- The Washington Times - Wednesday, June 21, 2006

Now that President Bush has nominated Wall Street’s Henry Paulson to be his next Treasury secretary, Social Security’s future will likely re-enter our national discourse. The new secretary will be challenged to fix Social Security, to somehow balance future taxes and benefits. If he accepts that as the appropriate challenge, he will make an error many others have made and continue to make.

If he is thoughtful, however, he will recognize the objective is not how to fix Social Security per se but how best to efficiently provide retirement income for all workers into the distant future. Social Security is one possible means to that end; preserving it is not the end, in and of, itself.

Any substantive reform should meet three principles, which most civil societies would accept:

(1) The elderly are able to retire with financial security and dignity.

(2) Younger workers are able to keep more of the fruits of their labor.

(3) And, in achieving Principles (1) and (2), the economy is benefited and not burdened.

The usual approach to fixing Social Security by raising taxes and cutting benefits violates all three principles. Cutting benefits violates the first, and raising taxes the second. The two together violate the third because benefits relative to taxes are very low in comparison to common alternatives, thus putting a burden on all workers and a dead-weight cost on the economy. Raising taxes or cutting benefits is a financial patch that treats the symptom of an inefficient system, not its cause.

Social Security is inefficient for at least two reasons. First, it relies on payroll taxes to finance benefits. Under such a structure, benefits can increase from year-to-year by no more than payroll increases year-to-year, holding the tax rate constant. Over the last half-century or so, payroll has increased annually by about 11/2 percent after inflation. This is the rough equivalent of saving and investing for retirement and earning a 11/2 percent rate of return. In comparison, over the last 80 years a conservative portfolio of 60/40 percent stocks and bonds, respectively, earned just a little less than 7 percent annually. A payroll-tax based system gives up the difference between the return on capital and the increase in real wages, in this example about 51/2 percent yearly. With compounding, that adds up to a lot of money left on the table.

The second reason is that for any particular beneficiary it matters how many people work and how many receive benefits. With life expectancy rising and birthrates falling, the relative number of workers declines. In 1950, there were 16 workers per beneficiary, today there are 3.3 and in 2030 there will be just 2.2. It is axiomatic that if we remain within the payroll-based structure, taxes will rise or benefits will fall. And both responses miss the bigger picture; they are adjustments to an inefficient structure that make the structure even more inefficient.

The cost-effective solution is to move from a payroll tax-based system to a saving- and investment-based system. This will allow each worker, should he choose to switch, to realize the capital market rate of return on his saving. This will provide greater retirement income, relative to the payroll-based system, for each dollar saved. This will always be true as long as the return on capital is greater than the real increase in wages.

Beyond the efficiency argument, saving and investing through individual accounts offer additional benefits relative to today’s law. Perhaps the most important is that the accumulating wealth is the personal property of each worker. Once his retirement needs are secure, he can allocate remaining assets to whomever he wishes. This is particularly important for lower-income workers for they will be able, in many cases for the first time, to help out their children.

Lower-income workers will also have greater retirement income than Social Security can provide. Aged widows and widowers who presently suffer a decline in family retirement income solely because of their spouse’s death, will no longer do so. And those who never reach retirement age because of an early death will be able to pass along their accumulated assets to whomever they wish. Lastly, those who wish to stay put, that is to remain in the Social Security system, may do so. No one is forced to leave the existing system, everyone is allowed to.

Hopefully, Mr. Paulson will consider these ideas as he contemplates the Social Security challenge. If he does and is successful, doors of opportunity will open to all Americans. If he does not, he’ll be just another civil servant who places another Band-Aid on a flawed structure, making it even worse.

But if he promotes the ideas of individual choice, market-based financing, greater personal responsibility and property rights over one’s retirement income, he’ll most certainly experience significant political pushback. These ideas, so fundamental to our nation’s history, are no longer mainstream in Washington, D.C. We have passed that tipping point. He will have to craft the message so citizens demand that Congress provide these freedoms. I wish him well and will root for his success.

William G. Shipman is chairman of CarriageOaks Partners LLC and co-chairman of the Cato Institute’s Project on Social Security Choice.

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