Washington November 2005

Progressive Dementia

The president may not get his way on Social Security reform, but one element of the plan will rise again. It shouldn't

Progressive indexation is not well designed to address future uncertainties. It would improve Social Security's fiscal solvency most when real wages were increasing rapidly. But under those circumstances the system would in all likelihood remain fully solvent without interference. When real wages were stagnating, progressive indexation would do nothing to improve Social Security's condition. But those are precisely the circumstances under which the system would face the greatest danger of insolvency.

In short, progressive indexation is a mechanism that would "work" when we didn't need it and wouldn't work when we needed it most.

Granted, there is a middle ground where progressive indexation could in theory have some modest effect. But here we need to revisit the issue of individual accounts, because combining them with progressive indexation would almost certainly drain money out of the system, exacerbating the solvency problem or even undermining Social Security altogether.

Some background: The president has argued that individuals would be able to get a better return on their retirement accounts than the government does. On this he is simply wrong: no private firm can compete with the Social Security Administration in the efficiency with which it has administered its funds. In other countries that have privatized their social-welfare systems, benefits have fallen—in Britain, according to one estimate, by as much as 40 percent—as year after year transaction costs eat up what workers have put away.

Social Security does seem to give lower returns than private investment, for four reasons. First, it is safer. Second, there is a hidden tax in the system for middle- and upper-income workers: their benefits are reduced to help ensure that the poorest Americans do not retire in poverty. Third, most of the standard calculations of Social Security's rate of return do not take into account the value of survivors' and disability benefits. Because more than a third of those who currently collect benefits are not retired workers (among them nearly 12 million spouses and children of retired, disabled, or deceased workers, and 6 million disabled workers), ignoring these benefits significantly lowers estimates of returns. And fourth, some of the contributions of today's workers are used to finance the retirement of previous generations—this is the nature of a partial pay-as-you-go system.

Already Social Security is being portrayed as a bad deal, although it is not, particularly when one takes into account that no private investment can, for instance, insure one against inflation. (Only recently has the government provided inflation-protected securities, and the returns on Social Security contributions do not look unfavorable in comparison to the returns on these securities.) If it is a bad deal for some, that is not because it is inefficient but because it is redistributive. Under progressive indexation the benefits per dollar contribution of all but the poorest would be cut, thus—to follow the logic—making Social Security an even worse deal for all but the poorest Americans. One calculation has shown that by 2045 the rate of return for a worker earning $58,400 would be cut by more than 50 percent.

If progressive indexation and individual accounts both came to pass, middle- and upper-income Americans would look ahead at the likely consequences and vote with their feet. That is, they would divert as much money as possible out of Social Security and into their individual accounts. This might be heralded as a vote of confidence in the individual-account idea—and it would generate billions of dollars in commissions for managers of private assets. But it would erode, not enhance, the solvency of the Social Security system as a whole. Simply put, those who once contributed the most to the system would drop out to whatever extent they could.

Of course, a system of progressive indexation without individual accounts wouldn't have this outflow problem (though one can't imagine the administration's giving up private accounts). But even that arrangement would raise a serious question of equity.

Since the current system of wage indexation means that benefits increase with average wage levels, which normally increase far faster than prices, it allows workers to benefit from the productivity gains that usually drive wage increases. These productivity gains are usually not the result of anything individual workers do, but follow from innovation and investment.

A simple philosophical question: Should those who are fortunate enough to have high wages today, because productivity in general has increased, share some of their good fortune with workers of previous generations? The answer has fundamental implications for the nature of our society, particularly if wages increase rapidly. Assume, for instance, that real wages (taking inflation into account) increase by three percent annually, which means they double roughly every twenty years: the average wage of a forty-year-old worker will be approximately four times what an eighty-year-old earned back when he was forty. And under a system of individual accounts, or of price indexing, even if the eighty-year-old saved so avidly that his retirement income was the same as his average working income (which is seldom the case), he would have a quarter of the income of the forty-year-old worker. The current Social Security system goes a little way toward rectifying such inequalities. If our economy sees a three percent annual growth in real wages, our eighty-year-old retiree will have a share in the bounty: his Social Security payments will be four times as high as they would have been had the president's progressive-indexation plan been in place.

Under Bush's proposal there would be an enormous income gap across generations, on top of the already increasing income gaps that separate various groups in our society—the skilled and the unskilled, college graduates and high school dropouts. This gap would exist not because the aged failed to work hard while they worked, or even to save, but because they were born when they were born.

Those who advocate a switch to progressive indexation need to explain not only how it can possibly work, despite theory and evidence to the contrary, but also why the price of a more divided society is worth paying even if it does.

Joseph E. Stiglitz is a professor of economics at Columbia University and a winner of the Nobel Prize in economics.
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