Most public discussion of Social Security focuses on the most obvious problem: financing benefits. It avoids the more fundamental question of how to produce goods and services to meet the needs of people when the number of workers per retiree drops to unprecedented lows as baby boomers retire.
There were 5.1 workers per Social Security beneficiary in 1960. That fell to 3.4 in 2000. The Social Security Administration’s most recent projection is that this will drop to only 2.3 workers per beneficiary by 2025.
Regardless of how we change Social Security, this changing ratio of workers to nonworkers is the underlying challenge. Output per worker will have to increase substantially to ensure that there are goods and services for all.
If Social Security changes do not increase output per worker, the “pie” that society divides will have to be sliced differently. The size of the pie, however, will not change.
If personal accounts give future retirees higher incomes than under the existing system, but do not increase productivity growth, there will be fewer goods and services for future workers to consume. This is important. Part of the rationale given for personal accounts is avoiding burdening future workers with onerous higher taxes. We don’t want to lower living standards for future workers in order to fund higher standards for future retirees. Yet that will happen if Social Security changes do not foster productivity growth.
One must then ask whether proposed modifications will increase output.
This might happen two ways. If changes increase the national savings rate, more capital will be available for new productive technology. Economists believe that the tools and machines available per worker are the most important determinant of how productive workers are.
If personal accounts are implemented, hundreds of billions of dollars will flow into stock and bond markets when workers invest 4 percent of their earnings into such accounts. And so, advocates contend, national savings must rise.
That argument ignores a less-visible effect of the proposed changes, however. The administration’s proposal does not cut payments to current beneficiaries or people 55 or older. Personal accounts may eventually give higher benefits to young people, but they cover little, if any, of the shortfall for boomers, currently aged 41 to 60.
The administration proposes funding payments to this generation by increasing the national debt. Every dollar that flows into private capital markets via personal accounts is one that is no longer available to fund boomer retirements. It thus represents one more dollar that the government will borrow from those same private capital markets.
Personal accounts will funnel new money into private capital markets that new government borrowing will suck right out again. There is not necessarily any increase in total national saving. No more money will be available for business investment in technology, plants and equipment.
Some economists argue that there would still be a net increase in national savings — despite this offsetting government borrowing to fill the hole left by personal accounts. How this will happen is complicated.
A more-important consideration is that personal accounts might foster greater output by motivating workers to work more.
FICA taxes reduce take-home earnings. Many young workers today expect no tangible return on those taxes. For them, FICA is no different from income taxes that pay for defense or Medicaid.
If, instead, workers see withholdings going into a personal account to which they hold title, regardless of future government whims, they will regard these contributions as additional income — albeit income deferred till retirement. They will work more in response to such higher perceived earnings.
This is a simple supply relationship. People are willing to sell more of anything when the price is high than when it is low. When workers perceive Social Security withholdings as guaranteed deferred income rather than a tax, they respond to these higher returns per additional hour earned by working more hours.
More hours worked results in more output per person per year. Productivity rises. Retirees can have more without workers having any less. The pie is bigger.
The crucial questions here are whether workers will think differently about money compulsorily paid into personal accounts than they do about current withholdings. A second question is the degree to which higher wages motivate people to work more.
Advocates of personal accounts, including Edward Prescott, the 2004 Nobel laureate in economics, argue that the number of hours worked is highly responsive to changes in take-home wages. Prescott argues that European workers work many fewer hours per year than Americans simply because Europeans face higher marginal tax rates on earnings.
Transferring this conclusion to Social Security reform, Prescott argues that personal accounts will, in fact, spur people to work more and that output will grow at a substantially higher rate than under the current system.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.