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Saturday, January 1, 2000

A New Deal for Social Security by Peter Ferrara and Michael Tanner

Ferrara and Tanner Offer a Welcome Exercise in Thinking Through Social Security

Cato Institute • 1998 • 264 pages • $19.95 cloth; $10.95 paperback

In 1980 Peter Ferrara produced the path-breaking critique Social Security: The Inherent Contradiction. Now he and the Cato Institute’s Michael Tanner ably update his exposition of Social Security’s flaws and offer a thought-provoking solution.

Social Security is a federal “social insurance’‘ program paying retirement, disability, and survivors’ benefits from taxes levied on labor income. Its flaws are glaring, and the case for repeal is powerful. The authors provide a concise, if uneven and derivative, history of Social Security, followed by a thorough discussion of its problems.

The first problem is the looming bankruptcy. Because the huge “Baby Boom” generation is due to retire in the near future, the Social Security “trust funds” will be unable to pay full benefits after 2032 unless the government imposes crippling tax increases. Social Security’s defenders claim that raising taxes by just 2.2 percentage points will fix it. Ferrara and Tanner neatly dispatch this argument, pointing out that at best this postpones the date of “trust fund” exhaustion.

The second problem is that Social Security offers today’s workers poor returns for their taxes. Using calculations of lifetime tax payments and projected benefits for two-earner couples, one-earner couples, and single people, the authors show that most of today’s young workers will actually get negative returns. Despite short-term fluctuations, private capital markets perform much better.

Third, Social Security is unfair to the poor, minorities, and women. The poor depend on it more than wealthier Americans, yet tend to die sooner and hence receive less in benefits. Having lower life expectancies than whites, blacks are likewise disadvantaged, paying taxes all their adult lives but often getting little or no retirement benefits. Social Security gives women either 50 percent of their husbands’ benefits or benefits based on their own employment, whichever is larger. The former usually is larger, meaning that many women get no return at all for the taxes they paid.

Social Security is also damaging to the economy. Its high payroll tax makes many Americans unable to save. Lost savings mean less money for investment and therefore slower economic growth. The payroll tax also discourages employment. Social Security is probably reducing Gross Domestic Product by 6 to 11 percent annually. Ferrara and Tanner argue that “Privatizing Social Security would reverse these effects and lead to increased economic growth and a better standard of living for all Americans.”

Facing similar problems, other nations have been abandoning “social insurance.” The authors survey privatization developments, from Chile’s pioneering 1981 reform to more recent efforts in other Latin American countries, Britain, Australia, and China.

Any reform, Ferrara and Tanner argue, should “irrevocably commit and emphasize” that benefits for current retirees would not be changed. It should also give payroll tax relief, provide a government- guaranteed minimum benefit, and give private retirement accounts the same tax treatment as Individual Retirement Accounts. They propose letting workers create their own accounts, financing them with 10 percentage points of the current payroll tax and using the remaining 2.4 percentage points to pay current benefits. Workers choosing the private option would receive government “recognition bonds” to compensate for past Social Security taxes. At retirement, workers could buy annuities with their account money, make withdrawals, or both.

Critics of privatization argue that workers would have to finance simultaneously their own retirement and benefits for current retirees. The authors deny this, and devote many pages to explaining the financing of the transition. Possibilities include continued payroll taxes, the sale of federal assets, and reducing other federal spending. They also expect new revenue from taxes on the returns to the new investment. Economist Martin Feldstein estimates the real, pretax average rate of return on capital at 9.3 percent. Taxing three percentage points at the business level (before payment of interest and dividends), the authors argue, would generate abundant revenue to defray transition costs and still leave workers with much higher returns than Social Security offers.

Their proposal has prima facie appeal. However, they assume that the historical real rate of return on capital will continue to be realized, without making a case for it. And they seem to have forgotten that Feldstein estimates that federal, state, and local governments are already taxing capital at the business level at the rate of 3.9 percent. When we add the proposed 3 percent tax, we get a total tax rate of 6.9 percent, which leaves an after-tax rate of return for workers of just 2.4 percent (9.3 percent rate of return minus 6.9 percent taxes), not 6.3 percent. Finally, they retain the compulsory payroll tax. If Social Security is so awful, why keep one of its central features? Better to repeal the Social Security law and ditch this punishing tax.

Still, the book superbly illuminates the flaws in Social Security. The plan Ferrara and Tanner propose might not be ideal, but it offers a welcome exercise in thinking the issues through.

John Attarian is a freelance writer in Ann Arbor, Michigan, and adjunct scholar with the Mackinac Center for Public Policy. He has recently completed a book on Social Security.

  • John Attarian (1956-2004) was a free-lance writer with a Ph.D. in economics. He wrote for numerous national publications and was an editorial advisor to Modern Age.