Social Security Reform Won't Boost U.S. Debt

The Social Security debate is quickly becoming one of how to finance any reforms. On Wednesday, the President stated he was open to raising Social Security taxes and Alan Greenspan, while voicing some support for private retirement accounts, also raised concern about effects on capital markets of aggressive transition to privatizing social security.

Forty-four Democratic US Senators have signed a letter ruling out any new debt.

Yet, the whole debate is wrong headed. Social security privatization need not have any impact on net debt for our economy or for the government.

Senators such as Richard Durbin (D-Illinois) charge that the reforms will add "2 trillion to $5 trillion addition to America's national debt" and reporters constantly ask, "how are you going to pay for that?"

This debate rests on an accounting fiction that fails to recognize the government's real liabilities as current debt.

  Take an example where people can invest $100 of current social security contributions into individual retirement accounts rather than the social security fund and in return future social security benefits are cut by the equivalent of $100 today.

The loss of $100 in current taxes requires an additional $100 of debt to be issued, but the government's obligatory future social security benefits are reduced.

Much Obliged
Why should we treat future social security obligations as less real than obligations to pay future interest and principal payments?

Surely no politician will argue that the former are less likely to occur and should therefore not be recognized as real obligations.

As another way to see how real the government's future obligations on social security are, there is a very simple way for the government to create personal retirement accounts without raising any additional debt.

All the government has to do is allow individuals to sell some portion of their future social security benefits in exchange for a lump sum payment today.

Wall Street makes these present value and life expectancy calculations all the time for annuities. Individuals who receive the lump sum payments would turn around and invest the money in diversified funds approved by the government and that would hold some mixture of stocks and bonds.

The entire round trip is a net wash: banks raise money by selling debt that is backed by current social security promises, but individuals immediately return the same amount back to the capital markets.

The net drain on capital markets is zero.

There are real advantages to creating private retirement accounts in this way. Individuals would receive a lump sum that they could invest in assets appropriate for their time horizon and risk preferences, rather than being forced to accept the government's (low but riskless) rate of return inherent in social security as it stands.

Rough calculations suggest that if we allowed a 45 year-old person to capitalize one-third of their expected social security benefits, they would get about $50,000 today. A personal retirement account funded to that level puts real meaning to the term ownership society.

Cutting Debt
President Bush's proposal though actually reduces government debt.

By voluntarily joining the program and getting the benefits of the higher returns and keeping the money, participants must agree to a reduction in future benefits that is slightly larger than the current reduction in taxes.

Unfortunately, this is all being missed in the debate. A computerized search of news stories over the last week finds over a thousand news stories mischaracterizing the reforms as causing us to go further into debt. Imagine the outcry among the press if private companies used the government's accounting rules. Firms could reduce worker's wages today in exchange for larger pension and health care benefits in the future.

Those future pension benefits that are paid more than 10 years in the future would not appear on the balance sheet, but the cut in current wages would increase reported profits. Of course, no one would believe the claimed "profits." Similarly, no one should believe the claims of government "debt."

An honest debate can be had over whether we continue with a pay-as-you-go, defined benefits system, where retirement funds are never invested, or a defined contribution retirement program that allows individuals to tap into the power of tax free compound returns.

Undoubtedly much of this is the fault of bizarre Federal accounting rules, but it is not clear how we can have a real debate with all these accounting fictions.

Counting only current changes in revenue and not future changes in liability would land people in jail if they were working for anyone other than the government.

*Hansen is the Senior Associate Dean at the Tuck School of Business and Lott is a resident Scholar at the American Enterprise Institute.