Transition Financing, Not Transition Costs

It is good news for all Americans that the debate over Social Security is moving from should we reform the system to how should we reform the system. The question of how to reform Social Security brings up new questions, but we must make sure these stones on the track don’t stop the train that is reform from continuing in the right direction.

Some argue that the biggest boulder in the way is the one labeled “transition cost.” The transition cost is the amount of money needed to pay for promises already made to retirees and current workers, currently estimated at $11 trillion. Under the current system, this money comes from taxes taken from those currently working—not out of some account in which a retirees’ Social Security taxes have been saved.

Opponents of reform say we’ll be better off staying with this system, and avoiding the transition cost. But it is this very payment method that is causing Social Security’s crisis. There are fewer and fewer workers paying for more and more retirees, and soon there just won’t be enough money in the system.

To end this tax dollar shuffle, from worker to retiree, and to secure future retirements, most reform plans call for personal retirement accounts. These accounts would be owned by workers and funded by their payroll taxes. Upon retirement, workers would get their pensions from the savings they built up in these accounts, instead of relying on taxes taken by the government from future workers.

Today’s retirees, however, do depend on payroll taxes collected by the government, and any reform plan must pay any promises already made. But, with payroll taxes going into personal accounts, where will the $11 trillion already promised to retirees and workers, the “transition cost”, the “unfunded liability”, come from?

First, it is wrong to think of the transition as a “cost”. It should instead be thought of as a transition investment. Its like switching from paying rent to paying a mortgage. In both cases, you have to pay for your home but, if you pay rent, after 30 years, you have nothing but more rent to pay. If you’re spending the same money paying back a mortgage, at the end of 30 years, you are both done paying and you own your house.

With Social Security, the $11 trillion is owed whether we move to personal retirement accounts or stay with the current system, it is just a matter of how it is financed. With personal retirement accounts, in a generation we’ll have retirees who own their retirement, instead of renting it from the government. With personal retirement accounts, in a generation, the unfunded liability will be approaching zero, instead of continuing to grow as it does under the current system.

In the mean time, the transition can be financed in many different ways. Some of the money will come from the benefits of reforms itself. Personal accounts will increase national savings, which will be a boost to the economy, and a boost to the economy means a boost to tax revenues.

There will also be new revenue coming in to the government from tax-deferred savings programs like 401(K)s and IRAs, which can be used to finance part the transition. Some of the payroll tax—which is currently 12.4 percent of income—could be used until current promises are paid off.

Last year the Social Security Administration paid out $453 billion—about what the deficit of the federal budget is expect to be this year. Of that, only $281 billion went to retirees. The other 38 percent went to the various insurance plans Social Security provides. Any plan involving personal retirement accounts would not only require a certain percentage of income to be saved, but also would require that workers purchase life and disability insurance, moving 38 percent of the liability to the private sector.

Bonds could also be sold to finance part of the transition. With a whole generation of investors looking for places to put their money, there won’t be a shortage people to sell to. Bonds, however, should be used as little as possible, since they represent further government debt rather than true savings. When Chile switched to personal retirement accounts 23 years ago, they used bonds to finance about 40 percent of the transition.

All of the $11 trillion isn’t owed today, but rather over a couple decades, to both those already retired, and those still working. Those who have paid into the system, but aren’t retired, can be give “recognition bonds” worth what they have already put into the system, redeemable upon retirement. These would not be new government debt, but rather an explicit recognition of an implicit debt already promised by the government. Since today’s workers aren’t likely to get back all the money they’ve put in anyway, these bonds could be valued at 90 of past contributions, to help ease the transition.

Of course, the best option is to finance the transition is by cutting wasteful government spending, and using the money saved. It is always tough to get politicians to cut their pork barrel programs, but it may be easier if they know they are doing it to ensure everyone a better retirement. Social Security expert Andrew Biggs, in a paper for the Cato Institute, suggests financing part of the transition with the $138 billion spent per year on corporate welfare—government money that goes to specific companies or industries—and the $35 billion subsidizing farms, usually large agri-businesses. Citizen’s Against Government Waste, in their annual Pig Book, identify 9,362 wasteful projects in the 2003 budget, costing tax payers $22.5 billion. This money would go a long way in finance the transition to private personal accounts.

However the transition is financed, there are clearly plenty of ways to do it. The sooner the transition to personal retirement accounts happens, the easier it will be to finance. Every day reform is put off, the unfunded liability grows, because every day reform is put off, more taxes are paid into the system. These tax dollars increase the unfunded liability because the government promises to pay these tax dollars back. As soon as these dollars start going into personal accounts, we both free ourselves from relying on the promises of government, and free the government from more promises to keep. Were everyone to switch to private accounts today, the unfunded liability would immediately stop growing.

There will be costs in transferring to a system where we own our retirements, just as there would be costs to fix any bankrupt entity. But, to say it will be too expensive is the opposite of the truth: it would be too expensive not to fix it.