Saving Social Security via Tax Reform Jude Wanniski January 11, 2005

Memo To: Allan Hubbard, National Economic Council
From: Jude Wanniski
Re: The 2002 Report of Aldona Robbins

Congratulations Allan on your appointment by President Bush to head the National Economic Council, a post at the White House that requires you to pull together the best economic material available in order to make the best possible economic policy. The fact that you are a supply-side businessman – succeeding an academic economist and a Wall Street banker – is all to the good, and I’ll do everything I can to help you succeed.

Because the President is now spending the next several weeks talking up the idea of Social Security reform, he’s getting lots of naysayers arguing against the partial privatization idea -- not only Democrats, but some Republicans, plus the AARP – the powerful lobby of retired Americans. What I suggest you do is read a paper written three years ago by Aldona Robbins for the Institute for Policy Innovation, a Texas think tank I think you know well. I think you also know Aldona, who worked in the Reagan Treasury Department in the 1980s as a fiscal technician and, with her husband Gary, as a theoretician and tax analyst. Her paper is important because it makes the correct argument that the pre-funding or privatization effort espoused by the President cannot work unless it is accompanied by basic tax reform.

In a sense, Aldona anticipated the virulent critics such as Michael Kinsley of the Los Angeles Times and Paul Krugman of the New York Times. She is essentially agreeing with them in advance, understanding that privatization by itself will not solve the basic problem because it in no way increases the returns to capital. Yet she believes the pre-funding aspect at some low level is necessary, and in combination with basic tax reform that does increase returns to capital fix most if not all of the long-term finances. These are issues Kinsley and Krugman don't take into consideration.

If I’m not mistaken, Chairman Bill Thomas of House Ways and Means has come to the same conclusion, which will mean that you will have more coordination to do. Thomas is the most knowledgeable supply-sider in the Congress, I think, which makes it nice that he chairs the most important committee. I’ll have some other thoughts on the problem for you in a future memo (I began writing about the long-term problems of Social Security back in the 1970s when I was an editorial writer for The Wall Street Journal, and have more or less followed it ever since.) But for now, here is the executive summary of Aldona’s paper, with a link at the end to the full pdf file:

 
Social Security Reform and Tax Reform: Is One Possible without the Other?
by Aldona Robbins on 02/12/2002

Executive Summary Text:

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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For the full pdf file with charts and graphs, 24 pages in all, please go to
ipi.org/ipi/IPIPublications.nsf/TEXT/9E3E42B658FD110D86256B59006D9221