Tuesday, December 21, 2010

CAP’s Social Security Hits and Misses

From AEI's Enterprise Blog

The Center for American Progress has released a Social Security reform plan authored by senior fellow Christian Weller. The plan, outlined in a paper titled "Building It Up, Not Tearing It Down: A Progressive Approach to Strengthening Social Security," is a solid and well-thought-out contribution to the Social Security reform debate. It is encouraging that while so many people sit on the sidelines and criticize without offering their own alternatives, others from both ends of the political spectrum are willing to put their ideas on the table.

CAP's plan includes a large number of modest benefit increases—many of which I could support—including stronger protections against poverty for low earners; increased benefits for survivors and the very old; streamlined divorcee benefits; and benefits for caregivers. The plan addresses solvency through a smaller number of larger changes, such as progressive benefit reductions for high earners (those in the top 30 percent of the lifetime earnings distribution, though lower earners could be affected if they collect auxiliary benefits based on a high-earning spouse); eliminating the current $106,800 cap on the employer side of the payroll tax; reducing annual Cost of Living Adjustments by around 0.3 percentage points; and investing around 25 percent of the Social Security trust fund in stocks.

Overall, it's not a badly constructed plan given the priorities of the designers. That said, two factors stand out as being behind-the-times in terms of Social Security reform plans coming from either side of the aisle.

The first is the plan's reliance on the equity premium—that is, the higher average returns produced by stocks over bonds—to keep Social Security solvent. In general, the Congressional Budget Office has not "credited" Social Security plans that include stocks with higher returns. CBO argues that higher stock returns are merely a return for higher risk, so crediting stock returns without accounting for stocks' greater risk would be misleading. As CBO put it here:

Although the government can reallocate the risk of stock holdings, it cannot eliminate it. If the government buys stock from private investors, it merely shifts risk from those investors to taxpayers and program beneficiaries. If stock prices drop, the government and the public in general have suffered the loss. Risk is not reduced simply because the government can borrow to avoid raising taxes or cutting spending in the current period. Government borrowing is a decision to tax or cut spending in the future rather than a means of avoiding taxation or spending cuts altogether. Nor is risk diminished by the government's ability to indefinitely hold a stock whose price has declined. A drop in the price of a stock is not a temporary aberration; it reflects the market's judgment that the value of the stock has declined permanently. An investment in private securities is no less risky when it is made by the government than when it is made by a mutual fund. Therefore, risk is costly to both the government and individuals.

For that reason, CBO risk-adjusts equity returns back to the government bond interest rate. This is particularly important in the CAP plan, since nearly one-quarter of the reduction in the 75-year funding shortfall derives from assuming higher returns on trust fund investments. If CBO follows the practice it used in scoring personal account plans, CAP's proposal would fall well short of 75-year solvency. Ironically, CAP categorizes trust fund investment as "Upgrading the structure to align with modern economic insights," just as budget scoring and financial theory have turned against equity-heavy portfolios.

Second, the CAP plan ignores a trend in Social Security reform over the past 15 years to aim not merely for solvency over 75 years, but so-called "sustainable solvency," which ensures that the program isn't running large annual deficits as it approaches the 75-year mark. The 1983 reforms, for instance, were solvent for 75 years but not sustainably solvent, with the result that current workers face large benefit cuts if and when the trust fund runs out. CAP doesn't estimate the annual cash flows for its proposal, but I estimate that in its 75th year the CAP plan would run a deficit of around 2.2 percent of payroll, versus a deficit of around 4.3 percent of payroll under current law. CAP's plan would reduce those annual deficits, but not nearly as much as most other Social Security reform proposals.

This means that within a decade or two, policy makers and the public would again face the need to fix the program, just as doing so becomes more difficult. There is nothing wrong with future generations revisiting Social Security policy—indeed, they should revisit it to keep the program current with economic realities and public goals—but there is no reason to force future citizens to revisit Social Security reform from the position of mounting deficits. I suspect that if we saw the annual cash flows of the plan it would look like more of a holding action on Social Security finances – at least relative to most other plans – and less like a permanent solution. While a permanent solution isn't necessary, it is necessary to acknowledge how much of the problem a plan truly solves when policymakers and the public are weighing the costs and benefits of alternative approaches.

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