Memo To: House Speaker [designate] Rep. Bob Livingston
From: Jude Wanniski
Re: Growth as the only solution
I caught you Sunday on "Both Sides with Jesse Jackson" and thought you did well. As expected, Jesse danced around with you on the Social Security issue, and there was enough fuzziness on both sides to give you freedom to maneuver in the 106th Congress. We published a paper several months ago on the supply-side growth option to Social Security. It shows the way toward a system that not only would secure the basic benefit package for the forthcoming surge in retirees, but also would initiate the transition to a system of personal accounts — without the austerity that is an inescapable component of current "privatization" plans. Before you commit yourself to a specific track, you should be aware of this position, which was developed by David Gitlitz of Polyconomics staff.
SOCIAL SECURITY: THE GROWTH OPTION
by David Gitlitz
July 13, 1998
It has now been nearly six months since President Clinton helped thrust Social Security into the forefront of national policy discussion with his State of the Union appeal to "Save Social Security First." Rather than initiating a contest of fresh ideas, though, the President's call has served mostly to expose the deep splits along predictable political and ideological lines of those with various interests at stake in shaping Social Security's future. For the most part, those aligned with the "liberal" Democratic perspective remain committed to preservation of the status quo. They see Clinton's proposal to "reserve" the budget surplus for Social Security as a usefiil ploy to make protection of the retirement benefit guarantee a top political priority. Just as assuredly, those individuals and groups identified as "conservative" Republican are unwavering in their commitment to privatization as the only route to salvation of a national retirement program. While the gap between these two poles is obviously vast, they share common ground in at least one important respect: Each would entail significant austerity in the form of reduced benefits, higher taxes, or both.
This paper offers an alternative concept, which holds that a modestly higher level of economic growth will dissolve the problem that concerns all parties. The current robust performance of the U.S. economy, in fact, presents an opportunity to initiate a discussion that breaks through this ideological divide. A growth-based approach could secure long-term solvency of the Social Security system in its role as a public safety net — while simultaneously advancing the development of private retirement accounts. This growth approach would require Congress to alter the tax system to accelerate growth of the nation's capital stock. It also would require rebating part of the growing payroll tax surplus as the seed-corn for private accounts. Time is critical to making the growth approach feasible, as every year of delay erodes the system's long-run outlook, making it increasingly difficult to fund the system without lower benefits, higher retirement ages or higher taxes on the working population.
Better-than-expected economic performance has already led the Social Security Administration (SSA) to begin upgrading its highly conservative actuarial estimates of the system's future financial condition. In April we showed how calculations of Social Security's ultimate demise were based upon unduly pessimistic assumptions about future economic performance ("Economic Growth: the Solution to Social Security," April 17, 1998). Within weeks of our assessment there was official confirmation of stronger growth positively altering the actuarial outlook. The 1998 Social Security trustees' annual report, published in late April, extended the date of estimated insolvency of the system by three years, from 2029 to 2032. They did so as a result of GDP growth of 3.8% and real-wage gains of 2.2% in 1997, well above the forecast of 2.5% and 0.8%, respectively.
At least as important as the direct effects of higher growth in boosting payroll tax revenues ~ thus raising the starting point of forward projections — were the indirect effects. The economy's recent vigor has compelled the actuaries to boost the assumptions that undergird the estimates of future growth. "The continuing favorable performance by the economy through 1997...indicates that economic performance over the early years of the projection period is likely to be better than was assumed in last year's report," the trustees acknowledged. More optimistic assumptions covering the next five to ten years "produce an increase in the level of employment, productivity, average real wages and GDP throughout the balance of the long-range projection period."
For the most part, conservative reform advocates dismiss this positive news as a diversion or ignore it entirely. Social Security's unfunded liabilities still range from $3-5 trillion, which they say only can be financed through a program of radical privatization. Obviously, a three-year reprieve from projected bankruptcy is not going to "save" Social Security. At the same time, though, the favorable revisions to the trustees' projections help underscore the potential for robust growth to pave the way for a far less disruptive and austere solution. More than likely, next year's report will also come with a positive "surprise," unless growth for the remainder of this year slows dramatically from the 4% year-on-year rate of the first quarter to the 2.5% SSA forecast. In fact, were the economy to enter a long-term trend typified by last year's performance, talk of a Social Security "crisis" would be relevant only to the most devoted reform advocates. Extrapolating from sensitivity analysis included in the 1998 trustees' report, we estimate that average real-wage gains of 2.28% — which under SSA assumptions would be consistent with productivity improvement of 3.2% and GDP growth of 3.3% — would secure solvency of the system for the next 50 years. This holds constant the SSA's demographic assumptions that retirement of the baby-boom generation, slowing labor-force growth, and rising life expectancy will reduce the worker-to-beneficiary ratio from about 3:1 currently to 2:1 over the same 50-year period.
The prospect of realizing such sustained, long-term performance may seem like wishful thinking based on standards shaped by the generation of capital scarcity that, with brief interludes, has characterized the past 25 years. The U.S. economy, though, almost certainly appears to be entering a peacetime age defined by consistently rising levels of entrepreneurship and risk-taking, accelerated wealth creation and rapid technological advance. Given that, the gains to productivity and living standards required to achieve these objectives appear considerably more realistic. For all its sub-par performance since the early 1970s, the U.S. economy has still averaged about 3.1% annual growth in the post-World War II era. Sustained stretches of considerably more robust growth have not been unusual. From 1960-70, GDP growth averaged 4.4% and real wages rose at a rate of 2.2%, with productivity growth of more than 3% annually. Similarly, 1983-87 saw aggregate expansion at a better than 4% rate and real wage growth of 2.2%. Bear in mind these periods of vigor, and earlier such chapters in U.S. economic history, simply did not peter out — they were extinguished by policy error. Even the powerful expansion of the 1960s could not endure the succession of fiscal and monetary blunders engineered by the Johnson and Nixon administrations. Nor could the Reagan recovery of the 1980s ultimately withstand the shock to capital formation imposed by the 40% capital gains tax hike effective in 1987.
Achieving long-term expansion of this size and scope, of course, would present serious challenges. Slower growth of the labor force means the bulk of the necessary expansion will have to come from higher productivity. If two workers instead of three will have to support a retiree as the 50-year actuarial period unfolds, there will have to be a sustained acceleration in the pace of capital formation. In simplest terms, one of the three workers is being replaced with a robot, a tool that does something that today requires human effort.
If we look at the last half century, the growth in productivity that would be required appears daunting. Statistics do not tell the whole story, however. A 3.3% average GDP growth rate for the next 50 years would represent an approximate quadrupling of aggregate real output, not appreciably greater than that which has occurred during the past 50 years. Since 1947, though, the labor force has more than doubled, from less than 60 million to about 137 million. Thus, although the economy as a whole grew nearly four-fold, the output commanded by each labor-force participant rose by less than half that, or about two-thirds. Over the next 50 years, by contrast, the Social Security trustees project total labor force growth of only about 20%. To achieve a 50-year quadrupling of real output consistent with this rate of labor force expansion, production of goods and services per labor force participant will have to more than triple.
While convenient for shorthand analytical purposes, these broad statistical aggregates have much less utility when studying a problem that requires two workers instead of three to support a retiree. This is because the data puts all economic activity under the umbrella of "output," when much of the economic activity being counted is devoted to managing the inefficiencies that have crept into the national economy during the long Cold War period. The explosive growth of accounting, legal and lobbying industries in the last 30 years is primarily a function of the enormous expansion of the federal tax and regulatory codes and the floating of the U.S. dollar. An enormous amount of manpower now devoted to managing the chaotic consequences of these systems will become obsolete in the decades ahead as the political class responds to demands for simplification. The millions of people employed in this "chaos industry," to guide the productive workers through the chaos, instead will use their skills to increase the efficiency of world commerce. In other words, the rest of the world will increase their payments to the United States of real goods in exchange for our talents at financing global commerce and supplying technological expertise.
Even so, the fiscal-policy setting that would facilitate this shift to a significantly more capital-rich, risk-friendly economic environment is not yet in place. If one unit of labor and one unit of capital will produce a specific wage, a higher wage cannot be achieved if labor and capital are held constant. If the labor force is not going to grow as rapidly in the future as it did in the past, capital has to be added even more quickly in order to reach the point at which two workers can support a retiree. Capital can only be increased by reducing the impediments or increasing the rewards to its successful formation. Last year's reduction in the nominal capital gains tax to 20% from 28%, plus the positive changes in the new Roth IRA and in estate taxation, were serious increases in the rewards to capital — and clearly had a great impact on the wealth-creation process. As their effects were discounted in the financial markets in 1997, they added roughly $3.6 trillion to household net worth last year alone.
To produce the dynamics that would completely solve the long-term Social Security problem almost certainly requires a zero capital gains tax — a political impossibility this year. As the arguments in this paper become more commonplace, we can realistically look to passage sometime early in the new century. It, of course, would be extremely helpful if the current proposal of House Speaker Newt Gingrich and Senate Majority Leader Trent Lott, to cut the capgains rate to 15%, were enacted this year. For years, Fed Chairman Alan Greenspan has contended that a zero capgains tax would remove the single largest obstacle to creation of new wealth, leading to higher revenue streams at all levels of government. In addition, there remains wide scope for tax-policy changes that would lift marginal returns to risk-taking and encourage a more abundant capital stock. Restoring the 28% top marginal income tax rate that obtained at the end of the Reagan administration would greatly help, as capital income accounts for a disproportionate share of tax liability in these brackets. By the same token, elimination of the multiple taxation of dividend and interest income would significantly reduce the marginal tax rate on capital, which is been estimated at more than 60%.
One of the major reasons a growth solution to Social Security gets so little attention is that the conservative think tanks resist the idea that a lower capital gains tax, for example, would have permanent consequences. They have it in mind that a lower rate will produce a burst of capital expansion, but the economy will then equilibrate at that higher level and remain there. This is one of several cash-flow arguments that have popped up over the years from conservative economists, which lead to the conclusion that public pensions in and of themselves are burdens to economic growth. By increasing the reward to successful capital formation, a lower capital gains tax will enable transactions to be financed today that would not have been financed yesterday. This is a perpetual benefit, not a temporary one. In other words, once the government gets the tax structure right, given the shifting demands upon it, the economy will continue growing at high rates until human creativity becomes the limiting factor. The U.S. economy is a long, long way from this barrier, and the rest of the world is even further away from it.
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For all that, it is not untoward to ask whether the best that we can hope for from such a vibrant economy is to sustain a government retirement system expected to offer the current generation of workers a mere 1-2% return - as opposed to the 6-7% historic real returns on stock-market investments. Nothing in this discussion is meant to suggest that the system as currently structured epitomizes an ideal retirement system in some objective sense. As we suggested in the April report, the potential is for the existing system to maintain a minimum safety-net in the context of a high-productivity growth economy, and without the high transition costs and disruption of the major privatization proposals. In an environment of steadily expanding national wealth and rising real wages, workers would have considerably more disposable income available to take care of their own retirement needs. Consider, for example, the married-couple household with median income today of about $50,000 per year. After 50 years of 2.28% average real-wage growth, this median would compound to nearly $140,000 in today's dollars. Obviously, this would provide a greatly enhanced capacity for households to channel present income to consumption of future goods.
The favorable economic environment, though, also offers a window of opportunity for changes to reduce the burden of the program and begin a transition to private accounts without the austerity that would be necessitated by other reform projects. The rising tide of surpluses now pouring into the federal purse also is flooding the Social Security accounts. Due to higher-than-expected growth rates and the upward adjustments to economic assumptions, surpluses in the system for the next five years now are projected to total $600 billion, some $110 billion more than last year's estimate. The cumulative surplus is projected to double again, to $1.2 trillion, by 2007. Chances are that even these revisions will come to be seen as significantly understated. The average assumed real-wage growth rate for the next five years, for example, was raised from 0.73% to 1.13%. But, given that the trend of real-wage gains since the 1990-91 recession has been closer to 1.5%, this still appears to be a lowball estimate. The new real-wage assumption was developed consistent with a GDP growth projection of slightly less than 2% for the next five years. In other words, unless the economy slows markedly from the near-3% average growth rate of the current expansion, the Social Security surpluses — assuming an unchanged payroll tax structure — likely will be even larger than currently estimated.
By our reckoning, these growing surpluses in the Social Security trust funds are no less a waste than are those piling up in the Treasury general fund. As currently handled, the Social Security "surpluses," in fact, are a bookkeeping fiction; their elimination would have no direct, practical impact on the program's long-term solvency. Payroll tax collections in excess of current benefit payments are not "reserved" to offset future benefit obligations. They are co-mingled with general federal revenues and spent each year as part of current budget outlays. In exchange, the Social Security System receives an IOU from the Treasury general fund. When it comes time to redeem the lOUs to fund future benefits, Congress will have to float additional debt, raise taxes or cut other spending to finance the buy-back. In effect, the Social Security surpluses amount to an increase in the Federal government's obligation to fund future benefits. The system's future solvency depends on the economy's ability to generate strong growth in productivity and real wages, not on the accounting legerdemain of classifying liabilities as assets.
With private estimates now projecting general fund surpluses of nearly $1 trillion during the next five years, whatever usefulness there may have been in using excess Social Security revenues to offset general fund deficits has run its course. Clearly, a payroll tax cut of some sort is justifiable.
Analysis indicates that even a three-percentage-point cut in the payroll tax, from 12.4% to 9.4%, would maintain an accounting surplus at least through late next decade under current assumptions. Initially, the payroll tax cut could be structured in a way that would instruct Treasury to cease intermingling the Social Security surplus with general fund revenues and instead use the funds to begin repurchasing its debt to the retirement system. The proceeds of the debt pay-down could then be returned to the public in the form of personal retirement accounts.
This would begin an incremental process of "privatization" without the heavy burden of the transition costs inherent to the major reform initiatives. Together with the supply-side tax policies outlined earlier, this would allow all workers to begin earning a market-based rate of return on personal retirement savings. Over time, the accumulation of funds in these accounts and the compounding of returns would help reduce the future burden of the government guarantee. At some point, the balance in these accounts would come to supersede the guaranteed benefit. The payroll tax could then be substantially reduced, with the Social Security benefit serving primarily as minimum protection for those whose work experience did not allow them to accumulate assets sufficient to secure a decent retirement income.
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Such a proposal would come under attack from the advocates of more radical reform for its gradual approach and long-term maintenance of a Social Security guarantee. Though well-meaning, proponents of a more aggressive route to Social Security privatization at such sites as the Cato Institute and Heritage Foundation are toying beyond the realm of practical political and economic reality. Their appeals for a fully privatized retirement system have been made to sound inviting largely by downplaying the transition costs that would essentially require up-front financing of current estimates of the system's unfunded future liabilities. That would require significant sacrifice for the next few decades in the name of what they consider bright future promise. Their conception of the route to such a promising future is seriously flawed with another cash-flow dead-end. It rests on a demand-based argument that shifting public savings to private savings will in itself propel growth of the capital stock and spur significantly higher rates of economic expansion. The idea dates back to a paper by Martin Feldstein 25 years ago, which essentially argued that Social Security was a major reason why the U.S. economy was growing so slowly. That is, if people didn't have the government "saving" for them, they would save for themselves, and that act would cause capital formation.
The theory is completely fallacious. Without action to increase expected after-tax returns to capital and propel growth, this savings-based proposition is a neo-Keynesian mirage. Simply having more funds crowd into the market for equity, and less into debt, mil not improve the prospects for capital formation and growth in the slightest. This is not to say that cutting the Social Security tax would not have supply-side growth effects as the funds are invested in private pension accounts. It would, but not because of cash flow arguments. It is because the system has become grossly overfunded, with the government using the surplus to reduce its bond finance of general spending needs. With the budget now moving into general surplus, a payroll tax cut would reduce the marginal cost of both capital and labor, slowing the paydown of government debt at one level, but increasing the wealth of the nation and government revenues at another. In other words, a payroll tax cut would help foster the economic environment needed to sustain the long-term viability of the system.
For all the potential of the high-growth option to begin resolving the Social Security problems that otherwise appear intractable, there should be no illusions. The pro-growth forces in Congress are stalled, stymied by a Hooverite austerity faction of the Republican party that believes its highest purpose is to pay down the national debt. We find little recognition on Capitol Hill or at the think tanks of the growth-induced shift in the fiscal status of the Social Security program itself. Instead, one is constantly told of the necessity of benefit cuts, retirement-age increases, and other measures to maintain the program as part of the long transition to a privatized system. In reality, this certitude could well become self-fulfilling. Just as the benefits of maintaining a high rate of growth compound over time, so to do the costs of sub-optimal performance. Without further action soon, the current climate of robust wealth creation and above-average economic vigor is unlikely to be sustained long-term. At some point, the growth required to overcome a period of mediocre economic performance and sustain financial viability of the system would be unobtainable, making an austerity "solution" inevitable.