then concludes that since private accounts don't close the financing gap they must fail.

To him, the four advantages of private accounts that acccrue to benefits that are financed -- increased retirement wealth, greater ownership of it, increased national savings, and prefunding of benefits when it is more affordable to pay for them -- don't exist.

Therefore, when Greenspan lists them before Congress as his reasons for supporting private accounts, Krugman reports that: "Greenspan offered no excuse for supporting private accounts."

Maybe the Professor has so separated himself from reality that instead of that being a conscious lie fib, he really believed it.