Thank you, Mr. Chairman. I am pleased to appear before this committee to discuss the effect on national saving and capital formation of shifting from our existing pay-as-you-go method of financing Social Security and Medicare to a funded system based on individual accounts invested in private stocks and bonds.
I strongly favor such a change in the financing of our Social Security and Medicare systems. Doing so would greatly reduce the tax needed to finance the projected level of Social Security pensions and the increasing cost of the Medicare program that will otherwise result from the long-term ageing of the population. This reduction in future taxes would raise the spendable income of all employees and therefore substantially increase their standard of living. The lower tax rates would also avoid the increased distortions of economic incentives that would result from higher marginal tax rates. And this more efficient financing mechanism would make it unnecessary to diminish the future Social Security pension benefits or to scale back the health care of the retired population that is now projected for the future. These are important reasons for favoring prefunding Social Security and Medicare benefits through a system of individual accounts.
In addition, such a system of mandatory saving in individual accounts would also increase saving and capital formation, thereby raising economic growth, labor productivity and real wages. In the long-run, the capital stock and the national saving rate would rise by more than 30 percent. That would significantly raise real wages, further increasing the real income gains that result from lower tax rates. The higher rate of saving would also permit the United States to achieve a higher rate of investment in plant and equipment while reducing our dependence on foreign capital and the accompanying trade deficit.
I have done detailed calculations based on the demographic and actuarial projections of the Census Bureau and the Social Security Administration. These calculations are part of a larger study of the feasibility of gradually replacing the existing pay-as-you-go Social Security system with a fully funded system based on individual accounts.2 The analysis shows that the existing system can be completely replaced by a funded system to which individuals eventually contribute only about 2 percent of their wages (up to the ceiling on the Social Security tax base). During the long phase-in period, individuals would contribute between 1. 5 percent and 2. 0 percent to their wages.
These mandatory savings would provide the base for a substantial increase in national saving. The increased national saving and the greater capital stock that would result from prefunding social security would however not just be the accumulation of these mandatory savings. Even more important would be the investment return that would be earned on those accumulated funds and that would be retained in each individual's Personal Retirement Account until that individual retires. Detailed calculations show that the investment return is an even more important source of increased national saving than the small share of wages that the individuals save in their accounts.
How large is the rate of return on these funds? Because the past few years have seen such a remarkable boom in stock and bond prices, I will be very conservative and look at the experience before 1995. During the nearly 70 year period from 1926 to 1994 for which comparable data are available, the real rate of return on a portfolio of stocks and bonds was about 5.5 percent after adjusting for inflation.' The return during the postwar period from 1946 to 1994 was almost exactly the same. While the future rate of return will fluctuate from year to year, there is good reason to believe that the average rate of return in the future will be similar to what it was in the past.
Even this relatively favorable rate of return on stocks and bonds understates the return to the nation on the funds that are saved and invested in stocks and bonds. Although the 5.5 percent return is calculated before any personal income tax, it is the return that portfolio investors earn after the taxes that corporations pay to the federal, state and local governments. The real return on additions to the capital stock before all taxes during these same years averaged slightly more than 9 percent.
With this rate of return, the assets in the Personal Retirement Accounts would grow very rapidly. Even with contribution rates that are only between 1. 5 percent and 2. 0 percent of wages (up to the maximum amount covered by Social Security ), the accumulated balances in the Personal Retirement Accounts would reach 25 percent of covered wages (about I 0 percent of GDP) after only 10 years and about 80 percent of covered wages (more than 30 percent of GDP) after 25 years. Looking further ahead to a time 75 years from now when the gradual transition from the pay-as-you-go system to a fully funded system would be complete, the accumulated Personal Retirement Account balances (net of all the benefit payouts that have been made) would equal 2.3 times that year's total payroll or about 100 percent of the Gross Domestic Product. Stated differently, the extra saving would be equivalent to a 34 percent rise in the capital stock.
I have spoken about the accumulated assets in the Personal Retirement Accounts as if that corresponds to an equivalent increase in the nation's capital stock. Wouldn't the mandatory saving in the Personal Retirement Accounts induce some changes in other personal saving?
In my judgement, in the early years of the transition to a prefunded system there would be a very small offsetting effect while in the later years the induced changes in private saving would actually reinforce the mandatory saving. To understand why this is so, note that the shift to a mandatory prefunded system would not alter the benefits that individuals would receive in retirement. The feasible transition that I have studied is calibrated to keep the combination of the diminishing pay-as-you-go benefits and the increasing Personal Retirement Account benefits equal to what the pay-as-you-go benefits alone would be under current law. The shift to the prefunded system therefore would not induce individuals to reduce private saving because of an expected increase in retirement income. The primary reason for the change in other saving would be the effect of the transition on the level of disposable income during pre-retirement years.
Consider first how private saving would be expected to respond in the long-run when the combination of the mandatory saving and the pay-as-you-go tax are lower than the payroll tax would be in the existing pay-as-you-go system. ' This implies that the disposable income of individuals in their preretirement years would increase while the disposable income during retirement would remain unchanged. Instead of increasing consumption only during their preretirement years, individuals would generally want to spread the higher disposable income during their working years between higher consumption at that time and in retirement, i.e., they would save some of the higher disposable income that results from the lower payroll tax. The response of private voluntary saving would therefore be to increase the national saving rate. The rise in the capital stock would therefore be greater in the long-run that the increase that comes directly from the balances of the Personal Retirement Accounts.
During the early part of the transition, the extra mandatory saving (i.e., the combination of the mandatory Personal Retirement Account contributions and the pay-as-you-go tax) would exceed the baseline pay-as-you-go tax, causing a decline in disposable income. In the first year, for example, individuals would experience a decline of disposable income equal to 2 percent of wages up to the maximum tax base in the Social Security program. Individuals who experienced such a decline in disposable income during their working years (while their expected retirement benefits remained unchanged) would presumably want to reduce some of their existing saving in order to cushion the decline in consumption and spread the consumption decline between their working years and their retirement years. However, this effect is likely to be very small because most individuals have little or no saving that can be reduced in this way. Even at age 60, the median financial wealth of households in less than six months earnings. Moreover, these small saving balances are generally held as "emergency reserves" for uncertain events (e.g., uninsured medical bills, replacing consumer durables, etc.) and would therefore not be reduced to spread the income decline.
Thus the rise in saving during the early transition years would be somewhat less than the previous discussion implied and the rise in saving in the long run would be substantially greater. I have no doubt that the net effect of the transition from the pay-as-you-go system to the prefunded Personal Retirement Account system would be a substantial rise in national saving and therefore a larger capital stock and a higher level of real national income.
Although I have focused my remarks on the idea of prefunding the Social Security pension system, the same logic applies to the Medicare program of health benefits for the aged. In both cases, the government is now using current tax receipts to provide benefits to a group of retirees that can no longer finance its spending out of current earnings. In both cases, the high level of current and even higher level of future taxes could be avoided by shifting to a mandatory funded plan based on individual accounts.
The total cost of Medicare (and of the portion of Medicaid that goes to the aged) is now approximately equal to the cost of the Social Security pensions but is scheduled to increase substantially faster in future years. The Congressional Budget Office estimates that by 2030 these health care costs of the aged will be nearly 50 percent greater than the cost of the Social Security pensions and that by the year 2050 they will be 70 percent higher. Continuing to fund Medicare and the related Medicaid expenditures on a pay-as-you-go basis would require a tax for this purpose alone that would be equivalent to a 30 percent payroll tax. If Congress chose to finance the increase in these health care costs with the personal income tax, it would require more than doubling all of the existing personal income tax rates. Even with substantial improvements in the efficiency of the Medicare program and restrictions on the services that are available, the tax increase required with the existing pay-as-you-go method of financing would be enormous. So there is a very powerful reason to switch from pay-as-you-go funding of Medicare to a prefunded system similar to the one that I have been describing for the Social Security pensions.
The funds accumulated in private Personal Retirement Health Accounts could be used at age 65 to buy a traditional indemnity policy similar to that provided by Medicare, or to pay for membership in some form of Health Maintenance Organization, or to finance a high copayment insurance plan like the Medical Savings Accounts. There are other issues about the operation of a prefunded system for Medicare that are different from prefunding Social Security but the implications for saving are similar.'
Because of the relative costs of the Medicare and Social Security programs, the private saving needed to prefund the Medicare outlays would be about 50 percent greater than the saving needed to prefund the Social Security pensions. The increase in national capital accumulation would therefore also be about 50 percent greater.
Let me conclude now by emphasizing the point that I made at the start of my testimony.
Continuing with the pay-as-you-go method of financing Social Security and Medicare would require
an unacceptable increase in tax rates. A shift to a funded system based on individual accounts
invested in stocks and bonds would eventually permit replacing these high tax rates with a very
much lower mandatory saving rate. This would substantially increase the after-tax income of all
wage earners and reduce the distortions caused by high marginal tax rates. The favorable impact on
the national saving rate would eventually produce a major increase in the nation's capital stock that
would cause a correspondingly large rise in real incomes.
Home | Menu | Links | Info | Chairman's Page