"In years past, you could hold a hearing like this in a bowling alley at 3 a.m.," observed Sen. Alan Simpson (R-Wyo.) on March 25, when a Senate subcommittee heard testimony from members of the Advisory Council on Social Security. The 13-member advisory council is the latest incarnation of a committee that has been appointed by every administration since FDR. Usually its reports do not receive much notice. But the current advisory council, appointed in 1994 by Secretary of Health and Human Services Donna Shalala, has been considering dramatic changes in the Social Security system, including various forms of privatization. Its report, which was scheduled to be released in April, has been anxiously awaited, with politicians and journalists trying to predict the recommendations of the deeply divided panel. Meanwhile, the House Public Pension Reform Caucus, co-chaired by Reps. Jim Kolbe (R-Ariz.) and Charles Stenholm (D-Tex.), has attracted about 40 members from both parties since it was formed last August. As Simpson noted at another Social Security hearing in March, "People are talking about this issue as never before."
That's because they are finally starting to recognize that, without fundamental reform, the Social Security system will start to collapse in the second decade of the next century, as the baby boom generation retires. A number of reformers have proposed ways to avoid the crash (see "Retirement Plans," March). So far, however, these plans have not received close scrutiny. Given Social Security's importance in our national life and in the retirement calculations of millions, and the pain that its bankruptcy would inflict, the temptation to escape into utopian quackery is enormous. For the sake of all concerned, it must be resisted, lest we embrace some clever but unsound scheme promising Americans their fantasy: a painless ending in which no hard choices are made, no one gives up anything, and everybody is happy.
A case in point is National Development Council Chairman Sam Beard's proposal to divide Social Security's payroll tax into two tiers, one to pay current retirees' benefits, the other to be invested in individual investment and retirement accounts (IRAs). Beard has been promoting his scheme assiduously, in Policy Review, in The Wall Street Journal, and in his book Restoring Hope in America: The Social Security Solution, recently published by the Institute for Contemporary Studies. Beard's book exhorts readers to join a citizens' campaign for his plan; it even offers "talking points" to help them. Republican presidential candidate Steve Forbes similarly proposed putting part of payroll taxes into IRAs or 401(k) plans. Certain to be prominent in the Social Security reform debate, Beard's plan is a good candidate for a hard look. It doesn't pass muster.
In his book Beard claims that his plan can "turn every hard-working American into a millionaire" via "a radically redesigned Social Security system." By century's end, more than 100 million Americans will be earning at least $10,000 annually. "Allow them to set aside their Social Security payments into personal investment and retirement accounts–and they will become millionaires."
Beard would "begin by keeping our promises to current retirees," using Tier 1 of the payroll tax. "Most of your Social Security taxes will be pledged to pay the Social Security of existing retirees." For Beard deems Social Security "a sacred contract" and intends to pay current retirees all benefits "as promised under the existing system," i.e., mandated by present law.
One's remaining payroll taxes would go into Tier 2 for IRAs. "Will it require paying higher taxes? No." Anyone who paid at least $500 in payroll taxes could participate. Drawn from payroll taxes and voluntary savings, Tier 2 contributions would be capped at $3,000 a year. The first $500 in payroll taxes would go automatically into Tier 2, matched by payroll taxes paid by your employer, up to a total of $1,560 in taxes. Workers earning $12,580 or more could have set-asides of $1,560, $2,500, or $3,000. To increase your set-aside to $2,500, you would add $628 in savings, matched by another $314 in taxes. To hit the $3,000 maximum, $1,500 in payroll taxes would be matched by $1,500 in savings.
This money would grow into huge nest eggs: "If you earn $12,580 or more per year, you can amass a capital pool of $1,291,433 with $30 per week set aside from your taxes." How? "The magic of compound interest": 8 percent interest generates that sum in 45 years; $2,005,799 in 50. Since the return on the Standard & Poor 500 stock index during the past 70 years has averaged 10.2 percent, Beard argues, a rate of 8 percent is not farfetched.
Besides saving Social Security, Beard's scheme to create "100 million millionaires" serves another agenda: to "democratize capital ownership" à la Louis Kelso, father of Employee Stock Ownership Plans (ESOPs). Most wealth, Kelso argued, is produced by capital. "The magic of compound interest" would enable workers to become rich and obtain a second income: payments from their capital. Furthermore, this "mind-boggling" additional wealth–100 million millionaires means a $100 trillion capital pool–would have "unprecedented" potential to stimulate economic growth. A tempting prospect indeed.
Unfortunately, Beard's plan is untenable. Use payroll taxes to simultaneously keep all of Social Security's promises to current retirees and create "100 million millionaires"–without tax increases? It can't be done.
Before we adopt any two-tier scheme, the first thing to ask is this: Assuming we're going to pay current retirees full benefits under present law, how much of the payroll tax must be retained to do so? This question is the crux of the matter, since its answer determines the scheme's possibilities. Yet Beard nowhere asks, much less answers, it. Indeed, he doesn't even seem to realize that it needs asking.
A handy way to answer the question is to consider the recent performance of the payroll tax. In recent years its revenues have been not only paying benefits but creating trust fund surpluses. From 1985 to 1995, the surplus of payroll tax revenue over benefit payments averaged 9.6 percent of revenue. So in an average year, 90.4 percent of revenue went to pay benefits, leaving 9.6 percent for the trust funds. This generates a rough proxy for the Tier 1/Tier 2 split that a commitment to pay current retirees full present-law benefits would dictate. Honoring that commitment requires (rounding to simplify things) 90 percent of payroll taxes, leaving only 10 percent for Tier 2. But this means that if we insist on paying current retirees full benefits, most Social Security taxpayers would have virtually nothing left for their IRAs–nowhere near enough to create a million-dollar nest egg in 45 years.
A $10,000-a-year worker putting 90 percent of his $1,240 combined employer-employee payroll tax into Tier 1 would have only $124 a year, or $2.38 a week, left for Tier 2. After 45 years at 8 percent, this would grow to just $102,652.
Higher-income taxpayers won't hit the cool million, either. At $61,200, Social Security's maximum taxable income, a 90/10 split of the $7,589 payroll tax leaves only $14.60 a week to invest, which would generate only $628,067. Not even the highest-income taxpayers, then, would be able to have "$20-$30 a week set aside from your taxes"–not while paying full present-law benefits. Becoming a millionaire would require adding far more voluntary savings than Beard contemplates.
Besides, these are only nominal-dollar nest eggs. By Beard's own admission, adjusted for 4 percent annual inflation, $1,291,433 becomes $229,935; $1,026,524 shrinks to $182,769. Our $10,000-a-year worker's $102,652 thus becomes $18,277.
Not only does Beard ignore the issue of how much payroll tax would be needed to pay benefits, but his plan counts payroll taxes twice. He says "most" payroll taxes would go into Tier 1 to pay current retirees' benefits. But his book's examples of capital accumulation from money "set aside from your taxes" on incomes up to $12,580 assume that the entire tax goes into Tier 2. And he consistently writes as if all of everyone's payroll taxes would be invested: "Allow them to set aside their Social Security payments…and they will become millionaires"; "the 12.4 percent payroll taxes compounded…will grow very substantially in personal savings and investment accounts"; "if they could set their current tax payments aside…".
It doesn't add up. The same dollar cannot go into both Tier 1 and Tier 2. Paying current retirees all present-law benefits (Tier 1) would, we saw, require 90 percent of payroll taxes. But creating "100 million millionaires" (Tier 2) would require all payroll taxes, at least on incomes up to $12,580. Beard's plan would allow someone at the maximum taxable income to put $1,560 of payroll taxes into Tier 2, or 20.6 percent–more than twice what a 90/10 split permits. The conclusion is inescapable. We can use payroll taxes to pursue one goal or the other, but not both.
Something's got to give.
Sure enough, in Restoring Hope in America, Beard escapes into something called Liberty Bonds "to finance the two-tier system." Liberty Bonds are "a new financial instrument" that would offer Americans "the opportunity to trade promised Social Security benefits which come due from 1996 through 2025–a thirty-year period–for a future benefit." Retirees with "more adequate" income from private means can voluntarily defer receiving benefits and instead pass them on tax free after 30 years (2026-2055) to their heirs or others.
Stripped of promotional humbug, Liberty Bonds are Beard's tacit admission that his plan doesn't work, that it overpromises, that it is unsound and must be "financed"–bailed out by asking current retirees who can afford it to lend Social Security money in exchange for not getting their benefits on time. Beard draws a specious analogy with a bankrupt firm asking creditors to accept deferred payment: "The business will bring in a large infusion of capital, and pay off the creditors once profits return. Similarly, Liberty Bonds will infuse cash into Social Security." It takes monumental effrontery, the kind found in banana republics negotiating with Western banks, for a deadbeat not only to stiff his creditors but to ask them to lend him more money. Worse, this particular deadbeat's only "profits" for repaying his creditors are taxes on those selfsame creditors or their children.
Coercion is statism's last resort when it runs out of tricks, and so it is here: "If a voluntary plan does not work, I recommend implementing the Liberty Bond system on a mandated basis…a scaled formula could be created whereby Liberty Bonds…would become mandatory." This is a singularly obnoxious stiffing of retirees with private savings, penalizing them for being provident and thrifty. Mandatory "Liberty" Bonds also amount to taxing retirees–who thus get taxed twice, once in their working years and again in retirement–by forcing them to buy 30-year IOUs on their benefits. And whether voluntary or mandatory, 30-year benefit deferral is tantamount to benefit termination. So much for keeping all promises to current retirees.
The other possible escape is to raise payroll taxes on selected victims. As described by Rick Henderson in the March issue of REASON, Beard's plan implicitly does this: "Workers who pay more than $3,000 a year in Social Security taxes couldn't invest all of their payroll taxes privately; benefits for current retirees would come from the payroll taxes these higher-wage workers pay." Translation: Taxpayers with taxable incomes between $24,194 a year (which corresponds to a $3,000 payroll tax) and $61,200 (the maximum) would carry the whole burden of supporting current retirees. Exempting taxable incomes up to $24,200 (rounding again for simplicity's sake) substantially narrows Social Security's tax base. Common sense says that if we narrow the tax base, we must raise tax rates to obtain the same revenue. Workers with $24,200 to $61,200 in taxable income would have to pay much higher payroll taxes.
This would be an economic and moral disaster. The Social Security Bulletin's 1994 annual statistical supplement includes tables giving the number of workers with taxable incomes below the 1991 maximum of $53,400 (since then increased, but these figures suffice for illustrative purposes). It turns out that workers with incomes below $24,200 paid 38 percent ($121 billion) of 1991's total payroll tax revenue ($317 billion); workers with incomes from $24,200 to $53,400 paid 62 percent ($196 billion). So if workers with incomes below $24,200 had been allowed to put all their payroll taxes into Tier 2, and all of them did so (which would be their rational choice), in 1991 Social Security would have lost 38 percent of its revenue.
Now, if people with taxable incomes from $24,200 to $53,400 were to support the retirees, they would have had to pay not $196 billion but all $317 billion, or 62 percent more. In other words, had Beard's plan been operating in 1991, these "higher-wage workers" would have had to pay a 62 percent higher payroll tax rate–i.e., 20 percent–all of it going into Tier 1, none into IRAs. So much for creating 100 million millionaires via payroll taxes. With today's maximum taxable income of $61,200, this tax hike would be smaller but still substantial. To use the payroll tax as an instrument of forced saving for these workers, so they too could have Tier 2 accounts, their taxes would have to go higher still.
Thus, this version of Beard's two-tier plan necessarily means a two-tier tax rate, with an abrupt, sharp jump when one's income hits a mere $24,200 or so. The effect on work incentives would be disastrous. It is not the plutocrats who would suffer–Social Security does not tax income above $61,200–but the middle class and small-scale entrepreneurs, who would despair at hitting so high a tax rate so quickly.
At work here is not only Beard's flight from a fiscal bind of his own making but his egalitarian agenda of democratizing capital ownership. Lower-income taxpayers would be allowed to escape payroll taxes and become "minimum-wage millionaires"–thanks to bleeding even modestly higher incomes. Far from ushering in a utopia of saved Social Security, 100 million millionaires, and an ocean of capital to finance fabulous growth, Beard's plan is a grim recipe for economic cannibalism.
In sum, Beard's two-tier plan cannot do what it promises to do without doing precisely what it promises not to do: raise taxes or cut benefits. It cannot work without making somebody suffer.
Even if none of these problems existed, fiscal realities would kill the plan in the cradle. The Social Security Board of Trustees' actuarial analysis using "high-cost" assumptions–the most realistic–projects that in 1999, payroll taxes will stop generating a surplus. In just three years, there will be no payroll taxes to spare for Tier 2.
This exposure of the Beard plan's calamitous weaknesses is a cautionary tale for two-tier plans in general and for the whole Social Security reform debate. There simply isn't enough wiggle room to allow current taxpayers to both pay full current retiree benefits and build nest eggs from payroll taxes.
As for Chilean-style privatization, its private pension option for taxpayers is analogous to Beard's Tier 2 and would likewise create a revenue shortfall requiring coverage, perhaps from general revenue, to pay current retirees full benefits. Again, making it work would require either beneficiary or taxpayer sacrifices.
The brutal truth is that Social Security's prospects are so bleak, and we have evaded reality for so long, that a cheap, painless solution is not possible. Beneficiary or taxpayer suffering is inevitable and necessary. Our first task here is to look reality in the face. That means admitting that you can't get something for nothing. It also means publicly demolishing the pernicious myths of Social Security, which still grip the minds of millions, including Beard. One doesn't get what one paid in; benefits are not an "earned right"; Social Security isn't retirement insurance. We have to face the immorality of Social Security, too. It is wrong to force people to support others. It is wrong, an odious abuse of trust and breach of faith, to lie to young and old about what is going on. And a system grounded in coercion, deceit, and dishonor does not deserve to survive. We must abandon the delusional entitlement mentality itself. There is no entitlement to comfortable retirement. Asserting that one exists doesn't make it true. The only guarantee in life is death.
Our best course is to accept the inevitable suffering and treat it as the price of buying back our freedom. Liberate the baby boomers and post-baby boomers–those born from 1945 on–from Social Security taxes in exchange for their renouncing all benefits. They would be responsible for their retirement and, if they wish, they could invest their erstwhile payroll taxes in tax-free IRAs. Their share of the necessary suffering will be to see the payroll taxes they've already paid for what they really are–transfers to today's elderly–and to forget about "getting their money back," or any benefits at all. But they would finally be free to manage their money their way, which is how it should have been all along.
As for current retirees and workers soon to retire, complete benefit termination is politically impossible–and after lying to them for decades the government is obligated to deliver something. But there is no legal or moral right to full current-law benefits, either. Retirees' share in the necessary suffering will be substantial benefit cuts. Benefits should suffice only to keep a retiree decently above poverty. They should be rigorously means-tested: The Clark Cliffords of America have no right to the earnings of struggling single mothers bagging groceries. Such bare-bones benefits should be financed from directed general revenue, perhaps a temporary national sales tax. As the beneficiary population disappears, the tax would be reduced accordingly, until it too disappears.
To make this admittedly hard step as bearable for the elderly as possible, all benefit taxation, retirement earnings limitations, and taxes on retirement income from all sources should be abolished. Retirees could earn all they want and keep all of it–a long stride toward true economic liberty.
And if retirees' savings, earnings, and minimal benefits won't amount to much? Then let their children help them. That's what children are for. That's what "family values" mean. We could give a tax credit for supporting elderly parents, but it is odious to bribe people into doing the duty that family membership commands.
I will not insult my readers' intelligence by pretending that this will be easy, fun, or painless. It won't be. But it will be honest. Current retirees who genuinely needed benefits would get something–not much, but something. Taxpayers would be liberated. And by the time baby boomers retire, Social Security would be gone–without taking America with it.
John Attarian is a freelance writer in Ann Arbor, Michigan, with a Ph.D. in economics.