Social Security Reform: Does Privatization Still Make Sense?

Abstract

The issue of Social Security reform is of critical if not unrivaled importance — and not just because the program is headed for insolvency as the baby boomers enter retirement. Lawmakers continue to introduce Social Security reform legislation, some proposing far-reaching structural changes including personal accounts. An important motivation is that America’s demography and economy have evolved to such an extent that the program no longer provides social insurance benefits as effectively as it once did, but instead, economic losses from its tax and benefit rules are continuing to accumulate. The longer that reforms are delayed, the larger will be the net economic harm that Americans must endure.

On balance, Social Security appears to be a regressive tax-transfer system and provides minimal wage insurance. Many of its features, especially the extreme complexity of its tax and benefit rules, weaken and mask the link between payroll taxes and benefits to induce large economic losses from dislocations to participants’ labor market choices. The program over-provides longevity insurance, with benefits commencing well in advance of the time when work abilities are depreciated and participants approach the end of their expected lifetimes. By providing benefits to retirees in excess of their past contributions, Social Security transfers resources from younger and future generations toward older ones in the form of annuities. These features stimulate consumption during retirement to reduce national saving, capital formation, and prospective economic growth.

Social Security’s approaching insolvency implies that someone must bear an adjustment cost. The larger the adjustment cost imposed on today’s older generations, the smaller the burden on younger and future generations, improving their ability to save for their own retirements. Transcending this zero-sum policy trade-off, however, requires a transition to a system with personal accounts. Personal accounts will not improve the program’s solvency directly, but would help generate new resources by strengthening the link between “contributions” and benefits, thereby reducing dislocations of individual labor-supply choices. At a minimum, personal accounts could be an effective mechanism for sequestering from government spending additional resources intended to reduce Social Security’s unfunded obligations.

Following the theme of Harvard Law School’s symposium on Government Privatization and Outsourcing held in the winter of 2012, this paper discusses the financial mechanics involved in privatizing Social Security, its potential contribution toward improving Americans’ retirement security, and the problems that may emerge from such a structural change to the program.

Keywords: social security reform, social security privatization, retirement age, Paul Ryan plan

JEL Classification: H50, H55, J26