Social Security Reform: Economic Issues

Publication Date: July 2002

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

Type:

Abstract:

For many years Social Security reform has been a major issue of debate in Congress. While Social Security originated as a Depression-era program aimed at alleviating the economic circumstances of the elderly, social insurance also corrects market failures in the annuity market (adverse selection), prevents free-riders (requires workers to provide for their retirement), spreads risk, and may correct for failure to optimize by shortsighted individuals. The system imposes costs on society as well, through distortions in savings and labor supply, and political risk.

The need for reform arises from projected financial shortfalls of the current system, a largely pay-as-you-go (PAYGO) transfer system. Trust fund assets cannot sustain the system. The assets were arguably not generated through real government saving (in light of the history of persistent budget deficits). The problem is not merely a blip that occurs as the baby boom retires. The worker/recipient ratio is projected to fall permanently and ultimately either taxes must be increased by about 50% or benefits must be cut by one third. Inaction would likely lead to significant tax increases in the future since it is difficult to cut the benefits of existing recipients. Reform now would allow future recipients to adapt to benefit changes and the economy to expand through saving, making the long run problem less burdensome.

Proposed reforms involve revisions to the present system, the introduction of individual accounts, or a combination of both. All else equal, raising taxes or cutting benefits increases government savings; most taxes would not significantly affect the private saving rate (especially wage and consumption taxes). Evidence suggests that some benefit reductions (e.g., raising both the early and full retirement age) are more likely to increase labor supply and the tax base than others. Investing trust fund balances in equities cannot, however, provide higher aggregate returns unless financed through higher taxes or lower government spending. Otherwise, gains from investment earnings will be offset by lower returns to private portfolios and higher government interest rates. This analysis suggests that increased government borrowing costs could largely negate the perceived gains to the government.

Individual accounts are often touted for their higher returns. However, these comparisons are not accurate: they do not account for general equilibrium effects on interest rates, transition costs of paying off existing liabilities, the increased risk for individuals, and – in some cases – the full cost of the current system’s social functions (e.g. disability, transfers). If debt financed, individual accounts systems would magnify the crisis because transition costs would increase. Moreover, if a pure individual account system is to be successful in addressing market failures such as adverse selection and free riders, it must be made mandatory in participation, annuitization, and prudent investment. Two problems emerge even if these rules are followed. Individual accounts would redistribute away from the poor because of their shorter lifespan and would eliminate the explicit redistribution of the current system. Individual accounts would also expose cohorts of retirees to significant variation in benefits due to the vagaries of the stock market. Individual accounts, however, could reduce tax distortions and political risk and facilitate budgetary discipline. This report will not be updated.