Thursday, September 16, 2010

Pay-as-you-go makes government grow, grow, grow

Over at The American
I conjecture on that the size and growth of government program is attributable in part to how those programs are financed. Compared to "pay-as-you-go" financed entitlement programs, which allow politicians to promise benefits today while leaving the paying part to future taxpayers, fully funded programs would provide better incentives to balance costs and benefits.


JG said...

As I noted in a recent National Review column on why Social Security reform has proved so difficult, shifting from a pay-as-you-go program to a funded system entails significant “transition costs,” ...

Milton Friedman disagreed...

"To see the phoniness of 'transition costs' (the supposed net cost of privatizing the current Social Security system), consider the following thought experiment: ..."

Here's the nub:

Social Security is underfunded by circa $15 trillion as per the Trustees because past participants have received that much more than they contributed to it. This means future participants must receive that much less than they put in, because in a paygo system benefits = taxes in total. It is arithmetic.

This $15 trillion is a sunk cost, because Ida May Fuller and Co. have already received that $15 trillion more than they contributed. Since it has already been paid, that cost cannot be avoided now. The only question still open is who is going to wind up getting the bill, and how it is going to be financed.

In the case of "privatization" plans, this cost has to be covered in some way that is made explicit -- cuttting benefits or raising taxes somehow to the tune of $15 trillion. When this is seen people yelp "painful transition cost".

But this shortfall is created not by the transition but by the status quo. It must cover the same $15 trillion in exactly the same way as any privatization proposal.

Yet defenders of the status quo have no plan whatsoever to cover this cost. The status quo offers no tax increase or benefit cut to cover the $15 trillion.

And because the status quo makes no provision to increase taxes/cut benefits by $15 trillion, the fact that it will do so is not seen. So this "cost" is seen only as a cost of transition to privatization.

However, a cost created by the status quo, which will be paid even if no transtion ever occurs, is not a transition cost.

Thus there is no transition cost -- and "transition cost" as an argument agaisnt privatization is bogus.

Andrew G. Biggs said...

Not to name drop, but I had the chance to argue this with Friedman back in 2002 or so. Basically we're saying different things: he's saying you can convert Social Security to what looks like a prefunded system without any transition costs. That's true -- just issue debt.

But this doesn't MAKE the system pre-funded in a broad economic or budgetary way. In a true prefunded system, national saving at a given time would increase by roughly the same amount as the program's obligations increased. In other words, if this year I accrued future benefit obligations with a present value of $X, then prefunding implies an increase in national saving and the capital stock of $X. Doing this would tend to increase wages and economic output down the road.

Under Friedman's plan there would be no increase in national saving, and thus in my view no broad pre-funding. The future economy would be the same as under current law.

Re the $15 trillion shortfall, that's different from transition costs. Let's say we made social security solvent by raising taxes or cutting benefits, thereby eliminating the $15 trillion shortfall. Even then, if we shifted from a paygo program to a pre-funded system there would be transition costs. Current participants would effectively pay more and future participants would get more.

In the end, I don't think there's any way around this. We may think it's worth it to pay the transition costs, since they bring commensurate transition benefits to future participants (higher benefits at lower cost). But without the costs you simply don't get the benefits.


Arne said...

While numbers of my fellow liberals seem to think we are not getting richer, I know it is not true. While some people are beset with financial regression, more are doing better.

I suggest that it is entirely appropriate that we think in terms of how we want to spend that extra - an incremental mindset. The trick is to not spend 110 percent of the increase. The increase in what we are spending on healthcare is smaller than the total increase in GDP, but it is an increasing portion of that increase (calculus rears its head).

We need a realistic discussion about whether that is the way we want to spend our increasing wealth. If it is, then we should decide how to pay for it. If it is not, we need to set clear expectations about what we can promise.

Arne said...

"means future participants must receive that much less than they put in, because in a paygo system benefits = taxes in total. It is arithmetic."

Not really. When the rapture comes or a comet hits, a lot of people who you include in your arithmetic will never draw any benefits and the unfunded obligation will simply disappear.