His testimony before the Senate Finance Committee this morning:
Social Security Reform
Peter R. Orszag
Joseph A. Pechman Senior Fellow in Economic Studies
The Brookings Institution
Senate Committee on Finance
April 26, 2005
Mr. Chairman and other members of the Committee, thank you for inviting me to testify before the Committee this morning. Social Security provides the foundation of retirement income, but must be combined with other saving to achieve full retirement security. Retirement income should thus be viewed in terms of tiers, with Social Security delivering a core tier of protection upon which additional retirement income must be built....
Both tiers of retirement security face challenges. In that context, my testimony makes four main points:
Retirement security can be significantly enhanced by improving 401(k)s and IRAs through commonsense reforms that both sides of the Social Security debate should embrace. The individual accounts we already have -- in the form of 401(k)s and IRAs -- can be substantially improved and strengthened through a series of commonsense reforms that would make the pension system easier to navigate and more rewarding for American families. In the face of the difficult choices presented by the current system, many people simply procrastinate, which dramatically raises the likelihood that they will not save enough for retirement. Disarmingly simple concepts -- such as changing 401(k) plans so that workers are automatically enrolled unless they opt out, and making it easy to save part of an income tax refund -- have the potential to strengthen retirement security significantly. Both sides of the Social Security debate should agree on the straightforward steps necessary to improve 401(k)s and IRAs, and should come together to enact the changes immediately.
Although improving the accounts we already have on top of Social Security makes sense, introducing accounts within Social Security does not. Under the Administration's proposal for accounts within Social Security, workers receive payroll revenue today, but pay the payroll revenue back, plus interest at a 3 percent real rate, at retirement through a reduction in traditional Social Security benefits. In effect, the individual accounts represent a "Social Security line of credit." Workers drawing upon that line of credit have payroll revenue deposited into their individual account today, but then owe the funds back, plus interest, once they retire. The system is thus similar to a loan from the government to workers. At best, assuming that all the loans carry the government's borrowing rate and are fully repaid, the accounts do nothing to improve solvency within Social Security over the long term -- as even the White House has acknowledged. A more likely scenario is that some of the loans will not be repaid in full, in which case the accounts harm solvency, even over an infinite horizon. And even if they are actuarially neutral over the long term, the accounts create a massive cash-flow problem in the meanwhile. Some argue that the accounts would facilitate other changes -- especially benefit reductions for higher earners -- that would help to restore long-term balance to Social Security. But it is hard to see why, unless they were subsidized, the loans should be particularly attractive, especially to higher earners. Indeed, a Goldman Sachs analysis recently concluded that, "In essence, the 3% real rate offset represents a loan from the federal government to the accountholder to fund the personal saving account. This is not an attractive proposition." Higher earners who typically already own a mix of stocks and bonds should find little or no value in unsubsidized loans from the government. And if the accounts were subsidized to make them more attractive to higher earners, their direct effect would be to expand the Social Security deficit. Increasing stock ownership among moderate and lower earners is desirable, but not by encouraging them to borrow against their future Social Security benefits. Instead, a better approach to increasing equity ownership and retirement saving for such households are the commonsense changes to 401(k)s and IRAs described above. Reducing traditional Social Security benefits to make room for individual accounts would also be unsound for society as a whole, since it would decrease the core tier of retirement income that is protected against financial market fluctuations, inflation, and the risk of outliving one's assets. Furthermore, whatever the initial rules for the accounts, there is likely to be considerable pressure over time for liberalizing pre-retirement access to the funds -- which is precisely what has occurred with 401(k)s and IRAs, along with the Thrift Savings Plan. Such access may make sense in the upper tier of retirement income, but not within the core tier because it undermines the preservation of funds for retirement.
Failing to dedicate additional revenue to Social Security means that larger benefit cuts would be necessary to restore solvency. For example, dedicating the revenue from a reformed estate tax to Social Security could eliminate the need for more than $1 trillion in benefit reductions over the next 75 years. Every dollar of estate tax revenue dedicated to Social Security is a dollar less of benefit reductions or payroll tax increases necessary to address Social Security's projected deficit. Despite the claims of some advocates, the Administration's proposal for individual accounts makes brutally clear that such accounts do not directly help to restore solvency. Since accounts do not directly improve solvency and may well impair it, the only available policy options to restore solvency are reductions in benefits or increases in dedicated revenue. A fundamental tradeoff thus exists: Proposals that fail to dedicate additional revenue to Social Security will necessarily involve larger benefit reductions than plans that do dedicate additional revenue to the program. When push comes to shove, Americans seem to prefer relying on additional revenue -- or some combination of additional revenue and benefit reductions -- to mainly relying on benefit reductions. As just one example of the tradeoffs, taking the revenue from a reformed version of the estate tax and dedicating it to Social Security could close a substantial share of the projected deficit. For example, the revenue from an estate tax with a $3.5 million exemption per person ($7 million per couple) and a 45 percent tax rate on estates above that exemption would eliminate at least one-quarter of the projected 75-year deficit. That would obviate the need for more than $1 trillion in benefit reductions over the next 75 years. For a 20-year-old medium-earning worker today, it could mean avoiding $1,500 per year in benefit reductions. As a further illustration of the tradeoffs, retaining the same exemption level but reducing the tax rate on large estates to 15 percent would avoid only about $300 billion in benefit reductions over the next 75 years. In other words, with the revenue from a reformed estate tax dedicated to Social Security, reducing the tax rate to 15 percent would increase the benefit reductions required to address Social Security's deficit by $700 billion over the next 75 years. We as a society must decide whether this $700 billion is better used to provide larger after-tax inheritances to wealthy children or to reduce any benefit reductions necessary to restore solvency to Social Security. Every dollar of estate tax revenue dedicated to Social Security is a dollar less of benefit reductions or payroll tax increases necessary to eliminate Social Security's deficit.
Recent "progressive price indexing" proposals are seriously flawed because they rely excessively on benefit reductions, cut benefits more if future productivity growth turns out to be faster than currently expected, and treat workers earning $900,000 or even $9 million a year the same as those earning $90,000. The recent "progressive price indexing" proposal involves surprisingly and excessively large benefit reductions for average workers. In addition, it reduces benefits more if productivity growth turns out to be higher than we currently expect, exactly the opposite of the appropriate response because the underlying 75-year actuarial deficit would be smaller with faster productivity growth. As the Congressional Research Service recently noted, "somewhat paradoxically, if real wages rise faster than projected, price indexing would result in deeper benefit cuts, even as Social Security's unfunded 75-year liability would be shrinking." Finally, the proposal treats someone earning $900,000 or even $9 million the same as someone earning $90,000; a sound reform plan would instead differentiate between the two. To be sure, imposing proportionately larger reductions in monthly benefits on higher earners compared to lower earners is sensible, in part because higher earners are increasingly living longer than others. "Progressive price indexing," however, is not the right way to accomplish that goal: It would make far more sense simply to adjust the current benefit formula directly to achieve the desired degree of protection for lower earners.
Why doesn't the White House care to find people of this caliber to staff its administration?