- The Washington Times - Wednesday, January 26, 2005

With both Social Security reform and tax reform on the agenda, President Bush has an historic opportunity to adopt complementary reforms that would produce a huge boost to long-term U.S. economic growth.

Harvard Professor Martin Feldstein, and several additional analysts published by the Cato Institute, have long been in the forefront in arguing that personal accounts for Social Security would greatly boost economic growth. In one Cato study by Mr. Feldstein, the Harvard economist and chairman of the National Bureau of Economic Research argued that a thorough personal account reform would increase future economic growth by $10 to $20 trillion in present value terms.

The personal accounts first boost the economy because they involve a large effective reduction in the payroll tax, depending on the size of the personal account option. The amount workers can shift from the payroll tax to their accounts is no longer a tax used by the government to fund spending for other people. It is personal savings owned and controlled by the worker, like the money in a worker’s 401(k) or individual retirement account. Therefore, it is not a tax but part of the worker’s compensation. Recent Nobel Prize winner Ed Prescott has written about the large economic growth effect of such a tax cut, as has Mr. Feldstein and other Cato authors.

The personal accounts could also greatly increase national savings and investment, a point Mr. Feldstein has emphasized for 30 years. Higher savings and investment translates in higher economic growth. The taxes workers now pay into Social Security are not saved and invested but immediately paid out to finance current benefits, with a small fraction lent to the federal government for other spending.

When these amounts are shifted to personal accounts, however, they are saved and invested for decades, up to 70 years or more, until a young worker passes away in old age.

President Bush’s tax reform commission has the opportunity to adopt complementary reforms that will enhance the effect of personal accounts in increasing economic growth. Our tax code is still heavily biased against savings and investment, taxing every dollar of returns to capital at least four times — through the corporate income tax, the individual income tax, the capital gains tax and the death (estate) tax.

And capital investment is the only business expense that cannot be deducted in the year incurred. Depreciation rules require it to be deducted over several years, even decades.

To the extent tax reform reduces this bias against capital returns, more of the savings and investment produced through the accounts will be invested in the United States, increasingly promoting domestic economic growth. Indeed, as the economy booms from these effects, and the incentives from pro-growth tax reform work more broadly, capital will probably be drawn in from around the world even more, producing large secondary effects in promoting growth.

But indications are this historic opportunity he himself set up may well be spoiled by Mr. Bush with a poorly crafted Social Security reform plan. The White House staff has floated the idea of a personal account supposedly allowing workers to shift 4 percentage points of the 12.4 percent payroll tax to personal accounts. But the option is capped at $1,000 yearly, i.e., only a 4 percent option for workers earning up to $25,000 yearly.

The option effectively declines for workers above that income, to about 1 percent for workers with incomes of $90,000 yearly. Such a small account will minimize all the economic growth effects of personal accounts discussed above.

The main focus of the Bush proposal instead seems to be changing the basic Social Security benefit formula from a wage-indexing basis to a price-indexing basis, which would cut the future Social Security benefits now promised to today’s young workers by between 30 percent to 40 percent. It also would reduce the already low, miserable return Social Security offers to today’s workers each and every year, in perpetuity.

But does cutting future promised Social Security benefits promote economic growth? No one has ever fully articulated an argument for that. Rather, this cut in future promised benefits just threatens to sink the whole reform effort politically.

President Bush should stick to pro-growth Social Security reform and just propose the largest personal account he thinks he can get passed. Over time, we can expand that to an option for about half the total payroll tax, or roughly the employee share. This would solve both the Social Security financing crisis, and the problem of the increasingly bad deal Social Security offers to workers today.

Peter Ferrara is a senior fellow at the Institute for Policy Innovation and director of the Social Security Project for the Free Enterprise Fund.

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