Order Code RL31498
CRS Report for Congress
Received through the CRS Web
Social Security Reform: Economic Issues
Updated December 3, 2004
Jane Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Marc Labonte
Analyst in Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Social Security Reform: Economic Issues
Summary
The President has indicated that Social Security reform will be a major issue in
the 109th Congress. While Social Security originated as a Depression-era program
aimed at alleviating the economic circumstances of the elderly, social insurance also
corrects market failures in the annuity market (adverse selection), prevents free-riders
(requires workers to provide for their retirement), spreads risk, and may correct for
failure to optimize by shortsighted individuals. The system imposes costs on society
as well, through distortions in savings and labor supply, and political risk.
The need for reform arises from projected financial shortfalls of the current
system, a largely pay-as-you-go (PAYGO) transfer system. Trust fund assets cannot
sustain the system. The assets were arguably not generated through real government
saving (in light of the history of persistent budget deficits). The problem is not
merely a blip that occurs as the baby boom retires. The worker/recipient ratio is
projected to fall permanently and ultimately either taxes must be increased by about
50% or benefits must be cut by one third. Inaction would likely lead to significant
tax increases in the future since it is difficult to cut the benefits of existing recipients.
Reform now would allow future recipients to adapt to benefit changes and the
economy to expand through saving, making the long run problem less burdensome.
Proposed reforms involve revisions to the present system, the introduction of
individual accounts, or a combination of both. All else equal, raising taxes or cutting
benefits increases government saving; most taxes would not significantly affect the
private saving rate (especially wage and consumption taxes). Evidence suggests that
some benefit reductions (e.g., raising both the early and full retirement age) are more
likely to increase labor supply and the tax base than others. Investing trust fund
balances in equities cannot, however, provide higher aggregate returns unless
financed through higher taxes or lower government spending. Otherwise, gains from
investment earnings will be offset by lower returns to private portfolios and higher
government interest rates. This analysis suggests that increased government
borrowing costs could largely negate the perceived gains to the government.
Individual accounts are often touted for their higher returns. However, these
comparisons are not accurate: they do not account for general equilibrium effects on
interest rates, transition costs of paying off existing liabilities, the increased risk for
individuals, and — in some cases — the full cost of the current system’s social
functions (e.g. disability, transfers). If debt financed, individual accounts systems
would magnify the crisis because transition costs would increase. Moreover, if a
pure individual account system is to be successful in addressing market failures such
as adverse selection and free riders, it must be made mandatory in participation,
annuitization, and prudent investment. Two problems emerge even if these rules are
followed. Individual accounts would redistribute away from the poor because of
their shorter lifespan and would eliminate the explicit redistribution of the current
system. Individual accounts would also expose cohorts of retirees to significant
variation in benefits due to the vagaries of the stock market. Individual accounts,
however, could reduce tax distortions and political risk and facilitate budgetary
discipline. This report will not be updated.

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Contents
The Economic Rationale for Social Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Adverse Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Incomplete Private Insurance Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Failure to Optimize . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Economic Costs of Social Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
What Is the Problem? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
How Big Is the Problem and What Role Do Social Security Surpluses
Play? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Economic Effects of the Current System: Savings and Labor Supply . . . . . . . . . 10
Social Security and Private Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
The Solutions: Potential Social Security Reforms within the System . . . . . . . . . 16
Inaction and the Default Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Raising Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Cutting Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Choosing Between Tax Increases and Benefit Cuts . . . . . . . . . . . . . . 21
Investing the Trust Fund in Higher Yielding Private Assets . . . . . . . . . . . . 22
Numerical Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Individual Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Rate of Return Comparisons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Transition Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Social Security’s Social Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Administrative Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Can Individual Accounts Fulfill the Objectives of Social Insurance? . . . . . 35
Restrictions on Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Minimum Benefit Guarantees and Moral Hazard . . . . . . . . . . . . . . . . 36
Should Annuitization Be Mandatory? . . . . . . . . . . . . . . . . . . . . . . . . . 37
Should Bequests Be Allowed? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Risk: Collective Social Insurance vs. Individual Accounts . . . . . . . . . 38
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Appendix: Portfolio Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
List of Figures
Figure 1: Worker-Recipient Ratio, 1970-2080 . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Figure 2: Projected Revenues and Outlays of the Social Security System,
2005-2080 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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Figure 3: The Effect on Social Security’s Finances of Introducing 2%
Individual Accounts (2004-2074, as a % of Taxable Payroll) . . . . . . . . . . . 28
Figure 4: The Effect on the Unified Budget Deficit of Debt Financing 2%
Individual Accounts (2004-2074, as a % of GDP) . . . . . . . . . . . . . . . . . . . 29
Figure 5: The Effect on the Budget Balance of Debt Financing Option 2 . . . . . . 31
Figure 6: The Effect on the Budget Balance of Debt Financing Option 3 . . . . . . 31
List of Tables
Table 1: Effects on Earnings, Federal Interest Costs and Rates of Return
from Investing Trust Fund Assets in Equities, Simulation . . . . . . . . . . . . . 24
Table 2: Percentage Increase in Benefit Due to Social Security’s Tax
Treatment Relative to Taxable Private Savings . . . . . . . . . . . . . . . . . . . . . . 33
Table 3: The Historical Performance of Hypothetical Individual Accounts . . . . 40
The authors gratefully acknowledge the help and comments provided by Geoffrey
Kollmann and others in the development of this report.

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Social Security Reform: Economic Issues
The President has indicated that Social Security reform will be a major issue in
the 109th Congress. For some time comprehensive reform has been an issue of debate
in Congress, but no major action has occurred. Reform proposals have been driven
in part by a recognition that in the future the program is financially unsustainable
under current policy. This report tackles the issue from an economic perspective that
focuses not merely on reform that achieves programmatic sustainability
(sustainability within the trust fund), but reform that achieves sustainability for the
government and economy as a whole. Moreover, it stresses the importance of
understanding the economic consequences of program changes if one is to understand
who pays to achieve this sustainability and what type of changes might be consistent
with the economic rationale for social insurance.
The Economic Rationale for Social Security
Before turning to the assessment of the current problem and the proposed
solutions to that problem, it is worth taking a moment to consider why we have a
Social Security system at all. Historically, of course, Social Security arose as a
Depression-era program to alleviate the economic circumstances of the elderly. For
that reason (and perhaps others) it began as a transfer rather than a fully-funded
retirement system and the susceptibility of a tax and transfer system to demographic
changes is the reason for the current problem. Today, Social Security is more than
a retirement system; it provides disability payments (which account for about 15%
of benefits) as well as benefits to survivors and dependents. (There is a companion
program, Medicare, that provides for health benefits in retirement.) Social Security
has also been a way to provide income redistribution that has lifted many elderly out
of poverty without resort to explicit (and to some, demeaning) welfare programs. To
some, these other functions of Social Security represent social goals that should be
separated from the provision of retirement income. For others, they are an integral
part of Social Security’s role of insuring against the risks associated with old age.
Why not simply allow individuals to cope with their own retirement and other
risks (such as disability) through private saving and insurance? Economic theory
suggests several reasons that are discussed below.
Adverse Selection. One reason for an aggregated mandatory social insurance
program is a problem called “adverse selection.” Since individuals know more about
their own circumstances than insurance firms, individuals who are more likely to
benefit from insurance would tend to purchase it. For example, using one’s life
savings to purchase an annuity that pays a fixed amount per month over the rest of
one’s life would be most attractive to individuals who expect to live a long time (and
unattractive to a person with a terminal disease). So the insurance industry will only

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CRS-2
offer to pay a smaller annuity than that justified by average life expectancy because
the companies know that their customers will more likely be those who expect a long
life. These less advantageous terms lead annuities to be attractive to an even smaller
group of individuals. The result is that markets do not provide attractive annuities
to the average person. The problem can be avoided by the government mandating
the purchase of annuities or by directly providing them through a tax and benefit
system.
Moral Hazard. A second problem is one known as “moral hazard,” which
arises from behavioral responses to incentives. In this case, moral hazard arises if
society has a safety net for only the poor. Individuals know that if they do not save
for retirement, society will not allow them to be destitute, so there is an incentive to
“free ride” on the program — to undersave, to take too many risks in saving choices,
and to spend accumulated savings too quickly. By requiring individuals to
participate in (and pay taxes into) a minimum retirement system that pays a lifetime
annuity upon retirement that is not risky, this moral hazard problem can be avoided.
Incomplete Private Insurance Markets. A social insurance system also
allows for the reduction of individual risk in saving for retirement, by spreading
investment and other risks across individuals within a generation as well as across
generations. Even if private insurance markets are complete within generations, they
are unlikely to be complete between generations, implying that a social insurance
system can lead to efficiency gains for society as a whole.1 A prolonged slump in the
stock market, for example, can be especially damaging to the generation reaching
retirement age during that period.
Failure to Optimize. There are other reasons for a mandatory social
insurance system. Individuals may not always do what is in their own best interest,
insurance and annuity purchases are complicated, and the optimal lifetime savings
plan is one susceptible to mistakes or myopia. Economists would call this problem
a failure of individual optimization. The fact that so many individuals retire at their
earliest age of eligibility is suggestive that such failures might occur. If the failure
to optimize is the dominant reason for Social Security, then economic models and
theories may have very little predictive power regarding the effects of reform.2
Economic Costs of Social Security. Social insurance programs also
impose costs on society. If taxes are not directly tied to benefits, they can cause
distortions in labor supply and other economic behavior. Since the current Social
Security system is not fully funded, it may reduce national saving from its efficient
level. It may be politically difficult to maintain an accumulated asset fund that is not
viewed as permitting a greater degree of deficit financing in the remaining part of the
1 See Robert Schiller, “Social Insurance and Institutions for Intergenerational,
Intragenerational, and International Risk Sharing,” Carnegie-Rochester Public Policy
Conference Series, Apr. 1998.
2 Other economic explanations for Social Security have been advanced. See Casey Mulligan
and Xavier Sala-i-Martin, Social Security in Theory and Practice (II): Efficiency Theories,
Narrative Theories, and Implications for Reform, National Bureau of Economic Research,
Working Paper 7119, May 1999.

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CRS-3
budget. And even social insurance programs that are funded may not reflect the
optimal choices in asset holdings.
Since the program is legislated, it can also expose participants to the political
risk of arbitrary transfers among individuals. Note, however, that the potential future
tax and benefit changes necessary to address the current solvency problem would not
disappear in a system of private saving: political risk should be thought of as shifting
costs and benefits among individuals and is not responsible for real risks such as the
demographic changes that are creating the current financing problem.
These economic rationales for social insurance, and the costs associated with
them, provide an important framework for analyzing alternative approaches to reform
and will be referred to frequently in this report. To illustrate their importance,
consider briefly what they imply about individual accounts, which have been
proposed as a full or partial substitute for Social Security by some and which have
the advantage of reducing economic distortions. Individual accounts (as a complete
substitute for Social Security) would not address the problems of adverse selection
and moral hazard unless they were mandatory (both with respect to contributions and
to conversion to a life annuity) and prudently invested. If these restrictions were not
introduced, then there is no economic advantage to government involvement in
retirement decisions and such decisions could be left to the private market. They also
do not permit explicit redistribution in favor of lower income individuals as the
current system does. Indeed, given the higher mortality rates of lower income
individuals, higher income individuals would actually enjoy higher benefits on
average. (The longer expected life span of high income individuals give them an
advantage in the current system as well, but explicit redistribution toward lower-paid
workers offsets this effect.)
Therefore, individual accounts are caught on the horns of a dilemma: they
cannot simultaneously satisfy the objectives of eliminating adverse selection and
moral hazard and the distributional objectives of the current system. To maintain all
of these objectives, individual accounts would need to constitute only a part of the
Social Security system or the accounts would need to be subsidized for low income
individuals.
What Is the Problem?
Social Security was, and largely remains, a pay-as-you-go (PAYGO) system in
which current workers pay the retirement benefits of current retirees through a payroll
tax.3 There is no saving component to this type of system; from an economic
perspective, it is a generational transfer system, not a pension or investment system.
If benefits equal tax payments, as a pure PAYGO system implies, then total benefits
can only grow at the rate that payroll tax revenues grow — with a stable population
growth and age distribution, that will be the growth rate of the economy. Thus, for
3 The economic incidence of the payroll tax is borne by the worker regardless of who has
the legal obligation to pay. Thus, the incidence of the one-half of taxes paid by employers
is no different from taxes paid by employees.

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an average retiree who has spent his entire life contributing to a PAYGO, the “rate
of return” on his payroll taxes would be about equal to the growth rate of the
economy. But for a retiree in the early years of the system who lived part of his
working life before the system’s inception, the “rate of return” on his payroll taxes
will be much higher because he receives the same benefits without making a lifetime
of contributions.4 According to one estimate, past and present generations will
receive $9.1 trillion more in benefits than they paid in contributions in present value
terms, which under current policy will be borne by future generations.5
When the number of retirees grows faster than payroll revenues, benefits per
average retiree need to fall for the system to remain solvent, and the return on
contributions would fall (and could become negative). Trouble arises in the future
because the retirement of the “Baby Boom” generation, along with increasing life
spans, cause the growth rate of retirees to greatly outstrip the growth rate of workers
in the system. A pure PAYGO system could rectify this imbalance by increasing
taxes in order to maintain the historical growth rate of benefits or by decreasing the
growth rate of benefits to maintain taxes. Neglecting economic effects for the
moment, the choice is simply a transfer of income: increasing taxes in 2018 (and
thereafter) constitutes a transfer from future workers to the Baby Boomers, while
lowering benefits constitutes a transfer from the Baby Boomers to future workers.
The only other possibility would be to cover the difference through the issuance
of government debt to the public. But this option would simply transfer the burden
further into the future because the budget deficits would decrease the national saving
rate and with it the future size of the economy; in the long run such an approach
could not be sustained. In any case, the imbalance is large enough that debt issuance
could not be a primary solution to the problem even in an intermediate horizon. CBO
forecasts suggest that as the Baby Boomers retire, debt would quickly exceed 200%
of GDP, primarily because of higher health care spending. It would be difficult for
the government to convince its citizens to purchase debt at reasonable interest rates
at these levels.
The problem of the Baby Boomers’ retirement is well appreciated. What may
be less well-understood is that the financing problem is a permanent problem; it is
not a decade-long blip while the baby boomers retire. A key to financing a PAYGO
system is the worker to recipient ratio, and it is the level of the worker-recipient ratio
that determines the revenues of a PAYGO system, not the change in the ratio. As
seen in Figure 2, this ratio deteriorates markedly while the baby boomers retire, from
3.4 workers per recipient today to about 2.0 by 2040.6 If the ratio then recovered as
4 For more information, see John Geanakopolis, Olivia Mitchell, and Stephen Zeldes, Social
Security Money’s Worth, NBER, Working Paper 6722, Sept. 1998.
5 Jagdeesh Gokhale and Kent Smetters, Fiscal and Generational Imbalances, AEI Press,
(Washington, DC: 2003), p. 26.
6 It is always important to remember that forecasting is not a science, and any future
estimates are only the most likely outcome of an uncertain event. As a projection moves
further into the future, uncertainty increases. In their report, the OASDI Trustees address
this issue by offering alternative high and low cost scenarios. Under the high cost scenario,
(continued...)

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the Baby Boomers died, the financing problem would be a temporary one whose cost
could be spread by borrowing to generations before and after the blip. But the
problem is permanent: the ratio is not projected to recover. Part of the reason for this
effect is the increasing life span upon retirement which reflects assumptions about
both longevity and earlier retirement.
Figure 1: Worker-Recipient Ratio, 1970-2080
4
3.5
3
io 2.5
Rat
2
1.5
1
1970
1990
2010
2030
2050
2070
Year
Source: Trustees of OASDI, Annual Report, 2004, Table IV.B2.
Note: Solid line based on Trustees’ intermediate assumptions. Dashed lines represent
worker-recipient ratio under alternative scenarios.
One can contrast the past and future financial state of the Social Security system
with the state that would have been achieved if a fully funded system had originally
been instated instead of a pay-as-you-go system. In a fully funded system, current
workers pay for their own future benefits (through either a collective account or
individual accounts) instead of the benefits of current retirees. Until they retire, the
proceeds are saved in real financial securities, allowing a fully funded system to
achieve a “market” rate of return. How would outcomes differ under this type of
system as opposed to a PAYGO system? Benefit levels and the “rate of return” on
workers’ taxes would no longer be directly related to the worker-recipient ratio (it
would only change as the capital stock per worker is affected). Thus, the retirement
of the baby boomers would not require reductions in benefits or tax increases because
6 (...continued)
the worker-recipient ratio would reach 1.8 by 2040 and under the low cost scenario, the ratio
would reach 2.4 in 2040.

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CRS-6
their benefits would come from their own contributions and the earnings on them.7
Where would the money come from to make this possible? It would come from the
fact that early retirees who spent only a few working years under the system would
have received little or no benefits. Instead, the money they would have received
under a PAYGO system would have been saved and invested for later retirees.
Because money has already been transferred to the early retirees in the current
system, there is no reform to that system to achieve solvency that can avoid lowering
someone’s “rate of return.”
The Social Security system has operated differently from a pure pay-as-you-go
system retirement system historically in two important ways. First, unlike a pure
PAYGO, our Social Security system has not always paid out as much as it has taken
in. Social Security has always maintained a small reserve against short-term
fluctuations. More importantly, changes to the system in 1983 led to Social Security
surpluses that have grown to be 1.3% of GDP in 2004. From an accounting
perspective, these surpluses have introduced a partial funding aspect to the system,
and the Social Security trust fund has grown to $1,355 billion as a result.
Unfortunately, the budget deficits of the government in most of these years appear
to have prevented the surpluses from partially funding the system in an economic
sense; indeed most years since the 1980s debt held by the public as a percentage of
GDP increased.
Second, the average single retiree will not enjoy the PAYGO rate of return equal
to the growth rate of the economy because a portion of his contributions are diverted
to benefits unrelated to retirement. The current system also provides benefits to the
disabled, survivors, and dependents; in 2003, these uses accounted for more than a
third of total benefits paid (18% for survivors, 15% for disability, and 5% for
dependents). In addition, it explicitly redistributes benefits by earnings level,
apparently further lowering the system’s rate of return for higher paid workers. For
example, single workers retiring at age 65 in 2003 earning low wages would recoup
the retirement portion of his and his employer’s payroll taxes plus interest in 10.4
years, a worker earning an average wage would recoup them in 14.9 years, and a
worker earning the maximum eligible wage would recoup them in 21.4 years.8
(However, comparisons of the benefit structure overstate the actual degree of
redistribution because of other factors, such as greater life expectancy for high
income individuals.9) It is important to factor in the resources devoted to these social
7 Increasing longevity, however, would result in smaller annual annuities for a fixed amount
of contributions under a funded system; this effect cannot be avoided, but it does not affect
the typical rate of return.
8 CRS Report RL31034, Social Security: The Relationship Between Taxes and Benefits for
Past, Present, and Future Retirees, by Geoffrey Kollmann.
9 See Karen Smith, Eric Toder, and Howard Iams, “Lifetime Distributional Effects of
Social Security Retirement Benefits”; and Lee Cohen, C. Eugene Steuerle, and Adam
Carasso, “Social Security Redistribtuion by Education, Race, and Income: How Much and
Why?” Both papers were presented at the third Annual Joint Conference for the Retirement
Research Consortium, “Making Hard Choices About Retirement,” May 17-18, 2001,
Washington, DC. See also Alan l. Gustman and Thomas L. Steinmeier, “How Effective Is
(continued...)

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functions when calculating the return the system can earn for retirees. Even a funded
system could not earn the return of a private saving account if it were to maintain
these social functions.
How Big Is the Problem and What Role Do Social Security
Surpluses Play?
This report defines reform as a measure that returns the system to long-term
solvency. The first question to ask is: what is solvency? The narrow definition, used
by the Social Security trustees, of preventing the Social Security trust fund from
being depleted over 75 years seems unsatisfactory from an economic perspective.
After all, the trust fund can be replenished in any number of ways that would not
make it any easier for the government to meet its financing needs and would have no
effect on the economy. For example, we could simply divert income tax revenues to
the trust fund any time benefits exceed payroll tax revenues. But if the government
wished to maintain its other spending without raising taxes, it would then have to
borrow to finance spending that would otherwise be financed through income tax
revenues. The government cannot borrow sufficiently to maintain current policy
through the retirement of the Baby Boomers without pushing up the government
borrowing rate significantly; nor can debt grow faster than GDP without limit as
current policy implies.
This analysis raises a further question: does the system become unsustainable
when benefits exceed revenues, as is forecast to occur in 2018, or is it sustainable as
long as there are assets in the trust fund to draw down, as will be the case until 2042?
The latter option seems unsatisfactory when one considers that there are not any
“real” assets in the trust fund at all. Since the Social Security trust fund holds U.S.
Treasuries, the government owes money to itself. It is analogous to saying that one
can afford to make a purchase because one’s left pocket has an IOU from one’s right
pocket, even though one’s right pocket is empty. What is in the left or right pocket
by itself is irrelevant, it is total wealth that determines whether the purchase can be
made. Similarly, it is the government’s overall ability to meet the needs of retirees
that determines the sustainability of the Social Security system when the Baby
Boomers retire. The government’s overall ability to pay benefits comes down to
what benefits have been promised, how much overall tax revenue is being raised, and
what is the size of the economy from which taxes are being raised. The answer to
these three questions determines the underlying solvency of Social Security.
Because the decline in the worker to recipient ratio is projected to be permanent,
the financing problem is permanent. This makes the trustees’ estimate of the 75-year
actuarial deficit of 1.89% of payroll a misleadingly low estimate of the system’s
financing problems — a trust fund that is solvent for exactly 75 years merely shifts
the permanent tax increases to year 76 and offers no indication of how the
9 (...continued)
Redistribution Under the Social Security Benefit Formula?” Presented at Second Annual
Joint Conference for the Retirement Research Consortium, May 17-18. Washington, D.C.
Julia Lynn Coronado, Don Fullerton, and Thomas Glass, The Progressivity of Social
Security, National Bureau of Economic Research, Working Paper 7520, Feb. 2000.

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government will finance the redemption of trust fund assets.10 The problem with
current policy is that it would place an unsustainable strain on the unified budget
deficit.11 Thus, the best measure to gauge the size of the problem is the difference
between taxes and benefits paid over time under current policy, as shown in Figure
2. For the time being, focusing on this measure sets aside the issue of trust fund
balances, which are not meaningful in an economic sense without considering total
government assets or liabilities.
Figure 2: Projected Revenues and Outlays of the Social
Security System, 2005-2080
7
6.5
6
5.5
% of GDP
5
4.5
42005
2025
2045
2065
2015
2035
2055
2075
revenue
outlays
Source: Congressional Budget Office
Note: Graph represents conditions under CBO’s intermediate assumptions.
As Figure 2 demonstrates, in the long run, paying benefits under current policy
would require permanent tax increases, reaching 6.3% of GDP in 2030 and 6.8% of
GDP by 2080 (the end of the projection period), ignoring for the time being
economic effects. Compared to current law, this percentage of payroll translates into
a tax increase of roughly 50%. It would also be about 3½ times as large the Trustees’
actuarial deficit of 1.89% of payroll. (Although this report addresses only Social
10 The measure of Social Security’s financing shortfall most commonly cited is the actuarial
deficit. The actuarial deficit is the size of the tax increase or benefit reduction, as a
percentage of payroll, that would be required for the trust fund to exhaust its assets in 75
years. It does not measure the tax increase or benefit reduction needed to prevent cash
deficits within the system over 75 years — the actuarial deficit assumes that cash deficits
in any given year can be closed by drawing down trust fund assets.
11 The indefinite maintenance of current policy implies that the national debt as a percentage
of GDP would be projected to asymptotically approach infinity.

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Security, it should be stressed that Medicare and Medicaid face projected shortfalls
that are even larger, and would require even larger tax increases to fund.)
The projections are extremely sensitive to underlying assumptions and should
be treated with caution. Under the low-cost alternative scenario, the shortfall would
reach 0.6% of GDP by 2030 and 0.4% of GDP by 2080. Under the high-cost
scenario, the shortfall would reach 2.2% of GDP by 2030 and 4.3% of GDP in 2080.
Thus, while the extent of reform is highly uncertain, even under the low-cost
scenario, some tax increase or benefit reduction would be necessary.
If a permanent future tax increase or benefit reduction of nearly 2.5% of GDP
is necessary, but the system is currently in surplus, is there any reason to reform the
system before it becomes insolvent? The worker to recipient ratio is nearly fixed,
barring massive immigration or higher birth or death rates. Only the future size of
the economy and the future state of government finances can be influenced today.
Thus, reform can ease the future financing burden only if reform causes the economy
to grow faster and improves the government’s finances.12 These are macroeconomic
problems that cannot be posed in terms of the Social Security system’s trust fund.
In these terms, according to standard economic theory, the crucial factor in
determining whether the Social Security surpluses increase economic growth and
improve the government’s finances depends on whether they are saved. Saving by
the government has two salutary effects. First, it increases national saving, which
increases private capital accumulation, the future size of the economy, and with it the
future size of tax receipts. In this way, saving budget surpluses is analogous to
transferring resources from present to future generations. Second, saving frees up
future government resources (by reducing interest payments and increasing tax
revenues in absolute terms) that make financing future imbalances easier. By
contrast, when the Social Security surplus is used to finance other government
activities or tax cuts rather than being saved, the Social Security trust fund is
increased but nothing is done to alleviate the government’s future fiscal imbalance.
Of course, it is difficult to actually determine whether the Social Security
surplus was saved because we cannot observe the budget that would have been in the
absence of surpluses. But we do know that the government had deficits every year
from 1983 to 1997 (and again beginning in 2002), when surpluses were appearing in
the Social Security system, and that debt as a percentage of output increased during
that period. If the Social Security surpluses were used to finance other spending, then
running surpluses in the accounts has done nothing to address the crisis in a real
sense. (The counter-argument is that the Social Security surpluses increased national
saving because the historical budget deficits would have been even bigger in their
absence.)13
12 Reform in advance is also essential for approaches that involve benefit reductions so that
workers have enough of their working careers left to adjust their personal saving behavior
to the reductions.
13 For alternative perspectives on the Social Security trust fund, see Kent Smetters, Is the
Social Security Trust Fund Worth Anything?, The Wharton School, University of
(continued...)

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From this discussion it should be clear that saving a surplus from any source
will increase the future size of the economy and improve the government’s future
financial position, even though non-Social Security surpluses do not increase the
Social Security trust fund. However, merely saving all of the projected Social
Security surpluses, which are determined by budget accounting rules rather than the
scope of the problem, is grossly insufficient to close the long-term financing gap.
A word of caution is in order. Simply increasing the size of the economy alone
will not convert a permanently unsustainable system to a sustainable one. A higher
wage base will increase tax receipts but because under current law benefits are linked
directly to wages, benefits will increase as well. (Because it would not raise the
benefits of those already retired, higher economic growth would improve the
system’s finances — but only temporarily.) What increased saving will do is make
other changes (such as higher taxes and/or reductions in benefits relative to wages)
easier because everyone will be better off. For example, if income is higher, a
relatively lower tax rate will be needed to raise a given amount of revenue. Plans that
aim to improve sustainability through economic growth would, therefore, be more
effective if the link between wage growth and benefit growth were weakened.
Economic Effects of the Current System:
Savings and Labor Supply
Before examining alternative reform proposals, we begin with two important
behavioral effects of the current system: effects on savings and the supply of labor.
The Social Security system, like all tax and transfer systems, has potential effects on
the size of the economy through effects on labor supply and capital accumulation.
First, the tax and transfer system could alter savings decisions because it reduces
income in the present and increases it in the future. Secondly, the payroll taxes
themselves could alter labor supply as would be the case for any tax on labor income,
with the effects depending on the linkage between taxes and benefits. In Social
Security, there is a link between benefits and taxes, however, so payroll taxes are not
taxes in a strict sense; workers may view them more as contributions that will later
be recouped. Higher earnings during the working years result in higher benefits,
albeit earning a much smaller return than would savings and perhaps reflecting forced
savings.14 Thus, the behavioral effects of a tax and transfer system occupy a middle
ground between an ordinary tax and expenditures system and a pension system.
Moreover, individuals may perceive the tax as different from other taxes; indeed, the
payroll tax is a tax that has generally not been as unpopular as income taxes.
13 (...continued)
Pennsylvania, Working Paper, May 13, 2002.
14 In the Medicare program, there is no link between the level of earnings and the level of
benefits.

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Social Security and Private Savings
To an individual, participation in the Social Security system appears to be a
form of saving: it reduces disposable income in working years and increases it in the
future. In certain models of household behavior over time (e.g., the life cycle model),
such an income shift should reduce personal saving. A natural response is to
rebalance consumption over time by increasing consumption today and reducing
funds available in the future that are less needed. In a simple model where Social
Security earns a normal return and borrowing is available, savings should fall by
exactly the amount of Social Security taxes. This expected effect has been the basis
for much criticism of the unfunded Social Security system. That is, the Social
Security system can be seen as a system that provides effects similar to saving in a
pension plan, except that no real accumulation of capital necessarily occurs. (The
system has generated surpluses but this effect is not very meaningful for two reasons:
first, most of the system is still pay-as-you-go and the surpluses are small in relation
to the future size of the unfunded liabilities, and secondly, these surpluses may have
permitted larger deficits in programs outside of Social Security, so that it is not clear
that real savings has occurred).
However, this effect on savings is not certain for several reasons. First, to the
extent that a Social Security system substitutes for pre-existing intergenerational
transfers, no savings effects would be expected. For example, if, in the absence of
Social Security, individuals expect to support their parents and expect, in turn, to be
supported by their children, and that obligation is reduced or eliminated by Social
Security, the transfer system is acting as a substitute for private transfers and would
not necessarily reduce private saving. Similarly, if parents had expected to leave
bequests to their children, the parents would have increased their bequests to offset
the payroll tax, and children would wish to save that bequest to relieve their own
children of the tax. (Most families do not leave bequests of any significance,
however, so it is the former rather than the latter phenomenon that is more likely).
At the extreme, one can argue that if all individuals are connected through
intergenerational transfers, anything the government does is offset by what
individuals do (this phenomenon is referred to as Ricardian equivalence). Although
such a model is obviously not entirely realistic (some individuals have no children,
for example), some elements of it may be present in the U.S. economy.
In either of these models, outcomes may also be affected to the extent that some
individuals are liquidity constrained; that is, they would like to consume more now
but cannot. Liquidity-constrained individuals are affected only by cash flow effects;
that is, taxes lower consumption and future income such as Social Security has no
effect on current consumption. There is evidence that a significant fraction of
individuals falls into this category. People may also save for precautionary reasons
because of future uncertainty and the potential for misfortune. Social Security may
lower private saving by reducing uncertainty and the need for precautionary saving.
(Then again, the family safety net may make precautionary saving largely
unnecessary, so that the introduction of Social Security has little effect on
precautionary saving.) Finally, this analysis of savings effects assumes that
individuals are making optimizing choices. However, making the appropriate
lifetime savings decision is not only complicated, it is done only once so one cannot
learn from mistakes. Thus, the possibility for a significant error must be considered.

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All of this discussion suggests that we need to turn to empirical evidence to
assess the effects on savings. Much of this approach has been based on time series
studies, which examine the change in savings rates over time with changes in Social
Security wealth. Unfortunately, the econometric evidence has been mixed.15 An
early influential study by Feldstein (1974) found Social Security significantly reduced
private savings (actually increasing consumption). However, that study was found
to have a programming error by Leimer and Lesnoy (1982), which caused the results
to become smaller and generally statistically insignificant. Feldstein (1982, 1996)
still found significant results with additional data: his findings suggested that Social
Security reduced the saving rate by half in 1992. These results were questioned by
Meguire (1998), who found a result about a tenth as large and by Coates and
Humphreys (1999) who found results that tended to be smaller and, in some cases,
in the opposite direction. A part of the problem with these studies is that it is very
difficult to measure Social Security wealth; another is that it is difficult to control for
other effects; and finally, the results tend to be sensitive to functional form. In
general, studies have found some savings offset, but typically not enough for Social
Security to offset private wealth dollar for dollar.
Some studies have used cross section data, and in most cases found some effect
on saving, but considerably less than the full savings reduction implied by the life
cycle modeling approach. Most of the effects were not statistically significant,
however. These data are, in any case, quite questionable because Social Security
rules are generally applied uniformly; thus, any variation is correlated with other
characteristics (income, family status, age) that could independently affect savings.16

A final approach is to compare savings rates in countries with different Social
Security systems. These results tend to not be very conclusive, finding both positive
and negative effects, usually without statistical significance. But perhaps it is not
surprising that it is difficult to detect results given the possible influence of cultural
mores on saving.17 In general, therefore, the evidence suggests a savings effect but
one that is by no means large enough to be consistent with the life cycle model.
At this point, a word of caution is also in order, for predictions of the effects of
Social Security reform that rest on simulation models. An example is the recent
15 See Martin Feldstein, “Social Security, Induced Retirement and Aggregate Capital
Accumulation,” Journal of Political Economy, 82 (Sep./Oct. 1974), pp. 905-926; Dean R.
Leimer and Selig D. Lesnoy, “Social Security and Private Saving: New Time-Series
Evidence.” Journal of Political Economy 90 (June 1982), pp. 606-629; Martin Feldstein,
“Social Security and Private Saving: Reply,” Journal of Political Economy, 90 (June 1982),
pp. 630-642; Martin Feldstein, “Social Security and Savings: New Time Series Evidence,”
National Tax Journal 49 (June 1996), pp. 151-163; Philip Meguire, “Social Security and
Private Savings,” National Tax Journal, 51 (June 1998), pp. 339-358; Dennis Coates and
Brad R. Humphreys, “Social Security and Savings: A Comment,” National Tax Journal 51
(June 1999), pp. 261-268.
16 See the review in Social Security and Private Saving: A Review of the Empirical
Evidence, Congressional Budget Office, July 1998.
17 Ibid.

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study that uses a dynamic model to estimate the effects of Social Security revisions.18
This model is a life cycle model (although it allows for bequests, the bequest motive
is not the type that leads to no effect of Social Security on savings). This study tends
to find privatization an attractive option, in part because of its effect on saving. But
this result is driven in part by the fundamental nature of the model. A different
model would not have led to the same predicted effect.

It should also be recognized that if individuals are well-informed, rational, and
optimizing, the projected insolvency of the Social Security system should already
have an effect on the national saving rate. If people working today know that the
system will be capable of paying only, say, two-thirds of their benefits as promised
under current law, then they should be saving more than they would if the system
faced no crisis. On the other hand, if individuals currently believe they will pay the
taxes and receive the benefits promised under current law, reform could induce more
private saving. This could happen because individuals are not well informed (e.g.,
they base their expected benefit on account statements from the Social Security
Administration instead of the financial position of the system) or because they think
that others will bear the burden of solving the problem (e.g., they believe taxes will
be raised after they have retired).
The theoretical and empirical evidence suggests that Social Security has had a
less clear cut effect on saving than is often assumed. If Social Security has not
caused individuals to save less, then the PAYGO approach may not be necessarily
faulted as discouraging savings. In any case, it is one thing to argue that had we
originally introduced a fully funded system rather than a PAYGO system, we would
have achieved higher national saving rates. But it is another to argue that now that
we have had a PAYGO system for over 60 years, shifting to a funded system will
raise the national saving rate. As discussed below, moving from a PAYGO to fully
funded system involves a significant transition cost, and if this transition cost is
financed through debt issuance, national saving will not rise. Thus, the move to a
fully funded system is only likely to increase national saving if real resources are
devoted to financing the transition in the form of higher taxes or lower benefits.
Labor Supply
Social Security systems can also affect labor supply. Economic theory suggests
that wage taxes have the potential to reduce or increase work effort depending on
offsetting income and substitution effects; these effects may be reflected in hours
worked or the workforce participation rate. If the tax reduces hours worked or
participation, raising payroll taxes themselves could have a negative effect on the size
of the work force relative to the retired population and the size of the economy. Most
evidence, however, suggests that labor supply is not very responsive to the wage rate,
because of offsetting income and substitution effects. Indeed, for men the evidence
suggests that an increase in net wages would slightly reduce work, while for married
women the effect is a slight increase; both of these effects are more likely to reflect
18 Laurence J. Kotlikoff, Kent Smetters, and Jan Walliser, Finding a Way Out of America’s
Demographic Dilemma, National Bureau of Economic Research, Working Paper 8258, April
2001.

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participation choices rather than choices of hours worked. Based on empirical
studies that reflected taxes, the Congressional Budget Office puts the total response
at an elasticity of between 0 and 0.3, meaning that a 10% reduction in wage might
reduce work effort by up to 3%, reflecting a response of between -0.1 to 0.2 for men
and 0.3 to 0.7 for married women.19
Social Security has some particular attributes for the effect on work that might
modify these results in various ways. First, there is a link between payroll taxes and
the size of Social Security at retirement that makes the payroll tax only partially a tax.
Because of redistribution in the system and the PAYGO nature, this relationship is
not perfect (i.e., the return earned is too low and variation in taxes does not lead to
the same degree of variation in benefits), but the payroll tax is more directly linked
to benefits than are other taxes. Secondly, there is a ceiling on covered wages, so that
higher income workers do not experience the marginal tax effects that tend to lead
to reduced work. Indeed, for such individuals (which would include higher income
men), there is, if anything, an inducement to increase work from payroll taxes via
income effects.
For married women, who have generally been viewed as most responsive to
taxes in their labor supply, the link between taxes and benefits is lessened because
they may receive spousal benefits even if they do not work. This latter link suggests
that the benefits to contributing are smaller than would be the case for other workers,
and the presence of the spousal benefit could reduce labor force participation.
Benefits for a non-working spouse are essentially a transfer, and some have argued
that such benefits should not be larger for non-working wives of higher income men;
rather the payment should be a flat payment. A smaller flat benefit would increase
the tie between Social Security contributions and benefits for married women who
work, and should increase their labor supply. However, empirically estimating the
labor supply responsiveness of women to wages is always difficult because potential
wages of non-workers are not observed. Moreover, the responsiveness to Social
Security benefits also depends on perceiving and expecting that working will result
in losing the non-working spouse transfer; younger women particularly may be
unaware of how spousal benefits are formulated. Empirical evidence that focuses
particularly on Social Security is relatively limited. One study found a significant
effect on labor force participation of the implicit benefit differential due to being
eligible for a spousal benefit for older married women, but not for younger ones;
another study found that the benefit differential led to earlier retirement.20
Perhaps the clearest effect of Social Security on work effort has been the
increase in retirement of older men since the introduction of the system. Between
1950 and 1989, labor force participation decreased from 46% to 17% for those 65
and over, and from 87% to 67% for those 55 to 64; the median age of retirement for
19 U.S. Congressional Budget Office, Labor Supply and Taxes, Memorandum, Jan. 1996.
20 See Therese A. McCarty, “The Effect of Social Security on Married Women’s Labor
Force Participation,” National Tax Journal, vol. 43 (Mar. 1990), pp. 95-110; Jessica Primoff
Vistnes, “An Empirical Analysis of Married Women’s Retirement Decisions,” National Tax
Journal, vol. 47 (Mar. 1994), pp. 135-156.

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both men and women fell from around 67 years to about 62 years.21 Labor force
participation of men aged 62-64 fell dramatically after the introduction of early
retirement at 62 in the early 1960s, even though there was an actuarial correction to
prevent early retirees from drawing larger lifetime benefits. In 1963, 76% of these
men worked; by 1985, only 46% participated (the number has roughly stabilized at
that rate).22 The fall in retirement age appears to have slowed down, and perhaps
stabilized from the 1970s to the 1990s, however.
There are a number of factors that might affect this decline, but some of it is
estimated to be due to Social Security, in part because Social Security makes
retirement feasible, and in part because Social Security has an earning test that
discourages work. In 2000, Congress repealed the test for recipients 65 and older;
it is probably too early to measure the potential effects of this change. For those
expecting not to live very long, retirement at 62 would be attractive despite the
aggregate actuarial correction. Moreover, by setting a minimum age for benefit
eligibility, Social Security may have contributed to setting some social norm.
Statistical studies have generally found an effect, although in some cases not a
large effect, of Social Security on retirement age. Some researchers attribute a
significant portion of the reduction in labor force participation to mandatory
retirement policies adopted by businesses and only recently made illegal, and to
features of private pension systems which encouraged retirement at a specific age.23
As in the case of saving, studies that rely on cross sections within the United States
may be questionable because Social Security wealth is correlated with other variables
that may affect retirement. Moreover, the observation of a falling retirement age
following the introduction of earlier retirement age eligibility and the dramatic fall
in labor participation has also occurred in other countries that did not experience
major changes in private pensions; older men’s labor force participation has been
declining in these countries as well. These studies suggest that a statutory early
retirement age significantly influences the average age of retirement.24
If these studies are correct, an important method of raising the worker to
recipient ratio may be to raise the age of early retirement (the “normal” retirement
age is already being increased). Critics argue that early retirement reduces the
pressure on disability insurance and that many individuals cannot easily work into
older age. However, most occupations have probably become physically less
demanding. They also argue that allowing earlier retirement prevents people from
21 See Andrew Samwick, “New Evidence on Pensions, Social Security and the Timing of
Retirement,” Journal of Public Economics, vol. 70 (Nov. 1998): 207-36; Murray Gendell,
“Retirement Age Declines Again in 1990s,” Monthly Labor Review, Oct. 2001.
22 William J. Wiatrowski, “Changing Retirement Age: Ups and Downs,” Monthly Labor
Review, Apr. 2001.
23 Ibid; also see Catherine Philips Montalto, Yoonkyng Yuh, and Sherman Hanna,
“Determinants of Planned Retirement Age,” Financial Services Review 9 (2000); 1-15, and
Congressional Budget Office, Raising the Earliest Eligibility Age for Social Security
Benefits, Jan. 1999.
24 See Jonathan Gruber and David Wise, Social Security Programs and Retirement Around
the World, National Bureau of Economic Research, Working Paper 6134, Aug. 1997.

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being thrust into poverty. The evidence suggests that about a quarter of men
receiving early retirement had a self-reported work-limiting disability. Of all early
retirees, fewer than one in ten were both disabled and had non-social security income
below the poverty level.25 Another study estimated that cutting early social security
benefits would increase the probability of normal retirement by twice as much as the
probability of disability retirement.26
The Solutions: Potential Social Security Reforms
within the System
Approaches to the Social Security’s financing imbalance fall into the following
five major categories:
! doing nothing at this time
! raising current and/or future taxes
! decreasing current and/or future benefits
! investing the trust fund in higher yielding assets
! the adoption of individual accounts
Whichever approach is ultimately chosen, changes will have to be made to the system
in one fashion or another. While this report does not provide a detailed quantitative
analysis of the options, they are each discussed briefly in light of the objectives of
social insurance, the distributional effects (both across generations and across income
levels), and implications for economic behavior. The efficacy of any reform will
depend on whether it limits the size of eventual tax increases or benefit reductions
implied in current policy.
In some cases, the effects of specific revisions are not as clear as they are often
portrayed. An illustration is a proposal to invest trust fund assets in the stock market
rather than in government securities, thereby earning a higher rate of return.
However, in the absence of basic increases in the supply of capital and labor, this
change cannot be a free lunch: somewhere, someone will pay for these apparent
gains. Another example is the potential effect of moving to voluntary individual
accounts, which can result in higher interest payments and, in the presence of adverse
selection and moral hazard, higher welfare costs in the rest of the budget. One of the
most important effects of this proposal is that individual accounts are supposed to
shift from pay-as-you-go finance to funded finance. To simultaneously solve the
problem of financing promised benefits in the Social Security system and shift to a
permanently pre-funded (even if only in part) system would require a great deal of
new resources during the transition period.
25 Congressional Budget Office, Raising the Earliest Eligibility Age for Social Security
Benefits, Jan. 1999.
26 See Olivia S. Mitchell and John W. R. Phillips, Retirement Responses to Early Social
Security Benefit Reductions, National Bureau of Economic Research, Working Paper 7963,
Oct. 2000.

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Commentators tend to divide reform proposals into “sacrifice” approaches, such
as benefit reductions or tax increases, or “investment” approaches such as equity
investment by the trust fund or the introduction of individual accounts. This report
suggests that policymakers cannot simply choose one approach or the other; they
must be linked to other changes to succeed. Tax increases or benefit reductions at
present are only useful if they result in a higher government saving rate; this effect
can be accomplished through debt reduction or an investment approach. If changes
lead to higher government spending outside of Social Security or to tax cuts, they
will have increased the size of the trust fund without improving the government’s
ability to honor trust fund promises in the future. Likewise, investment approaches
are only useful if they lead to a higher government saving rate, and a higher
government saving rate is only possible through tax increases or benefit reductions.
Otherwise, investment in the trust fund or individual accounts will be “debt financed”
and have no positive effect on national saving.
To make the system sustainable or solvent after reform, Social Security should
have roughly no effect on the unified budget balance every year. To achieve this if
Social Security is to remain in its current (PAYGO) form would require that its cost
rate be approximately equivalent to the income that has been designated to the
program. It is also possible for some of the system’s income to come from
investment earnings, if the trust fund or individual accounts were invested, or for the
system to be redesigned to receive revenue from on-budget sources, such as the
proceeds of an increase in income tax revenues.
This definition of solvency may seem overly strict since there is nothing
preventing the system from running deficits as long as the trust fund possesses assets
and nothing preventing the government from supplementing the system with general
revenues if it desires. Nevertheless, the definition used in this report is conceptually
useful because it is the only definition that requires an explicit description of how the
financing gap would be closed in each year. Reform options that include proposals
such as the use of unidentified general revenue transfers, the redemption of trust fund
assets, or the issuance of debt — on a temporary or permanent basis — implicitly
depend on further tax increases, benefit reductions, or reductions in other government
spending, but do not explain how they will occur. Again, it should be stressed that
deficit financing does not impose a smaller burden than tax increases or benefit
reductions; it simply shifts the burden forward to future generations.
Of course, reforms can only return the system to projected solvency, and the
margin of uncertainty on projections is large. If the projections are too pessimistic,
then reforms could turn out to be overly harsh. If the projections are too optimistic,
then further tax increases or benefit reductions would become necessary in the future.
Inaction and the Default Solution
Inaction itself does have some consequences. As stressed at the beginning of
this report, the Social Security system is not sustainable in its current form, and
inaction shifts the burden of fixing it to the future. Without action now, however,
these future changes cannot be softened by preparation or warning. As noted above,
given the permanent gap between income and outflow, eventually payroll taxes will
have to increase by about one half or benefits be cut by about one third in order to

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match income and outflow. On the other hand, if Social Security cannot be more
successfully insulated from the rest of the budget and gains from reform are used to
finance other government spending or tax cuts as has happened in the past, inaction
may be preferable.
A second reason to take action soon is that if benefits were to be reduced, it
would be appropriate to determine those reductions in advance so that workers could
plan for them. Policy makers are reluctant, for obvious reasons, to reduce benefits
of those currently retired, and taking no action today may simply result in increased
taxes in the future as a default condition.
Raising Taxes
Raising taxes now and saving the proceeds by improving the unified budget
balance would raise the national saving rate and improve the government’s finances.
(The beneficial effect would not occur if taxes were raised and the proceeds were not
saved.) Raising taxes now would impose part of the adjustment burden on current
workers, including the baby boom generation, if this accumulation could occur
without causing deficit finance in the rest of the budget. Increases in the capital stock
result in a true improvement in sustainability, as wage income would rise. However,
the improvement in solvency would be partly offset unless there were some reduction
in benefits relative to wages. That is, one would need to keep benefits on the path
they were already on which would effectively mean a cut in Social Security benefit
relative to the larger economy. Raising taxes now and keeping them permanently
higher as a method of achieving sustainability could convert the system to a partially
funded system.
While tax increases are never popular, it should be noted that in this case — if
one’s goal is to maintain the current size of the Social Security system — raising
taxes now is more economically efficient than raising them in the future. Since the
deadweight loss of taxation grows exponentially as taxes increase, there is a smaller
efficiency loss from raising taxes now than maintaining them for the time being and
raising them to a greater extent in the future.
If the current payroll tax base were raised, there would probably be relatively
little adverse effect on private savings or labor supply. Generally wage taxes are
unlikely to have an effect on the savings rate (or private capital accumulation) in the
economy through price effects. Its only effect may be that because any tax reduces
net income, it reduces the saving of those who save at a fixed rate. That is, some
small part of any tax increase may come out of savings because individuals wish to
spread the reduction in consumption over their lifetimes.27 There are also concerns
about the regressivity of Social Security taxes, which might argue for increases in the
earnings base as well (currently there is a ceiling on wages subject to the payroll tax).
27 There are economic models where such an effect would not occur, including infinite-
horizon models with fixed labor supply, where taxes have no effects (only spending).
However, in the context of these models, the government as well as the economy must be
dynamically stable and one could view the taxes simply as a consequence of spending
decisions.

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Alternatively, income taxes could be increased to help reduce the system’s
liabilities. These taxes are relatively progressive and fall on the elderly as well as
workers, but they may have somewhat larger distorting effects on savings and even
labor supply. Income taxes have mixed effects: they still have some effect on income
in retirement, but they also have the potential for discouraging savings through
effects on the rates of return. These offsetting effects may be the reason that
substituting wage for income taxes typically has little effect on the economy in life
cycle models.28
Some studies have proposed using a consumption based tax, such as a value-
added tax, to supplement payroll taxes.29 One argument for using such a tax is that
it is less likely to adversely affect savings and labor supply. While payroll taxes fall
solely on workers, consumption taxes also impose a lump sum tax (i.e., a tax that
does not distort economic behavior) on older individuals because they fall on assets
as well as on wages. In general, Social Security benefits are not affected since they
are inflation-indexed, so that elderly individuals without income from wealth would
not bear this burden. Moreover, because it falls on existing retired workers it can be
imposed at a lower rate than a wage tax.
Another approach to raising tax revenue would be to change the tax treatment
of Social Security benefits for purposes of the income tax to make it consistent with
the taxation of private pensions, as discussed below. Currently, about two-thirds of
Social Security recipients pay no income tax on their benefits. This approach could
also be thought of as an effective benefit reduction. It would fall relatively lightly on
low-income individuals who would be less likely to pay income tax because of
standard deductions and personal exemptions in the tax system. Its impact would
also be limited for higher income individuals who already pay tax on a larger fraction
of their benefits.
Cutting Benefits
There are many ways to cut future benefits, which this report defines as reducing
benefits relative to current law rather than in absolute terms. Most proposals would
make benefit cuts prospective, to provide time for adjustment, so little of the effect
would be felt by the current elderly. A proportional, across-the-board, phased-in
decrease could be used, or a slowing of indexation to prices and wages could be used.
The advantage of the latter approach is that the savings to the government would
grow over time, offsetting the growth in funding shortfall (although if carried out
indefinitely, it would cause Social Security benefits to become extremely small
relative to pre-retirement income). CBO estimates that one proposal along these
28 See Eric Engen, Jane Gravelle, and Kent Smetters, “Dynamic Tax Models: Why They
Do the Things They Do,” National Tax Journal, vol. 50 (Sep. 1997), pp. 657-682.
29 See Laurence J. Kotlikoff, Kent Smetters, and Jan Walliser, “Finding a Way Out of
America’s Demographic Dilemma,” National Bureau of Economic Research, Working Paper
8258, Apr. 2001. Note that their study shows very beneficial effects from VAT finance as
opposed to finance via payroll or income taxes because in a life-cycle model saving tends
to respond very powerfully to such a tax regime.

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CRS-20
lines could reduce outlays to 4.1% of GDP from 6.2% of GDP (under current law)
by 2050.30

Two particular approaches to restoring solvency that could also induce
economically beneficial behavioral effects are reducing benefits for dependents of
high wage earners and increasing the retirement age. As noted earlier, one of the
transfers in the Social Security system is a spousal benefit guarantee that rises with
the payment to the primary worker. For a secondary worker, the existence of these
benefits means that contributions paid into Social Security earn a lower return, and
thus may have adverse behavioral effects more in the nature of pure taxes. Lowering
the expected benefit to women who do not work increases the return to working and
should, in theory, result in more labor force participation. Evidence (cited earlier)
suggests that this treatment particularly has an effect on the labor force participation
of older married women.
A second approach is to increase the normal (or full benefit) retirement age.
Proponents justify this approach on the grounds that rising life expectancy means that
retirees are collecting benefits for longer than previous retirees. The full benefit
retirement age is already scheduled to increase to 67. Raising the full benefit
retirement age would result in direct savings in terms of benefit reductions, either
because of fewer delayed retirement credits or because of reductions in payments
received in early retirement. CBO estimated that a proposal to raise the retirement
age and reduce early retirement benefits would reduce outlays in 2050 from 6.2% of
GDP to 5% of GDP.31 Another study found that raising the projected retirement age
by an additional three years would reduce the projected increase in spending on
Social Security (as a percentage of GDP) by about 40%.32 To the extent that workers
delayed retirement because of these changes, output would be higher and more taxes
would also be collected.
An alternative that might have a greater behavioral effect is to raise the age of
early and full benefit retirement or to reduce benefits for early retirees. Such an
approach might have a larger effect on delaying retirement, which would also boost
output and tax revenue. Raising the early retirement age should also reduce the
amount of adverse selection in the system (the tendency of shorter-lived people to
choose early retirement); reducing benefits to early retirees permits adverse selection
but does not reward it as much. However, if early retirement decisions are not
primarily driven by adverse selection, the behavioral effect of lower early retirement
benefits may be limited. These proposals have a cost, in that the burden may fall
disproportionately on demographic groups with lower life expectancy (including
lower income individuals, men, and minorities) or those who work in arduous
occupations, and it may increase claims for retirement based on disability.
30 Congressional Budget Office, The Long Term Budget Outlook, Dec. 2003, p. 22.
31 Congressional Budget Office, The Long Term Budget Outlook, Dec. 2003, p. 24.
32 Ibid. After 75 years, costs (including Medicare) were projected to rise to about 0.264
from 0.137; instead they would rise to 0.209. These projections included some adverse
labor supply and savings responses.

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CRS-21
Choosing Between Tax Increases and Benefit Cuts. Given that tax
increases or benefit cuts appear necessary to restore the system to solvency, does
analysis provide any guidelines as to what mixture of the two would be desirable?
The answer to this question depends on the economically optimal size of the Social
Security system, which in turn depends on the tradeoff between the system’s costs
and benefits.33 The smaller the system, the less it is able to alleviate the market
failures it was designed to cure — moral hazard, adverse selection, incomplete
insurance markets, and failure of optimization. The larger the system, the more it
distorts labor and saving decisions. Higher taxes have negative substitution effects,
while benefit reductions have none. Thus, in economic models, benefit cuts would
typically lead to better macroeconomic outcomes than higher taxes because there
would be no negative effect on saving and labor supply.
Because evaluation of the costs and benefits of Social Security is so deeply
embedded in value judgements, the optimal size of the system must ultimately be
determined through the political process, and cannot be evaluated in this report. If
the current size is too large, a reform should be directed more to a benefit cut, with
private saving making up the difference; if the current size is too small, a reform
should be more directed to a tax increase.
If the current system is assumed to already be the optimal size, however, at least
some rationale exists for providing a mixture of relatively small benefit cuts and large
tax increases. If individuals want to smooth the effects of reform over their lifetimes
after reform is completed and adjusted to, they might prefer a roughly proportional
effect on their standard of living. Since Social Security benefits are a larger fraction
of retirement income than Social Security taxes are of workers’ income, it could be
argued that much of the adjustment might be made in tax increases. As an
illustration, consider a case with a 10% contribution during a working period of 45
years, to finance an annuity for a retirement span of 10 years. Assume a 6% rate of
return and a 2% growth in wages. If the retirement span doubled to 20 years, one
could either increase the contribution by 55% or decrease the annual annuity by 35%.
Suppose, however, one desired a proportional decrease in income for all years. To
accomplish that would require a tax increase of about 47% and an annuity decrease
of 4.7% — most of the adjustment (85%) would come on the tax side. The share
allocated to taxes would still be significant if the Social Security annuity represented
only part of retirement income. For example, the average share of retirement income
from Social Security is 51% for singles and 37% for married couples.34 With these
shares, the tax adjustment would be between about 2/3 and about 3/4 of the total
adjustment, respectively (rather than 85%). This relative shift away from tax
increases to benefit cuts occurs because a change in benefits now constitutes a
smaller portion of overall retirement income.
33 It can be argued that the solution to the system’s funding crisis is not primarily an equity
argument. If higher taxes or lower benefits affect the same people (at different points in
life), then there is no equity rationale for favoring one approach over the other.
34 Social Security Administration, Office of Policy, Income of the Population 55 and Older,
Feb. 2002.

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CRS-22
Of course, to the extent that the cause of the crisis is greater longevity,
individuals might also prefer a delay in retirement age (which is characterized above
as a retirement benefit reduction, but which also increases the revenues available for
benefits). In the illustration above, retirement would need to be delayed by about
four years to maintain benefits. If increased longevity were accompanied by
increased health during the foregone retirement years, then an increased workspan
might also be an optimal solution. Nevertheless, it would be problematic for those
whose health does not permit a longer working period.35
In sum, what this life cycle discussion suggests is that if Social Security were
initially set at optimal levels, only a relatively small portion of an adjustment to
reflect longevity should be in the form of a general benefit cut, and most of the
adjustment should take place in either higher taxes or higher retirement age.
Investing the Trust Fund in Higher Yielding Private Assets
One proposal intended to alleviate the Social Security problem is to invest funds
in higher yielding assets. Although most often associated with the development of
individual accounts, other proposals have suggested that such investments be made
by the trust fund itself instead. In either case, the results would be the same.
The key to whether this strategy provides any net national benefit rests on
whether it is debt financed. If the investments were funded by raising taxes or
lowering government spending, they will result in higher rates of capital
accumulation, which would increase the future size of the economy and increase
future resources. But if the investments were financed through the issuance of
government debt or the use of existing surpluses, the exercise amounts to a mere
shifting of assets into different portfolios. Since this shift results in no increase in
net national savings, there would be no increase in the total capital stock, and the
exercise would not create more resources for the nation as a whole. As will be
shown in the simulation below, diverting funds out of non-marketable Treasury
bonds and into equities would decrease returns to other investments and raise the
government borrowing rate. Much of the improvement in the system’s finances
would be offset by higher interest payments in the overall government from the debt
issued to finance the trust fund’s investments. Moreover, increases in the cost of
government debt would further increase the budget deficit. To the extent that the
system’s equities earn a higher rate of return than the government must pay on its
additional debt, the government’s overall finances would have improved at the
expense of a burden placed on anyone who holds private equities, including the
retired.36
35 One solution would be to shift more workers with poor health near normal retirement age
into the disability program. Another solution would be to increase the normal retirement
age, continue to allow early retirement with a reduced benefit on average, but provide
subsidies to permit maintaining a minimum benefit so that these individuals are not thrust
into poverty.
36 An extensive literature describes the presence of what economists call an equity premium
in financial markets. That is, the spread between the returns on equities and the returns on
(continued...)

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CRS-23
Assuming the fund remained a defined benefit plan, any risk of lower return
would also need to be made up, presumably by higher taxes. Estimates that find that
investment in equities improves trust fund balances are based on expected returns.
The variance of financial markets implies that in reality returns on assets could be
higher or lower than their expected return. For example, one study found that if
equity markets continued to perform as they have historically, there is a greater than
25% chance that the value of a trust fund invested in equities would be lower after
10 years than if it were invested in government bonds, as it is now. Over longer
periods of time, however, the probability diminishes: after 75 years there is a less
than 1% chance that the equity-invested trust fund would have a lower value.37
Numerical Simulation. A simulation will illustrate how investment by the
trust fund affects financial markets and the government budget. In a simple model
with only one type of debt and equity, the effects of shifting from holding debt to
equity is clear, and the gain in earnings will be divided into an offsetting rise in
government interest payments, and a fall in the return on equities. (This fall in the
return on equities also reduces the return on trust fund assets, although this is a
second order effect for a small change.) The same results would occur if the
government introduced individual accounts with debt financing, and the accounts
were invested in the stock market.
Moreover, one can estimate the basic magnitude of the effects (as discussed
briefly in the appendix, using 2000 asset shares), which depend on the willingness
of business to substitute debt and equity and the willingness of individuals to
substitute in their portfolios. (The degree of willingness is called an elasticity; it is
the percentage change in the ratio of assets divided by the percentage change in the
ratio of asset returns.) The smaller these elasticities are, the larger the effect on
government borrowing. For example, if both elasticities are 0.3 (and there is some
evidence to support small elasticities38), then 45% of equity earnings will show up
as an offsetting increased cost of borrowing, so the government as a whole gains only
about half of the amount projected. The public, in its role as a private investor, loses
the remaining 55%. The amount that shows up as higher interest costs falls as
elasticities rise, becoming 12% at elasticities of one.
36 (...continued)
bonds is larger than can be explained by models which attempt to weigh the tradeoff
between risk and return. If the equity premium does (still) exist and it is caused by a failure
to optimize, investment by the Social Security system (centrally or through individual
accounts) has the potential to lead to an improvement in social welfare. By contrast, if the
equity premium is the result of other factors (e.g., transaction costs) or mis-specification by
economists, then there will be no increase in social welfare. Even if social welfare was
increased, the reduction in the equity premium would still, by definition, lead to the same
relative reduction in rates of return.
37 Amy Harris, Noah Meyerson, and Joel Smith, “Social Insecurity? The Effects of Equity
Investments on Social Security Finance,” paper presented at National Tax Association
Symposium, Apr. 2001.
38 See Jane G. Gravelle, The Economic Effects of Taxing Capital Income (Cambridge MA:
MIT Press, 1994), p. 84 for a summary.

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CRS-24
This model is highly simplified, and one of the most important simplifications
is that it assumes only two assets. The model would be richer if assets were divided
into riskless government debt, risky private debt, and equities. The results for a
three-asset model are presented in Table 1. As before, the outcome depends on
assumptions about elasticities of substitution: the degree to which firms are willing
to substitute debt for equity in their demands for capital (F), the degree to which
individuals are willing to substitute debt for equity in their portfolios (g) , and the
degree to which individuals are willing to substitute government for private debt (S).
The limited evidence we have suggests that debt and equity are not perceived as close
substitutes and we set those elasticities relatively low; we assume, however, that
private and public debt is a much closer substitute and set those elasticities relatively
high.
Table 1: Effects on Earnings, Federal Interest Costs and Rates
of Return from Investing Trust Fund Assets in Equities,
Simulation
Values of F, g,
Increased
Increased
Percent Increase in Private Interest
and S
Earnings of
Federal
Rate (I ), Equity Return (E),
p
Trust Fund (or
Interest, as %
Government Interest Rate (I ) and
g
Individual
of Col. 2
Total Private Return (R)
Accounts)
(% of GDP)
Ip
E
Ig
R
0.3, 0.5, 2.0
0.2136
59.0
-5
*
56
-1.1
0.6, 0.5, 2.0
0.2150
55.0
-7
*
53
-1.1
0.3, 0.8, 2.0
0.2155
59.0
-5
*
56
-1.1
0.3, 0.5, 1.5
0.2136
89.0
-5
*
85
-0.3
0.3, 0.5, 2.5
0.2136
43.0
-5
*
41
-1.5
0.3, 0.5, 1.01
0.2135
163.0
-5
*
156
1.8
Source: Author’s Calculations.
Notes: F, g, and S refer respectively to the elasticity of substitution between debt and equity by firms,
the elasticity of substitution between equity and a composite of government and private debt in
individual portfolios and the substitution between private and government debt in individual portfolios.
Results based on 2000 asset shares. See appendix for model details.
* Less than 1%.
The results suggest that the substitutability between government and private
debt is an important factor in determining whether the benefit of higher returns with
a shift to equity primarily results in a decline in private returns or an increase in
government interest payments. In the simulation, the effect on the return to equities
themselves, is relatively small. With that elasticity set at 2.5, interest costs rise by
43% of the gain in the return to the trust fund, while the remaining 57% appears in
a decline in private returns, mostly through a decline in private interest rates. With

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CRS-25
an elasticity of 1.01, interest costs rise by more than the gain in trust fund earnings
and private returns rise.
This model is not definitive, but rather illustrative. It suggests that a potentially
significant amount of the gain in earnings would be offset by an increased burden on
taxpayers through higher interest rates. The results are the same whether assets are
accumulated centrally by the government or in individual accounts, although in the
latter case the investment returns would flow to account owners while the debt
payments would be borne by the government.
Individual Accounts
Perhaps the most sweeping change is a proposal that Social Security move away
from its collective, defined benefit format towards a system of defined-contribution
individual accounts. Were these accounts to completely replace the current system,
then the PAYGO system would be replaced by a fully funded system.
Other advocates have argued that individual accounts should augment rather
than replace the current system. One of the key differences among competing
individual accounts proposals concerns whether they would be “added on to” or
“carved out of” the current Social Security system’s tax and benefit structure. But
pursuing either of these approaches alone would not reduce the system’s unfunded
liabilities. Add-on accounts that use additional revenues (in the form of higher taxes,
general revenues, or voluntary contributions) to finance individual accounts but leave
the current benefit structure of the system intact would not alter the system’s future
financing imbalance. Likewise, proposals for carve-out accounts that divert revenues
from the payroll tax into individual accounts, and then lower benefits paid by the
system to offset the diverted revenues only reduce the system’s unfunded liabilities
to the limited extent that the benefit offset is greater than the diverted revenues, as
explained below. The unfunded liabilities can only be significantly reduced by
raising (“adding on”) taxes while holding benefits constant or cutting (“carving out”)
benefits while holding taxes constant.39
The objective of the following discussion of individual accounts is to analyze
the claimed merits of individual accounts, as well as explaining some of their
disadvantages. For analytical clarity, we consider the economic effects of a
hypothetical proposal to move completely from the current PAYGO system to a
fully-funded system of pure individual accounts. (The report’s conclusions apply to
specific proposals only where explicitly noted.) Once the costs and benefits of a pure
system have been identified, one can evaluate whether specific costs and benefits of
39 From an economic perspective, carve-out accounts would be unlikely to significantly
affect public or private saving. Add-on accounts, however, could lead to some increase in
national saving, and hence economic growth, but only if they did not supplant private
saving. This would be the case for individuals who under-save. For individuals who
planned their saving through optimization and were not liquidity constrained, add-on
accounts would strictly supplant private saving unless they were subsidized, in which case
they would instead reduce public saving.

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CRS-26
a mixed system are attributable to its individual accounts or its government-provided
PAYGO portion. A mixed system could address some of the market failures and
social goals that a pure system of individual accounts could not, but would also
reduce the benefits stemming from individual accounts. First, we begin by
discussing a claim commonly made for individual accounts: that rates of return are
larger than the return in the Social Security system and that these higher returns can
help achieve solvency.
Rate of Return Comparisons
There is no doubt that expected returns are higher on private assets than benefits
under the current system. Yields for current workers are expected to be small or even
negative because of the fall in the worker-retiree ratio upon the retirement of the baby
boomers. But even setting this demographic problem aside, and considering a
sustainable steady state, if the economy is growing at a real rate of 2% per year, a
dollar paid into a PAYGO system over, say a 25-year period, would permit a benefit
payment of $1.64. A dollar invested in an individual account that yielded an
expected 8% return would be expected to permit a benefit payment of $6.85. Such
is the power of compound interest.
There are several important problems with this argument. The one noted in the
previous simulation holds for individual accounts as well: without an increase in the
capital stock, there can be no net gain to society. Gains in individual accounts will
be offset by losses to other investors and to the rest of the government budget. By
our calculations, it is certainly possible for half or more of the apparent gain from
investing in equities to appear as an added interest cost in the general budget. While
an individual account may appear to outperform Social Security, society as a whole
(including individual account holders) cannot escape the unfunded liabilities of the
current system.
There are other reasons that Social Security cannot earn a market rate of return.
First, over one-third of contributions finance benefits for the disabled, survivors, and
dependents. Contributions also redistribute income to lower income recipients.
Second, individual accounts are likely to have higher administrative costs than Social
Security. Finally, the risky returns offered by individual accounts cannot be
meaningfully compared to the safer returns offered by Social Security since people
willingly accept lower returns to avoid risks.
The economy-wide benefit to individual accounts would not come from the rate
of the return that they earned. It would come from the stronger link between benefits
and contributions that should reduce or eliminate the distortions arising from social
insurance, such as effects on labor supply and savings. These distortions may not be
completely eliminated as long as there are mandatory components to the system and
some individuals save more than they would otherwise prefer. But in general they
should reduce distortions in private decisions to work and save.
Transition Costs. Furthermore, a reform plan based on individual assets will
have to deal with the cost of paying off currently accrued obligations and making the
transition to a funded system. This effect is far from trivial. Suppose all
contributions were immediately shifted into individual accounts but the system was

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CRS-27
committed to make no one who had already participated in the system worse off.
Existing retirees would still have to receive benefits, and working individuals would
have to pay close to the existing 12.4% payroll tax, as well as set aside their new
contributions, to finance those benefits. These payroll tax dollars would earn no
return, even of principal, for their contributors.
What if a mixed system were introduced that diverted some of the payroll tax,
say 2%, into individual accounts and used the rest to pay current benefits? Would
this allow the future funding crisis to be diverted without tax increases or benefit
reductions? To make this evaluation more concrete, we analyze the budgetary effects
of the proposals of the President’s Commission to Strengthen Social Security, based
on the official estimates of the Social Security Administration (SSA) actuaries. The
estimates make it clear that introducing 2% individual accounts without introducing
a new stream of revenue to finance them would not prevent a funding crisis.40
The President’s Commission on Social Security proposed three such plans. In
Option 1, workers under 55 could elect to deposit 2% of their OASDI taxable
earnings in an individual account, with an offsetting reduction in benefits based on
diverted amounts compounded at a real rate of return 3.5%. It is the only option that
relies solely on individual accounts. In the second, the amounts diverted were 4%,
up to $1,000 per year, of taxable earnings with benefits offset by compounding at a
real rate of return of 2%. This plan also included a benefit cut: to slow the growth
of benefits by indexing to prices rather than wages. Option 3 allowed the diversion
of 2.5% of earnings not to exceed $1,000 plus a required additional 1% of taxable
earnings for which a refundable tax credit would be received. The diverted amounts
would reduce benefits, compounded at a real rate of return of 2.5%. According to the
trustees, Options 2 and 3 lead to a significant long-term improvement (but short-term
deterioration) in the system’s finances, while Option 1 does not.41 None of the
reforms achieve solvency according to this report’s definition, however.
Figure 3 illustrates the effect of introducing individual accounts on the income
and costs of the Social Security system as a percentage of taxable payroll.42 The
estimates are based on the introduction of individual accounts under the Option 1
plan of the President’s Commission on Strengthening Social Security. Option 1
makes the effects of individual accounts clearest because it is the only option that
40 See also Peter Diamond and Peter Orszag, “Reducing Benefits and Subsidizing Individual
Accounts: An Analysis of the Plans Proposed by the President’s Commission to Strengthen
Social Security,” Center for Budget and Policy Priorities and the Century Foundation, June
18, 2002.
41 For the sake of brevity, many of the details of the commission’s proposals are omitted
here. For a detailed description of the commission and its proposals, see CRS Report
RS21095, Social Security: Report of the President’s Commission to Strengthen Social
Security, by Dawn Nuschler.
42 This graph does not illustrate the overall income and cost rates under a system of
individual accounts, but rather the change in income and cost rates caused by the
introduction of individual accounts. Thus, the future financing crisis is not averted if the
proposals generate additional revenues. It is only averted if the proposals generate enough
additional revenues to cover the entire financing gap.

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CRS-28
does not include benefit cuts. Roughly 40 years after the introduction of individual
accounts, when enough retirees had spent their entire career making contributions,
the accounts would indeed allow a larger reduction in Social Security benefits than
the revenue lost from a 2% marginal payroll tax cut.43 Over time, the savings to the
government would get larger and larger and eventually become quite significant.
Unfortunately, for the first 40 years after the introduction of individual accounts, the
accounts would generate less revenue than was being diverted from beneficiaries.
Figure 3: The Effect on Social Security’s Finances of
Introducing 2% Individual Accounts
(2004-2074, as a % of Taxable Payroll)
0.03
0.025
0.02
0.015
0.01
Taxable Payroll
0.005
% of
0
2004 2014 2024 2034 2044 2054 2064 2074
Year
Reduction in Income Rate
Reduction in Cost Rate
Source: Chief Actuaries of Social Security Administration, Memorandum to President’s
Commission to Strengthen Social Security, December 2001, p. 53.
Notes: Estimates based on Commission’s Option 1 reform plan with 66.7% participation
rate. It assumes accounts are introduced in 2004.
Thus, individual accounts would exacerbate the financing problems of the
Social Security system for roughly 40 years, but improve the system’s finances from
that point on. Whether this is desirable can only be determined by judging their
effect on the economy and government as a whole. And such accounts improve the
government’s overall finances and national saving only if the revenue shortfalls
caused by them in the first 40 years of their existence are financed through tax
increases or benefit reductions. In this case, the improvement in the government’s
43 This graph does not illustrate the revenue generated to the individuals who own the
individual accounts. It illustrates the reduction in benefits that the government is obligated
to pay because Social Security benefits are offset by an amount equal to the diverted payroll
tax compounded at a 3.5% real rate per year.

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CRS-29
finances could be calculated by compounding the rising line in Figure 3 (reduction
in cost rate). By contrast, Figure 4 illustrates the effects the accounts have on the
unified budget balance if the accounts are debt financed (i.e., introduced without an
accompanying source of financing). As explained in the introduction, the effect on
the unified budget balance is the most meaningful measure because it is the only one
that clearly identifies the cost of reform to the government as a whole. It may
surprise some readers to see that individual accounts, if debt financed, still generate
less revenue than the current system for the entire 75-year projection window. In
other words, debt-financed individual accounts worsen Social Security’s financing
crisis for the next 75 years.
Figure 4: The Effect on the Unified Budget Deficit of Debt
Financing 2% Individual Accounts
(2004-2074, as a % of GDP)
0
-0.005
-0.01
% of GDP
-0.015
-0.022004 2014 2024 2034 2044 2054 2064 2074
Year
66.7% Participation
100% Participation Rate
Source: Chief Actuaries of Social Security Administration, Memorandum to President’s
Commission to Strengthen Social Security, December 2001, pp. 53-54.
Notes: Estimates based on Commission’s Option 1 reform plan with 66.7% and 100%
participation rate. It assumes accounts are introduced in 2004.
Since the private assets in individual accounts are growing through the
accumulation of interest, these results may seem puzzling. Although the assets in
individual accounts are growing through the accumulation of interest, the debt issued
by the government to finance the accounts is also growing because of interest
accumulation. The individual accounts offset government benefits at a higher rate
of return than the interest payments on government debt, so eventually (outside the
75-year window) the individual accounts save the government money. But because
so much debt must be issued immediately, it takes more than 75 years before the
accounts pay for themselves. In fact, the actuaries of the SSA make two sets of
assumptions, both of which are illustrated in Figure 4. Since the accounts are

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CRS-30
voluntary, they estimated the costs under the assumptions (1) that 66.7% of eligible
individuals elect to participate, and (2) that 100% elect to participate. Comparing the
results under the two assumptions leads to a surprising result: the best way to limit
the costliness of debt-financed individual accounts is to reduce the participation rate.
The President’s Commission on Social Security made it clear that Option 1
would not avert a future financing crisis. For that reason, it also proposed two
further options that coupled the introduction of individual accounts with benefit
reductions. These two options, it asserted, would make Social Security solvent. In
both cases, the actuaries of the SSA believe that a 66.7% participation rate is most
likely, and the figures below are based on this assumption. The reforms do not make
the system solvent, however, if solvency is defined as the avoidance of cash deficits
throughout the 75-year forecast window; both proposals would greatly reduce the size
of the deficits in the second half of the projection window, however. Under Option
2, the system would generate cash deficits from 2010 to 2059. Under Option 3, it
would generate cash deficits from 2014 to 2072. In other words, additional
unidentified funding would need to be found to pay benefits promised under reform,
and this funding would ultimately come from further tax increases or reductions in
benefits or other government spending. However, these options do achieve solvency
if solvency is defined as achieving a cash surplus at the end of the forecast window.
This means that — unlike reform proposals that achieve 75-year trust fund balance
— they do not result in renewed crisis in 76 years.
By examining Figures 5 and 6, which illustrate the effect these options would
have on the unified budget balance, one can see that if the individual accounts are
debt financed, only the benefit reductions are responsible for the improvement in the
system’s finances.44 Indeed, a much larger improvement in the system’s finances is
possible if the individual accounts were excluded from Option 2 and 3 and only
benefit reductions were made (assuming the proceeds were saved). In other words,
the system’s finances could be improved to the same degree with smaller benefit
reductions than recommended in Option 2 and 3 if individual accounts were not
implemented.
44 Although the benefit reductions in Options 2 and 3 grow significantly over time, for the
first half of the projection window they would generate insufficient budgetary savings to
finance the individual accounts. For that reason, the creation of individual accounts would
result in an increasing debt for roughly the first half of the projection period unless taxes
were increased or other government spending were reduced.

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CRS-31
Figure 5: The Effect on the Budget
Figure 6: The Effect on the Budget
Balance of Debt Financing Option 2
Balance of Debt Financing Option 3
0.05
0.04
0.04
0.03
0.03
0.02
GDP 0.02
GDP
0.01
% of 0.01
% of
0
0
-0.01
-0.01
2004 2014 2024 2034 2044 2054 2064 2074
2004 2014 2024 2034 2044 2054 2064 2074
Year
Year
Benefit Cuts Only
Benefit Cuts Only
Benefit Cuts and Individual Accounts
Benefit Cuts and Individual Accounts
Source: Chief Actuaries of Social Security Administration, Memorandum to President’s
Commission to Strengthen Social Security, December 2001, pp. 57-58.
Notes: Estimates based on Commission’s Option 2 and Option 3 reform plan with 66.7%
participation rate and contribution rates equal to 2.39% and 1.97% of taxable earnings,
respectively. It assumes accounts are introduced in 2004.
Throughout this discussion, the report has focused on the effect of individual
accounts on the government’s finances. This may seem at odds with many other
evaluations of individual accounts which center on whether there are gains to the
worker. But the effect on the government’s finances is quite separate from the effect
on the worker. Government finances are affected because the benefits the
government must pay are reduced by the presence of individual accounts (e.g., in
Option 1, benefits are reduced by the amount of tax redirected to the account
compounded at a real rate of 3.5%). The potential gain to the individual comes from
the fact that the accounts are expected to be worth more than the amount the
individual has lost in reduced benefits (e.g., under the assumptions of the SSA
actuaries, the accounts would earn a real rate of return of 4.6% whereas benefits
would be reduced by 3.5% in Option 1).45 Debt financed accounts would only result
in an (eventual) cash-flow improvement in government finances if the compounding
factor used in the benefit offset is greater than the interest rate on government debt.
This is not the case in Option 2 or Option 3, which call for offsets with real interest
compounding factors of 2.0% and 2.5%, respectively, compared to a 3% rate of
return on U.S. Treasuries.
The reason this report focuses on the effect on government finances is that the
system’s crisis centers on the fact that the government does not have enough money
to pay promised benefits. In preventing that crisis, estimating the gain to individuals
45 Note that the SSA estimates do not take into account the negative effects on rates of return
that portfolio shifts may cause, as suggested in the numerical simulation above. Thus,
individual accounts may have a lower return than the SSA estimates suggest for any given
portfolio.

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is largely irrelevant. Individual accounts could earn rates of return of 100% a year,
but if they did not offset government-provided benefits, then the funding shortfall
would be the same, and the same unidentified financial sacrifice would need to be
made in the form of higher taxes or lower benefits. Furthermore, even if a reform
proposal reduced the system’s unfunded liabilities, if it did not eliminate them, then
further unspecified sacrifices would have to be made at some point. Since those
unspecified sacrifices would need to come from the same workers possessing the
individual accounts, calculating the rate of return on the accounts gives only a partial
picture of the proposal’s overall effect on the individual.
Social Security’s Social Functions. As discussed above, only 62% of the
current system’s income is paid out to retired workers. The other 38% is paid to
disabled workers (13%), survivors (19%), and dependents (6%). These payments for
“social functions” directly lower the “rate of return” available to healthy single
retired workers. One, therefore, should make sure that, in comparisons, these social
functions are being included in any comparisons of the return on social security and
individual accounts. For example, if one contracted to invest and purchase an old age
annuity, one would not be covered for disability or insurance payments for early
death; the purchase of such insurance would use some of the investment that could
grow in the annuity.
In addition, the “rate of return” available to wealthier retirees is lowered further
because of the system’s progressive benefit formula. The degree of this
redistribution is not certain, because of offsetting factors. Higher income individuals
tend to have larger ratios of retirement years to working years, largely because they
live longer. They also tend to enter the workforce later because of more extensive
schooling. Moreover, the distributional effect depends on whether one examines
families or individuals. Higher income men who marry wives who do not work
outside the home (a typical event in the past) receive benefits for their wives that are
proportional to their own benefit levels, and if one includes these benefits, high
income families have a higher return.
Another regressive feature of the current Social Security system is the tax
treatment of benefits and payroll contributions. If Social Security is thought of as a
retirement plan, contributions are (like other retirement plans) subsidized through the
tax system compared to other investments. There is a subsidy because contributions
made by employers are not subject to individual income tax at the time of
contribution and because “earnings” (benefits in excess of contributions) are taxed
only when received, and then taxed only partially. Social Security benefits are taxed
differently from pensions, however. A fraction of Social Security benefits is taxed
when income exceeds certain levels, with individuals with relatively high incomes
paying tax on 85% of benefits, low income individuals paying no tax, and some
individuals falling in between. Currently about two-thirds of all individuals do not
pay a tax but the number covered will grow absent legislative change because the
exclusions and phase-outs are not indexed. Pensions are taxed in a way that
explicitly permits previously taxed benefits to be excluded (and many pension
systems allow full exclusion of contributions from the income tax base).
Even though there are no aggregate assets in a PAYGO transfer system, there
is a return from the perspective of the individual since benefits typically exceed

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contributions.46 These tax benefits favor higher income individuals, and the subsidy
per dollar of payroll tax is more pronounced, other things equal, the higher the
individual tax rate, the longer the holding period and the higher the rate of return.
Benefits are positive at any reasonable rate of return, and are also larger in absolute
value for higher income individuals because they have larger contributions. Table
2 shows the ratio of end-of-period value from an investment receiving Social
Security’s tax treatment compared to an investment subject to a normal tax for a
variety of returns (including holding periods), depending on whether benefits are
taxed. The current system offsets these effects through both direct redistribution and
exclusions from benefit taxation, the latter of which favors middle income
individuals but not the poor, whose ratio is one (i.e. who would pay no income tax
in any case because of the income tax system’s regular exclusions).
Table 2: Percentage Increase in Benefit Due to Social Security’s
Tax Treatment Relative to Taxable Private Savings
Percentage Increase in Benefit for:
Income Tax
Asset Held for 35 Years
Asset Held for 20 Years
Rate
0%
5%
10%
0%
5%
10%
Yield
Yield
Yield
Yield
Yield
Yield
15%

No Benefit
8.8
39.9
76.0
8.8
25.6
43.2
Taxa
85%
-5.1
22.2
53.5
-5.1
9.6
25.0
Taxedb
25%

No Benefit
16.7
77.4
160.8
16.7
48.2
84.8
Taxa
85%
-8.2
39.7
105.4
-8.2
16.7
45.5
Taxedb
Source: Author’s calculations.
Note: Calculated as [0.5/(1-t) + 0.5][1-0.85at]{(1+r)/[1+r(1-t)]}T - 1 where t is the tax rate, r is the
yield, T is the holding period and a is equal to zero with no benefit tax and one if 85% of benefit is
taxed.
a. Assumes no part of Social Security benefits are taxed.
b. Assumes 85% of Social Security benefits are taxed.
46 As explained above, the rate of return on contributions to a PAYGO system would
average the economy’s growth rate in the steady state.

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A pure system of individual accounts would, therefore, tend to favor higher
income individuals if the current Social Security system’s tax treatment were applied
to those accounts. The relative subsidy to higher income individuals would increase
in the post-transition period as rates of return rise and the benefit exclusions are
eroded through inflation. This tax subsidy differs from that of IRAs, which have
fixed dollar rather than percentage-of-wage limits (constraining the benefit for high
income individuals); the treatment is more like that provided for private pensions.
One could offset that effect by withdrawing favorable tax treatment (taxing employer
contributions and taxing account earnings as accrued) or by introducing offsetting
subsidies, such as higher contribution levels or government matching contributions
for low income individuals.
When all of these factors are taken into account, the magnitude of the
distributional effects of the current system are not entirely clear.47 Nevertheless,
these observations suggest that individual accounts would place lower income
individuals at a disadvantage compared to the current system because they would lose
the explicit redistribution in the current system. It is also possible that they would
place low income individuals at a further disadvantage if their tax treatment were
similar to the current system, unless the accounts were subsidized by earnings. At
the same time, because the poor do not live as long, individual accounts would
maintain one of the redistributional disadvantages of the current system if
beneficiaries were forced to annuitize (for the reasons discussed below).
Some proponents of the current system base their opposition to individual
accounts on the fact that these social functions could not be incorporated into
individual accounts — “ownership” of assets is incompatible with horizontal and
vertical redistribution. While that is true, these social functions could be carried out
through new government programs that were financed through general revenues.48
What should be realized is that a comparison between the rate of return offered under
the current system, which fulfills several social functions in addition to “paying
back” workers’ “investments” (payroll taxes), and the rate of return under an
individual account system that does not finance such social functions is invalid.
Stated differently, dropping Social Security’s social functions would be one way to
reduce its unfunded liabilities, but the option is not predicated on moving to a system
of individual accounts.
Administrative Costs. Another factor reducing the rate of return that could
be achieved by a system of individual accounts is the administrative costs that nearly
47 See Karen Smith, Eric Toder, and Howard Iams, “Lifetime Distributional Effects of
Social Security Retirement Benefits,” presented at the third Annual Joint Conference for the
Retirement Research Consortium, “Making Hard Choices About Retirement,” May 17-18,
2001, Washington, DC., who find that the current system favors the lowest income group
and projects redistribution to increase in the future under current policy. However, their
paper does not consider the distributional effects of tax treatment.
48 Survivor and disability benefits could be partially incorporated in a system of individual
accounts through bequests and annuities. Maintaining the level of benefits available under
the current system would require government subsidization, however. For example,
personal accounts could not replace current survivor benefits when death comes before
retirement age.

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all analysts agree would be higher than under the current system. Administering the
system would be significantly more complex than the current system — individual
account balances would need to be tracked, funds would need to be transferred
between investment portfolios upon request, assets would need to be bought and
sold, and so on. There is both an explicit cost to consider, in terms of the fees
charged by the system’s administrator (or funds appropriated if the system were
administered by the government) and the implicit cost to employers and employees
in terms of more complicated paperwork and higher compliance costs. The more
choice that was allowed in the system, the higher the administrative costs would be.
The administrative costs of the current system equaled 1% of benefits paid in
2000. MIT economist Peter Diamond believes that the administrative costs of
individual accounts could run four to five times as high as the current Social Security
system.49 The Thrift Savings Plan’s (TSP) administrative costs are fairly low. As the
retirement system for the country’s largest employer, however, the centrally-
administered TSP may enjoy economies of scale that would be unavailable to private
sector firms if individual accounts were administered competitively. The TSP also
offers relatively little investor choice (participants choose among five passive index
funds). Thus, administrative costs could be higher for private firms than the TSP,
and this additional cost would directly reduce the benefits paid to retirees.
Can Individual Accounts Fulfill the Objectives of Social
Insurance?

As explained above, the economic rationale for Social Security rests in part on
the presence of adverse selection, moral hazard, incomplete generational insurance
markets, and non-optimization in the market for retirement planning. This section
explores the restrictions that would need to be placed on individual accounts to
correct for these factors. Without these restrictions, there would be no economic
advantage to the government provision of individual accounts and retirement choices
could be better left to the market. In the latter case, the government could pay off the
outstanding obligations of the existing system and leave individuals on their own.
Restrictions on Choice. Many of the arguments for individual accounts and
issues in their design revolve around how much choice individuals should have over
their individual accounts. Many see an expansion of choice as a compelling moral
argument in favor of individual accounts, compared to what they judge to be the
paternalistic nature of Social Security. They argue that individuals should be able to
choose how to deal with their own contributions: whether to participate, what to
invest in, and whether to annuitize or withdraw their assets as they desire.
On the other hand, if the purpose of Social Security is to correct for the adverse
selection, moral hazard, and non-optimization, then these restrictions on choice are
fundamental to the system. They include not only mandatory participation, but also
mandatory annuitization, restrictions on account withdrawals, and restrictions to
ensure that investments are prudent. The problem is not only the lack of actuarially
49 Peter Diamond, “Administrative Costs and Equilibrium Charges with Individual
Accounts,” working paper, Mar. 2000.

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fair annuities, but also the possibility of free riders who do not save and rely on
welfare to support them in old age. In a sense, choice is in fundamental conflict with
the basic economic reason for social insurance.
Partial restrictions, such as requiring individuals to save but not annuitize,
would also run afoul of both adverse selection and moral hazard issues. Adverse
selection would lead to smaller annuities for those who take them, and still allow
individuals to spend down their assets and then rely on welfare. As a simple
example, in an economy where half of the individuals live five years and half live 20
years after retirement (assume all individuals know their own life span), an average
monthly actuarially fair mandatory annuity would pay $970 per $100,000 of assets.
If annuities were made voluntary, the individuals with five-year life spans would not
purchase an annuity and the annuity would fall to $454 per $100,000 of assets. But
the need for mandatory annuities to avoid moral hazard and adverse selection also
means that it would be impossible to rely completely on individual accounts without
higher income individuals and women enjoying higher rates of return, on average,
than lower income individuals and men since the latter have shorter life spans.
Minimum Benefit Guarantees and Moral Hazard. To reproduce Social
Security’s role as a dependable, safe portion of an individual’s retirement portfolio
(or for others, the only significant source of retirement income), some individual
account advocates have suggested that the government should “guarantee” a
minimum benefit to retirees in case their accounts suffer investment losses. It can
be argued that such provisions, in effect, would defeat the purpose of individual
accounts, which is to allow individuals to shoulder more risk if they desire and offer
them more control over their retirement saving. Furthermore, many proponents of
individual accounts state that individual accounts could help fund the system’s
unfunded liabilities by achieving higher rates of return. The introduction of a
minimum benefit guarantee would make stand alone rate-of-return comparisons
misleading because these guarantees pass on the benefits of higher returns to the
retiree while leaving the government with the same liabilities to retirees as the current
system.
In fact, the guarantees would increase the potential liabilities of the current
system because of moral hazard. If individuals received all of the benefits of holding
high risk/return assets, but assumed few of the risks (because they were guaranteed
a minimum benefit), then they will shift their portfolio towards riskier assets than
they would otherwise desire. This choice increases the expected value of liabilities
to the government, since the presence of moral hazard makes it more likely that the
government will have to pay minimum guarantees.
The moral hazard problem can be reduced — but not eliminated — by placing
restrictions on investment decisions (e.g., limiting equities to, say, 60% of the
portfolio) for a portion of the portfolio, although this approach would run contrary
to the goal of promoting investment freedom. And the restrictions, by forcing
investors to hold lower risk/return assets, would reduce the expected return on
individual accounts and make their funding advantage over the current system less
favorable. Individual accounts that entirely eliminate risk without creating moral
hazard would have to be invested in much lower yielding assets than proponents
typically use in rate of return comparisons.

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Even without an explicit minimum guarantee, the government might feel
compelled to use other government programs, such as Supplemental Security Income,
Medicaid, or the food stamp program, to aid retirees whose life savings were lost.
Thus, the moral hazard problem may not be avoidable even in the absence of an
explicit guarantee because individuals may act in the belief that losses they suffer
would be implicitly guaranteed for political reasons. If avoiding moral hazard is the
motivation for individual accounts, however, why not maintain Social Security as a
PAYGO system of a smaller size (that covers only a minimum benefit) and leave
individuals free to make other investments if and when they choose? And while
higher spending on other programs is not a “cost” to the retirement program, it is still
a cost to the government that lowers the funding advantage of individual accounts.
Should Annuitization Be Mandatory? Aside from the volatility risk
associated with private investments, retirees would face another risk with individual
accounts that they do not face with the current Social Security system: the risk that
they will outlive their assets, known as “longevity risk.” Because one’s time of death
is uncertain, there is the risk that retirees will draw down their assets too quickly and
be left impoverished in their last days. This risk can be avoided through
annuitization, that is, through the exchange with a financial intermediary of one’s
assets for a promised stream of income. Unfortunately, annuities can currently be
purchased in private markets only on terms unfavorable to retirees — on average, the
expected value of the annuity benefit can be 15%-25% lower than life expectancy
would suggest.50 Since annuities would presumably be more desirable in the absence
of the current Social Security system, the purchase cost might go down as the market
grew, particularly if it reduced adverse selection. The only way to eliminate adverse
selection completely, however, would be for the government to make annuitization
mandatory. This would not prevent companies from attempting to “cherry pick”
unhealthy retirees from each other, however — either government provision or
regulation would be needed to prevent it.
The problem of moral hazard also argues for making annuitization mandatory.
Here again, the government would need to weigh the benefits of allowing individuals
greater freedom of decision-making (e.g., the ability to spend a large amount of
wealth suddenly in response to a personal calamity) against the social desire to
prevent people from becoming destitute because they ran down their assets too
quickly. Even if it were in a person’s best interest to buy an annuity, he or she may
not do so if given the choice. And again, if annuitization were not made mandatory,
the government might feel obliged to use other government resources to prevent
individuals who had run down their assets from becoming destitute.
Yet mandatory annuitization introduces an element of risk that is not present in
the current system: the problem of market fluctuations close to retirement
undermining the value of an individual account. If the market were to fall
dramatically before retirement, mandatory annuitization — particularly of accounts
invested in equities — would “lock in” that low market value, whereas individuals
might feel that they could regain some of that lost income as the market turned
50 Congressional Budget Office, Social Security Privatization and the Annuities Market, Feb.
1998.

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around if they were allowed to hold on to their portfolio into retirement. (Of course,
their misfortune could be compounded if markets continued to fall.)
Should Bequests Be Allowed? With proponents’ stress on the
“ownership” qualities of individual accounts, a logical next question is whether
individuals should be able to bequeath the balance of their account to their heirs upon
death. Doing so would raise some problems. Since closing the current system’s
unfunded liabilities is one of the major justifications proponents raise for switching
to a system of individual accounts, it is important to note that bequests would
increase the unfunded liabilities of the system. That is because they would represent
a new set of benefits that do not exist under the current system. The current system
does pay survivor benefits to spouses and dependents, and to the extent that bequests
partially replaced those benefits, they would not represent a new liability. But the
ability to transfer benefits to a broader circle of heirs upon death — particularly in
the case of a premature death — is not possible under the current system and would
represent a new liability.
In a pure system of individual accounts, allowing bequests would reduce
annuities. For example, returning to our case where half of the individuals live for
five years and half live for 20 years after retirement, guaranteeing a minimum 10-year
stream of payments (with the heir to receive the payments in the case of premature
death) would reduce the monthly annuity from $970 to $807 per $100,000 of assets.
However, giving individuals a choice between a larger annuity with no bequest and
a smaller annuity with a bequest would re-introduce the adverse selection problem,
because healthy individuals would likely choose the former and sick individuals
would choose the latter. This feature would lead to smaller annuities for the healthy
than in the absence of choice.

Risk: Collective Social Insurance vs. Individual Accounts. Individual
accounts differ from an aggregated system in the allocation of risk. There are
different types of risk that face individuals in planning for retirement: some are
unavoidable in any system, while some can be mitigated, or worsened, by collective
provision. Before examining specific types of risks, it is useful to ask how risk
affects individuals’ preparation for retirement, both privately and through Social
Security.
What Is the Role of Risk in Social Insurance? Generally in investment
markets, higher rates of return can be enjoyed only by taking on greater risk. The fact
that an aggregate social insurance system offers a relatively low return is not
necessarily an undesirable feature of the system; nor in a funded aggregate system
would a portfolio invested in low return/low risk securities (such as government
securities) necessarily be undesirable. For most individuals willing to set aside
adequate investments for retirement, Social Security is only one portion of their
investment portfolio and most individuals would like to have some part of their
retirement kept relatively safe. They are free to invest their private assets in more
risky ventures. Other individuals (who fail to optimize) do not set aside adequate

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retirement savings, for whatever reason. Because they are relying primarily on Social
Security in their old age, a strong case can be made that it should remain risk-free.51
How do the higher rates of return offered by individual accounts affect these two
types of individuals? For those individuals who save adequately, is the current
system keeping too much of their retirement income safe (and earning low returns)?
Or if given the choice in an individual account, would they place an equal proportion
of their overall portfolio in riskless assets? If that were the case, then the rate of
return on their individual account would be no higher than their overall portfolio is
at the present, after accounting for transition costs. For those individuals who do not
save for retirement outside of Social Security, should society allow them to expose
their individual accounts to greater risk (and return), knowing that if they are unlucky
they will have no other private source of income to fall back on and that it will fall
to government transfer programs financed by all taxpayers to provide some minimum
level of subsistence?
Investment Risk. A move away from the current PAYGO system towards
individual accounts or trust fund investments in private assets introduces a new type
of risk into Social Security: the risk of investment market volatility. The two
approaches could theoretically distribute market risk very differently, however.
Some market risks can be reduced relatively easily, for example through portfolio
diversification (although it is not clear that all individuals reduce these risks
optimally in reality). There are other market risks that are more difficult to pool,
however, such as risk across time.
As explained above, a dollar invested in private assets by the Social Security
system would have the same rate of return as a dollar invested in the same asset
through an individual account. Obviously, the same amount of risk is associated with
that investment in either case as well; losses associated with trust fund investments
would ultimately result in lower benefits or higher taxes. But there is a significant
difference in who bears the risk (and enjoys the profit) associated with any given
investment between the two systems. In a system of individual accounts, the entire
risk is placed on the individual who chose to make that investment. In a system with
a collectively invested “trust fund” and benefits only indirectly tied to the system’s
income, those risks can be spread both among the members of a generation (because
the system has “defined benefits” rather than “defined contributions”) and between
generations if the system is allowed to build up and draw down its assets over time.
Is the difference in risk-bearing between the two systems significant? Table 2
demonstrates that, if the stock market performs in the future as it has in the past, the
historical difference in outcomes would have been extremely large.52 Historically,
51 Note that when using the term risk free, we are speaking of avoiding investment risk;
demographic risks that are currently affecting the return to Social Security, such as increased
life span, would affect any retirement plan, whether private or public.
52 For more information on the results in Table 2 and results under alternative assumptions,
see CRS Report RL31324, Social Security Reform: The Effect of Economic Variability on
Individual Accounts and Their Annuities, by Geoffrey Kollmann, Dawn Nuschler, and
(continued...)

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the stock market has frequently gone through long phases of doing extremely well
(e.g., the 1990s) or extremely poorly (e.g., the 1970s), and this would be fully
reflected in the value of accounts accrued during those times. The first column of the
table demonstrates that if a system of individual accounts had been in place between
1927 and 2001, the value of the account invested entirely in the Standard and Poor’s
composite stock index would have varied from 22.8% (for a retiree in 1974) to 97.8%
(for a retiree in 1999) of the value of Social Security benefits, depending solely upon
the year in which the worker retired.53 Of course, individuals could reduce risk by
choosing a portfolio that mixed equities and bonds, but this would also reduce the
rate of return they could enjoy, as demonstrated in the second column. In fact, even
though risk would be reduced, more than 25% of the time the mixed portfolios of
stocks and bonds would have underperformed the worst performing year for the
portfolio of 100% equities.54 This means that even if individual accounts matched
the benefits paid by Social Security on average, absent government guarantee
subsidies, some beneficiaries would do much better than under Social Security while
others would do much worse.
Table 3: The Historical Performance of Hypothetical
Individual Accounts
Statistical Measure
Percentage of Social Security benefit
replaced for account invested in:
100% Equities
60% Equities,
40% Bonds
Mean (Average)
49.1%
26.2%
Minimum
22.8
15.3
25th Percentile
41.0
20.6
50th Percentile
47.9
26.7
75th Percentile
55.6
31.3
Maximum
97.8
40.7
Standard Deviation
15.7
6.1
Source: CRS Report RL31324, Tables 4 and 12.
52 (...continued)
Patrick Purcell.
53 The table is based on workers who have typical work patterns that produce the Social
Security benefit of someone who always earned an average wage and who contribute 2%
of pay for 41 years to individual accounts. In the first column, it is assumed that the
accounts earn the same historical rate of return as the S&P 500 minus a 1% administrative
fee; in the second column, it is assumed that 60% of the portfolio earns the same rate of
return as the S&P 500 and 40% earns the historical return on long-term U.S. government
bonds. The table assumes that the amount accumulated in the account is converted to a
fixed life annuity based on the prevailing rate of interest on long-term U.S. bonds. It should
be noted that volatility is higher if accounts are accumulated over shorter careers.
54 Similar results are confirmed by Gary Burtless, Social Security Privatization and
Financial Market Risk, Center on Social and Economic Dynamics, Working Paper 10, Feb.
2000.

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Demographic Risk. Another type of risk that is already present in the current
system is demographic risk, which cannot be avoided since mortality will always be
unknown. In Social Security or individual accounts with annuitization, demographic
risk comes from dying before one has received the value of one’s contributions. In
individual accounts without annuitization, the demographic risk comes from
outliving one’s assets. (Demographic risk could be avoided through annuitization
with bequests, but would result in smaller annuity payments.)
A demographic risk that is part of the cause for the current insolvency of the
system is the increase in life spans that is not anticipated in advance, and will leave
individuals with smaller retirement accumulations and potentially smaller retirement
incomes. Just as an individual facing such an increase must either save more or
accept a smaller retirement income (or delay retirement), a social insurance system
must increase taxes or reduce benefits. Thus potential variability in taxes or benefits
(which is sometimes characterized as part of the “political risk”) is not a risk that can
be avoided with an individual account system. And the large increase in taxes or
decrease in benefits needed to restore the current system to solvency is still present
in any shift to individual accounts. A pure system of individual accounts would still
have to alter contribution levels or benefits in the face of increasing life spans.
Another type of risk, changes in fertility, would not affect private accounts or a fully-
funded social insurance system, but such changes might still affect private retirement
incomes by altering the availability of private intergenerational transfers. Thus, these
risks would not be avoided, but rather would be addressed in different ways.
Political Risk. A final type of risk that many argue would be diminished by
individual accounts is political risk. Because there is no “ownership” of benefits in
the current system, retirees and workers planning for retirement are always at the
mercy of legislative change. Individual accounts would remove assets, income, and
benefit flows from the government budget and create individual “ownership” of
retirement benefits that would be less subject to manipulation through legislative
changes. As a result, it might be more difficult to use surpluses in the retirement
system to finance other government spending. It is important, however, to
distinguish this political risk from actual risks such as demographic or investment
risks discussed above. Only political risk, which involves shifting benefits and costs
among individuals, is zero-sum for society as a whole.
Political uncertainty is a particularly compelling issue when one considers that
the current system is unsustainable because of anticipated life span and fertility
changes. At some point, either workers will see taxes raised or retirees will see
benefits reduced from their current level. Since much of the political risk revolves
around future uncertainty, the transition to a fully funded, pure individual account
system would also have the benefit of forcing the question of who will bear the costs
of reforming the system to be answered immediately. In other words, a pure system
of individual accounts would bring the future funding crisis forward to the present
by making implicit liabilities explicit. Then individuals would no longer be left
uncertain of how they will be affected by reform in the future arising from
information already available today. This argument does not apply to most current
proposals, however, because the proposals do not call for pure individual account
systems. They call for mixed systems, and many of these mixed systems do not
increase the system’s prefunding. Thus, proposals that do not address the issue of the

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system’s current unfunded liabilities do not really reduce political risk, even if they
have created individual ownership, because they make further, undefined reform in
the future necessary.
The risk of credit distortion is another potential political risk present if a
centralized trust fund were to make private investments, but avoidable in a system
of individual accounts. If markets allocate capital among different types of
investments efficiently on their own, then, from an economic perspective, any move
towards investment by the government retirement system should preserve that market
allocation or it would lower economic efficiency. A system of individual accounts
would largely preserve the market allocation of capital because private individuals
would continue to choose where they wished to invest their money. By contrast, if
the government were to make private investments centrally through the trust fund,
there would be the possibility that investments would be made on the basis of
political criteria rather than the profit motive. This potential risk seems relatively
easy to avoid, however, by stipulating that the trust fund be invested on the basis of
a passive index, similarly to some mutual funds and the TSP.
Of course, political risks are present in any sort of government intervention into
the provision of a fully-funded retirement system. For example, ideally the
government may be able to offer individual account holders actuarially fair annuities
on more favorable terms than the private sector. But were the government to do so,
there also would be the possibility that it would offer actuarially unfair annuities
instead for political reasons (e.g., making annuities overly generous to win political
support among the elderly). Such an outcome could create new unfunded liabilities
that could undermine government finances in the long term. Similarly, in theory the
government could equitably spread the risks of a centrally-funded trust fund over
time, but it could also distort risk-spreading formulas in ways favorable to current
generations which store up problems for future generations.
Conclusion
The analysis in this report points to two major conclusions. First, it
reemphasizes the old saying: “There is no free lunch.” Someone has to pay to
address Social Security’s funding imbalance, and while the burden can be distributed
differentially across individuals and across generations, it cannot disappear.
Inaction continues uncertainty as to who will pay and when. Tax increases and
benefit cuts provide at least a general picture of who might bear the burden. Some
approaches, such as investing the trust fund (or individual account) savings in higher
yielding assets other than government bonds, have the appearance of being costless,
but the benefits to be gained from these higher yields appear as costs in other parts
of the economy: higher interest rates on government debt or lower returns on private
investment (which may include direct reductions in the returns to private securities
in the accounts or trust fund), and changes in risk. Analyses of such approaches need
to account for any declines in private returns to capital, and also address what taxes
are to be increased, or government services to be cut, to pay for the increased
government borrowing cost. None of the current proposals being discussed has
provided such detail. Of course, one way to avoid an increase in interest costs would

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be to increase national saving but, again, such saving would mostly likely only be
accomplished by some forced government saving plan, and the policies to
accomplish it would need to be spelled out to clarify who pays.
Trying to judge the merits of alternative approaches based on which approach
poses a smaller burden is not really meaningful: all plans face the same problem, that
income does not cover cost. The only difference between plans is who bears the
burden. Rather, they may be framed in terms of losses and gains in economic
efficiency. If one rules out options that spread the costs to other parts of the
economy, the choice between higher taxes and lower benefits primarily depends on
the optimal size of the Social Security system. The smaller the system, the less it is
able to alleviate the market failures it was designed to cure — moral hazard, adverse
selection, incomplete insurance markets, and failure of optimization. The larger the
system, the more it distorts labor and saving decisions. The form of tax increases or
benefit cuts can also have implications for economic behavior and distribution.
Besides economic efficiency, the decision depends on social goals and distributional
effects that may affect social welfare.
Funding the system can occur under either a centralized system or individual
accounts since it is national saving, not saving in the accounts, that matters. The
principal distinction between maintaining an aggregated system such as we have
currently versus a set of individual accounts involves efficiency gains, and not
differential rates of return. Many of the potential criticisms of individual accounts
are mirror images of the rationales for social insurance. If individual accounts are to
fulfill the objectives of social insurance, then they must be very much like an
aggregate system in that they must involve mandatory contributions, mandatory
annuitization, and requirements for prudent investment. But such requirements are
in direct contradiction with the notions of choice and of the complete elimination of
distortions induced by taxes; indeed, choice is itself in conflict with the rationale for
social insurance.
From this analysis, it follows that if individual accounts meet the minimum
requirements for the objectives of social insurance (that contributions and
annuitization are to be mandatory and investment choice restricted), there are still
two limits to individual accounts. First, they could not, by themselves, fulfill the
current system’s social objectives, which include redistribution and the provision of
benefits to survivors, dependents, and the disabled. They could reverse the
distributional objective of the current system, shifting income from the poor to the
rich on average because of the latter’s longer expected life span, and potentially
through the tax treatment of the accounts. This effect could be addressed by
subsidizing the poor and taxing the rich (e.g., government matching rates for low
income individuals), but that revision would move away from a pure individual
account system and its economic benefits. Second, they would introduce elements
of risk, including risk across cohorts reflecting variations in returns and in stock
market valuations. If the goal of reform were to move towards greater pre-funding,
an aggregate system could be more successful at spreading risk among and across
generations.
Nevertheless, it is important to also understand the advantages of individual
accounts. Individual accounts do maintain a connection between marginal

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contribution and marginal benefit that can reduce distortions in private work and
saving behavior (although the mandatory nature of the contributions may undermine
this gain to some extent). Individual accounts also eliminate political risk, at least
within the program itself, which makes the retirement plan itself less risky in some
ways. Finally, individual accounts may impose more budgetary discipline by
explicitly removing any Social Security surplus from government control, so that in
reality, they may be more likely to lead to an increase in national savings than would
be the case of the aggregate trust fund. But for this to occur, individual accounts
must be financed through tax increases or benefit cuts.
Many proposals actually include a mixture of individual accounts and some
smaller version of the current system. Such a mixed system might be used to address
some of the problems with pure individual accounts discussed above, such as their
tendency to redistribute from the poor to the rich and the problem of moral hazard.
Such a shift dilutes both the costs and benefits of individual accounts. In particular,
it reduces the return to investment and it leaves a significant portion of the system as
a PAYGO system. But it is the interaction between PAYGO financing and
demographic change that is responsible for the current system’s impending
insolvency. There is a fundamental tension between the objectives of social
insurance (to deal with adverse selection and failure of optimization as well as moral
hazard and risk spreading) and the merits of individual accounts (choice and
reduction of other behavioral distortions); any mixed system is giving up some of the
benefits of the first to attain the benefits of the second. Evaluating a plan necessarily
involves assessing those costs and benefits.
It is important to keep this trade-off in mind. For example, proponents of a
mixed plan may argue that their plan does not suffer from moral hazard or
undesirable redistribution; nevertheless, correcting these elements must reduce the
rate of return for most individuals, constrain the degree of choice, and limit reduction
in economic distortions that are the rationale for considering individual accounts in
the first place. Thus, mixed plans do not address these problems without a cost.

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CRS-45
Appendix: Portfolio Model
The portfolio model is based on a portfolio function for individuals, and a debt-
equity trade-off for firms. Individuals maximize, acting as price takers:
(1) P = (a{ [bB (1+1/S)+(1-b)D (1+1/S)](1/(1+1/S)) }(1+1/g) + (1-a)E (1+1/g) )(1/(1+1/g))
p
p
subject to rW = r B + r D + r E
b
p
d
e
p
where B is government bonds held by the public, D is corporate debt, and E is
p
p
corporate equities held by the public, W is a fixed amount of wealth, r is the average
return to wealth, r is the interest rate on government bonds, r is the interest rate on
b
d
corporate debt, and re is the return to corporate equity. S is the substitution elasticity
between bonds and debt, and g is the substitution elasticity between equities and the
composite of interest bearing assets. In the case of the simple two asset model, the
value of S is set to infinity and the initial interest rates are equated. However, for a
three asset model, the return on government bonds is lower than the return on private
bonds.
First order conditions with respect to B , D, and E lead to the following ratios
p
p
(2) B /D = [(1-b)/b] S (r /r )S
p
b
d
(3) D/E = (r /r )g [(1-a)/a] g (1-b)-[(g+1)S/(S+1)] { [(1+b)/b]S(r /r )(S+1)+1} [(g-S)/(S+1)]
p
d
e
b
d
Firms also choose sources of finance (debt versus equity) depending on their
cost of debt and equity:
(4) F = [8D (1-1/F)+(1-8)E (1-1/F)](1/(1-1/F))
Subject to C = r D +r E
d
e
First order conditions with respect to D and E yield:
(5) (D/E) = (r /r )-F [8/(1-8)] F
d
e
To complete the model we have the following constraints and identities:
Total equities are:
(6) E = E + E
g
p
where the p subscript refers to equities held by the public and the g subscript to
equities held by the Social Security trust fund. E is exogenously determined, and is
g
zero under current rules, but equal to the total assets in the trust fund in the new
equilibrium.
Total government bonds B equal:
(7) B = B +B
p
g

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where the p subscript refers to equities held by the public and the g subscript to
equities held by the Social Security trust fund. All are exogenously determined, with
Bg equal to the assets in the Social Security trust fund under current rules, but equal
to zero in the new equilibrium.
(8) K = D + E
The private capital stock, K, is fixed, and is the sum of debt and equity finance,
which are determined endogenously.
Since the private capital stock is fixed, so is the marginal product of capital:
(9) F’(K) K = r D + r E
d
e
Equations (2), (3), (5), (6), (8), and (9) are six equations in six unknowns: r , r ,
d
b
r , D, E and E.
e
p
For purposes of illustration, the model was calibrated for FY2000. Based on
data at that time, and norming output to 1, the private capital stock (K) was 3.35,
with 1/3 debt and 2/3 equity, the government debt held by the public was 0.34 and
assets held in the Social Security trust fund were 0.10. Real interest rates on private
debt, equity, and government debt were set at 0.048, 0.088 and 0.017 respectively.
For the two asset model, the model was differentiated and the interest rate set
to approximately 0.04, a weighted average of government and private bonds.

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