- The Washington Times - Saturday, August 19, 2006

David Sloane’s view (Forum, Aug. 6) is that Social Security can be fixed by raising payroll taxes on higher incomes and diversifying investment of Social Security surpluses. Messrs. Rahn (Commentary, July 27) and Duke (Forum, Aug. 13) favor personal retirement accounts. I offer a third course.

When considering Social Security reform one must understand the Social Security Trust Fund. Since its early days, Social Security has taken in more than it has paid out. The Treasury has always treated these surpluses as a part of its General Fund to be used to run the government. It has then issued IOUs in the form of Special Purpose Bonds and placed them in the Trust Fund.

At present the government owes the Trust Fund $2 billion. In 2006, Social Security income will exceed payments, but such surpluses will expire by about 2016. In their 2006 report, Social Security’s Trustees describe the Trust Fund as an “unfunded obligation,”and they explain current annual surpluses“will soon become rapidly growing deficits covered by cash transfers from the General Fund of the Treasury.”This means that after 2016, Social Security will not collect enough to pay benefits and the difference will have to be made up from the General Fund; in other words through higher taxes or higher deficits, or a combination of both.

AARP does not face the painful truth that America’s workers have paid into a pension fund that has disappeared. According to AARP’s Web site, the Special Purpose Bonds are “like the bonds that you or I might buy to save for retirement or for our children’s education. Far from being ‘worthless IOUs,’ those investments are backed by the full faith and credit of the federal government.” This position is clearly not consistent with the statements of Social Security’s Trustees.

If a country were to set up a Social Security system now, the best approach would be to allow workers to direct their contributions into a personal retirement account (PRA) where their funds would be invested in marketable securities. Each contributors’ assets would become his/her own property in the same way as people own IRA or 401k plans that can be passed on to their descendants. This is in contrast to our Social Security system that is basically an insurance plan that provides only a safety net during the life of a participant and spouse and makes no claim to create assets for future generations.

The options can be simply stated: Option A: Repair Social Security to serve as a safety net (insurance plan), or Option B: Convert Social Security to become in whole or in part an investment plan (mutual fund). As explained below, Option A is simpler and less costly in terms of transition costs than Option B.

Application of the PRA approach to our Social Security system faces a dilemma as regards the annual amount a worker can be allowed to divert into his/her PRA. If it is set too low at $1,000 as in the preferred plan of the President’s Commission to Strengthen Social Security, the financial benefit for most workers is negligible.

However, if the amount is set high, for example at 50 percent of total contributions (worker plus employer), it diverts half of the annual income of Social Security to existing contributors and cuts deeply into what is left to pay current retirees or those who will retire in the future. This huge gap would have to be filled by enormous transition costs and budget deficits. Further, the frequent claim that PRAs create an “ownership society” is suspect. The tax code already allows workers to make tax-sheltered investments outside of Social Security and, in fact, the IRS subsidizes IRA contributions by low income workers.

The one selling point of the PRA approach is that would divert the Trust Fund surpluses into real assets. An alternative would be to convert the pre-2016 surpluses into real assets by placing them in a Special Account where they would be invested in the stock and bond markets. The task of investing the assets would be given to a number of major financial institutions to avoid that the government becomes involved.

Also, the payroll tax would have to be increased from 12.4 percent at present to 13.6 percent to extend the period when Social Security is in surplus to about 2025. By 2025, the Special Account might reach $3 trillion in real assets. The cost of this approach would be some additional borrowing to make up for the current Social Security surpluses that would normally be treated as general revenues.

The earnings on the Special Account plus a gradual redemption of the Special Purpose Bonds would meet the gap between Social Security’s income and outgo for many years beyond the 2042 date that is now estimated as the year when the paper assets of the Trust Fund are exhausted. And there would be no further build-up of the unfunded obligation beyond the 2006 figure of $2 trillion. In fact, this debt could be frozen at $2 trillion and the accounting fiction that the government pays interest on the debt could be abandoned. This liability could be paid off in the distant future with much cheaper dollars.

This reform plan would, as recommended by the President’s Commission, reverse the misguided decision by Congress in 1977 to base future benefits on a wage index instead of an inflation index. The current use of a wage index leads to a situation in which an average retiree in 2050 would receive close to 40 percent more in real terms than an average retiree today. This should be seen not as a cut in future benefits, but as a measure to prevent unreasonable growth that exceeds the rate of inflation. Various measures would also be taken to insulate low income people from the effects of this change, along with a provision to raise survivors’ benefits.

While a payroll tax increase (from 6.2 percent to 6.8 percent) would be unpopular it would be much less painful than the much larger income tax increases inherent in a “do nothing” approach or a personal account option. A small increase in payroll taxes now would be better than large boosts in income taxes and external borrowing in the years ahead.

WILLIAM T. SMITH

Consulting engineer

McLean, Va.

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