Allaying Social Insecurity

Social Security: The Inherent Contradiction, by Peter J. Ferrara, San Francisco: Cato Institute, 1980, 484 pp., $20.00.

Peter Ferrara's Social Security is the latest of a large number of articles and books about the current problems plaguing the social security system. It starts with an exposure of the ingenious mythology surrounding the social security system. It then analyzes the system's financial problems and the rationales that have been given for having the system compulsory. In the last two chapters, Ferrara evaluates the major proposals for reform made by others and presents his own libertarian reform program. Ferrara is a recent graduate of the Harvard Law School. The book is a challenging reevaluation of the social security system.

Ferrara's principal criticism of the system is that it is financed pay-as-you-go—current revenues used to provide current benefits. This type of financing, he contends, reduces saving and investment, gives persons a lower rate of return on their saving than they could get on private assets, and makes the system vulnerable to financial crises.

Ferrara supports his claim that saving and investment are reduced by relying on the results of Martin Feldstein's path-breaking studies; however, this criticism is not completely on firm ground because not all research on this issue has come to the same conclusion. The current debate over the effect of social security on saving is still inconclusive.

Ferrara's second criticism—that people can earn a higher rate of return on saving in funded programs than they earn from social security—is also not well supported. It is based primarily on estimates of the historical real rates of return on common stocks (7.5 percent) and on investment in real capital (12.4 percent before tax). In sharp contrast, the historical real rate of return is only 0.8 percent on long-term US government bonds, about 1 percent on municipal bonds, and 3 percent on corporate bonds. These latter investments are usually considered particularly appropriate for retirement accounts.

In our pay-as-you-go system, the average young worker who enters the system at the present time and pays social security taxes throughout his work life can expect to earn a real rate of return equal to the growth of real wages—about 1.75 percent. During the past 15 years, in contrast to Ferrara's expectations, social security benefits have risen sharply, while the real value of most private pension benefits (such as those from TIAA and CREF) has declined. Although Ferrara's proposals to extend tax exemptions to all types of saving for retirement and to pension benefits, as well as to payments to pensions and pension earnings, would increase the rate of return to saving for retirement, most tax reformers would choose lower tax rates rather than more exemptions.

In regard to Ferrara's third criticism, the reasons for the system's current financial crisis are much more fundamental than simply the lack of a fund to cover contingencies. F.A. Hayek predicted 20 years ago that the social security system would encounter financial difficulties of the type that emerged in the 1970s (see his chapter on social security in The Constitution of Liberty). The reasons he gave were the tendency for social security programs to overexpand, the difficulty of foreseeing future changes, and the slowness (or even inability) of a compulsory, national system of social security to adjust to changing conditions.

As Hayek predicted, social security benefits have been overexpanded—they were raised 15 percent in 1970, 10 percent in 1971, and 20 percent in 1972. These increases raised the ratio of the average worker's social security benefit to his preretirement earnings from 30 percent to 45 percent. When these increases were made, there was no looking ahead to any potential financial crises. The principal cause of the system's long-range financial deficit—the decline in the birth rate that started in 1957—illustrates Hayek's second point. It was not possible for the administrators of the system to foresee this demographic change. Finally, as Hayek predicted, the social security system has been slow in adjusting to the new demographic conditions. It was not until 1974—17 years after the start of the decline in the birth rate—that the Social Security Administration changed its demographic projections, the long-range deficit became apparent, and the system was widely reported to be "on the road to bankruptcy." Congress has still not done anything to correct the financial imbalance caused by the decline in the birth rate.

Even if pay-as-you-go financing were retained, other features of Ferrara's reform program would eliminate most of the inequities in the present system. He recommends that the welfare function—care of those who are too poor to save enough for old age—be transferred to the Supplemental Security Income (SSI) program. In the remaining insurance program, a worker's benefits would be based solely on his payments. This would eliminate the inequities caused by the progressive tilt in the benefit formula, the minimum benefit, spouses' benefits, the earnings test, and the maximum family benefit.

Ferrara's proposal to replace the present system with funded private pensions and insurance accounts includes a large amount of government regulation. In his initial program, persons who opt out would be required by the government to have private coverage; all eligible private pension plans and insurance accounts would be required to have government approval; their payments would be guaranteed by the government; and the government would issue special social security bonds to those who do not opt out. As an alternative to Ferrara's sweeping proposal, the present system might simply be cut in size. This would not only make it possible to avoid the expansion of government regulation of private pensions that he proposes but would still encourage various forms of private saving. As Ferrara has shown with numerous examples, the great variety of available private pension contracts and kinds of saving often meet the needs of particular individuals much better than a uniform social security system.

How to phase out a pay-as-you-go social security system is a particularly difficult problem. During the phase-out period, at the same time that the cost of the social security benefits of those who have retired and of those who expect to retire in the near future must be financed, the new generation (not covered by social security) is expected to accumulate alternative types of savings. In fiscal 1979, expenditures for old age, survivors, disability, and hospital insurance amounted to over $121 billion—one-fourth of the federal budget—and there are also several trillion dollars' worth of unfunded liabilities to those who have not yet retired.

In his program for reducing the system's huge unfunded liabilities, Ferrara again makes the questionable assumption that the rate of return that persons can get on private pensions is much higher than from social security. If this were true, younger workers could shift to private pensions and still receive a larger pension than they would have had, even if they forgo the amount owed to them by the social security system. Ferrara would cut back the system's unfunded liabilities by terminating the accrued social security obligations to such persons.

If payroll taxes were abolished, as Ferrara recommends, financing social security's current obligations would require that revenues from the corporate and personal income tax or from other federal taxes be increased. Ferrara believes that his proposal's stimulating effects on employment and investment would increase the income tax base sufficiently to avoid large increases in income tax rates, and he predicts that it would take only six to eight years to increase revenues enough to pay for the cost of current benefits. He assumes that eliminating the payroll tax would sharply increase the supply of labor and that the new private saving that would replace the payroll tax would increase real capital expenditures dollar for dollar. If his program could not be financed solely by a growing tax base, but necessitated higher income tax rates, the effect on employment and economic activity could be the opposite of what he expects. Also, Ferrara makes the mistake of assuming that the purchase of stocks and bonds by private pension systems would necessarily result in a similar increase in real capital expenditures.

Even though, in our opinion, Ferrara attaches too much importance to pay-as-you-go financing, his thorough analysis of its implications brings out clearly many of the important issues. Ferrara should also be commended for tackling head-on a problem that most persons have thought was impossible—phasing out the social security system. While he is probably overoptimistic about the effects of his reform program on the supply of labor and on capital formation, he discusses in a forthright way the problems involved.

Colin Campbell, a professor of economics at Dartmouth College, directs the American Enterprise Institute's studies on social security. Rosemary Campbell is a coauthor of their Introduction to Money and Banking and of other publications.