Friday, August 29, 2008

New paper: “Social Security increases poverty”

Following on our conversation from a week or so ago, here's a new paper published by the Independent Institute that argues that Social Security increases poverty. (Even I didn't go that far…) Here's some background below via the NCPA, followed by a quick comment from me:

Social Security is often touted as a crucial safety net that protects American retirees from abject poverty.  In reality, Social Security has made it harder for retirees to grow wealthier by reducing their ability to save and thus has contributed to poverty in old age, argues Texas A&M economist and Independent Institute Research Fellow Edgar K. Browning.

For those retiring in 2008:

  • Social Security returned an average of slightly less than three percent on retirees' contributions, adjusting for inflation.
  • Had they invested their contributions in a balanced portfolio (60 percent stocks, 40 percent bonds), those retirees would have earned, on average, 5.5 percent - a huge difference when compounded over a lifetime.
  • In fact, the annual retirement income provided by a 5.5 percent return is double that provided by the three percent return of Social Security; even more compelling, an investment in the stock market averages seven percent real return, which would mean an annual income of three times what Social Security provides.

Moreover, the yield from Social Security looks even worse when considering that savings fuel investment and economic growth, adds Browning.  It is likely that we would have fewer poor among the elderly had they been free to invest their taxes in private assets.  Once Social Security's rate of return drops to below two percent, it will only continue to aggravate poverty in the future.

Policymakers are left with the decision to cut benefits or double the tax rates.  Neither option is attractive, but the longer we wait, the harder it is to implement change and the more likely we will be forced to accept substantially higher taxes, concludes Browning.

Browning seems to be arguing almost fully through the equity premium, the idea that by investing in stocks one can get a higher return – and thus, a higher benefit – than a low-risk, low-return "investment" like Social Security. There's some truth in this: for a low earner without any other savings, Social Security constrains them to a retirement savings portfolio without any equity exposure. That said, the higher return on equities is compensation for increased risk, which the paper doesn't appear to account for. Moreover, Social Security's progressivity means that low earners receive higher average returns, which helps compensate for the lack of equity exposure. So I don't really buy the larger argument, but worth checking out in an case.


Arne said...

Does the writer's analysis include the payroll taxes going to Disability Insurance? I could not tell, but that would be bad analysis.

I think it is also bad analysis to look at historical returns without making some adjustment for risk. Comparing SS to "a balanced portfolio" is questionable.

Andrew G. Biggs said...

I don't know whether he uses the full payroll tax rate or just OASI (and even the OASI 10.6% rate is too much to use, since the survivors portion is funded out of this and that can't simply be covered by letting people pass on their accounts).

I also agree on the interest rate. You'd want to use an interest rate that matches the 'risk' of Social Security. Depending on different factors, this could be either higher or lower than the trust fund discount rate.

Paul Lawin said...

Andrew has already pointed out two problems with this approach (which is hardly original with Prof. Browning) – the full use of the risk premium, and the use of average IRRs when discussing low earners.

I’ve got three more issues:

He looks at the negative effect of past SS taxes on savings, but he ignores the offsetting positive effects of past SS benefits on savings. (My point in the earlier thread.)

He assumes that without SS, past consumption would have been lower and past investment higher. If so, what would have been the effect on past returns to capital? I expect they would have been lower because the capital market is subject to supply/demand forces. (Andrew may have a source for a discussion of this issue, I don’t.)

He talks about “poverty” in the present only. But any analysis that includes investments over time needs to consider time-based trade-offs. Even if all of his omissions are insignificant, he still would need to address the question of whether SS reduced poverty in the past by more than it increased it in the present.