- The Washington Times - Sunday, January 16, 2005

President Bush’s plan to allow individuals to invest their Social Security taxes in private investments, in return for surrendering commensurate future benefits, addresses the fundamental flaws of Social Security; a “pay as you go” Ponzi scheme that relies on unrealistic demographics and is thus doomed to implosion.

However, the president’s plan creates a huge cash flow deficit, the “transition costs” and leaves future retirement benefits open to market risk, two shortcomings on which liberal demagogues, led by the likes of the AARP, already capitalize.

The president can make moot all this opposition and expand his program from partial to full privatization by simply requiring that, in the short term at least, all private investments be restricted to TIPS; price-indexed Treasury bonds.

Opposition to Social Security reform is based on the “Trojan Horse” that the current system is secure and can be easily “fixed” without fundamental reform. But Social Security is a misnomer: It is not secure and doomed to financial implosion. It relies on the ratio of workers-to-beneficiaries for solvency; a 40-1 ratio at the program’s genesis in the 1930s, but due to longer lifespans and lower fertility rates this ratio is shrinking from 3-to-1 today to 2-to-1 in the coming decades. Your second grader can do the math; while it once took only 2.5 cents of taxes to support a dollar of benefits it will soon take 50 cents to maintain benefits; and that is a formula for socioeconomic Armageddon.

As a result of this doomed “pay-as-you go” scheme, the system has already accumulated more than $10 trillion of unfunded promises due to retirees over the next 70 years.

Neither side wants to admit it, but Social Security must break its promises or raise taxes to fund this liability. The costs can be addressed rationally and without considerable pain, but only if the basic program is first reformed to stop the bleeding.

The most immediate problem with the president’s plan is that the more it diverts Social Security taxes from the Trust Fund to private investment the greater are the taxes, debt or benefit reductions necessary to fund the cash deficit.

The TIPS plan has no such cost because no cash leaves the government until benefits are paid, as already promised, years later. There are no “transition costs.”

The TIPS plan also moots the claim private investment is risky. While fallacious, the claim is still politically devastating.

In reality, both theory and empiricism demonstrate private equities deliver higher returns over any intermediate or long-term planning horizon, but that does not keep the AARP from raising the threat private investors will lose their fortunes only to return to the government till for a double dip.

Nevertheless, the president should focus on the most important principals: creating a true savings plan based on private ownership and not lose the opportunity for reform. Because the TIPS plan restricts investment to inflation-adjusted government-guaranteed bonds, investor risk is eliminated. In fact, the TIPS program is more secure than Social Security.

After all, the Supreme Court has allowed Congress to expropriate promised Social Security benefits from retirees, which several Democrat-led Congresses have done via higher taxes and later retirement ages. But no Congress has ever defaulted on Treasury bonds, a point trumpeted by the AARP.

What about the $10 trillion deficit already accumulated? Reform freezes this loss, which any plan (reform or status quo) must address. It took 70 years of New Deal schemes to create the deficit, but by spreading the pain over different programs over the next 70 years it can be ended without significant pain.

Possible solutions include an across-the-board 1 percent increase in income tax rates, a 1 percent payroll tax, or a 1 percent tax on payments from Social Security.

It would be more efficient to spread the burden among the three solutions; a meager one-third-point increase in income taxes, a half-point increase in payroll taxes and a half-point increase in taxes on Social Security benefits. Harmless? No. But reform must not fall victim to the Trojan Horse that this cost is somehow “avoidable” if we keep the status quo, which would mean these costs will increase over time.

What is the tradeoff vis-a-vis the president’s plan? Hardly any. The president creates the “illusion” there is a free lunch in private equities, that the added return is a windfall to retirees and the government. Perhaps, but the windfall is offset by costs to the rest of the economy that give up private equities to purchase the increased government debt. The net effect is a mere reshuffling of paper, with absolutely no net increase in national savings or returns.

Privatization is fundamental to solving Social Security: It replaces the “pay-as-you” go scheme with a true savings program. By relying on savings, not unstable demographics, for retiree benefits, privatization will stabilize and secure future benefits and increase capital, productivity and wages.

By converting to the TIPS plan, the president would emasculate his opposition and immediately cap the Social Security deficit and secure 100 percent of the benefits of generations to come. It also would address collateral issues such as administration costs or covering investment losses. Administration is negligible, and since the returns are assured there are no concerns about investors losing their funds and having to return to the public trough.

Therein lies the path to Social Security reform that is truly both secure and private.

John Palffy is president of JMP Financial, a Detroit investment banking firm, and adjunct professor of business administration at Wayne State University. He served as chief economist to Dan Quayle, and as a political appointee in the Reagan administration’s Agriculture Department.

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