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Making the Most of the Surplus

Sunday, October 1, 2000

The projected federal budget surplus continues to grow. For the current fiscal year, the Congressional Budget Office (CBO) projects the total surplus to finish around $232 billion, with $148 billion produced by the Social Security account, and $84 billion outside of Social Security. The non-Social Security surplus is projected to grow to over $100 billion in the next fiscal year, and to reach $377 billion by 2010. Over the next 10 years, the non-Social Security surplus alone is projected to total almost $2.2 trillion, with another $2.4 trillion in Social Security surpluses, for a total surplus over this period of $4.56 trillion.

Beginning about three years ago, as the prospect of these budget surpluses arose, different reform camps raised three big economic policy ideas that would be far easier to implement because of those surpluses. One was simply to pay off the national debt. This goal has substantial appeal among grass-roots conservatives, and this has been reflected in support for it among congressional Republicans. Interestingly, this option has also become the centerpiece of the economic platforms of President Clinton and now Presidential candidate Al Gore. Indeed, Clinton and Gore propose to use even the Social Security surpluses to pay off the reported, net, national debt, now totaling about $3.4 trillion.

Supply-siders, conservatives, free market libertarians, and many other Republicans have advocated a second course — a major tax cut. Many from among these same groups, as well as some moderate Democrats and leaders from minority communities, have advocated a third alternative — a personal investment account option for Social Security.

While all three of these possibilities appeal to many people, there is a conflict between them, for if the surplus is used for one, it can’t be used for the others. For Social Security reform, the surpluses would greatly help to finance promised benefits during the transition, as workers start paying at least some of the payroll taxes into personal accounts instead of Social Security. The more of the total surplus devoted to Social Security reform, including the surplus within Social Security itself, the bigger the personal account option can be.

By contrast, the more of the surplus devoted to paying off the national debt, the more it can be reduced and the more quickly it can be paid off. And the more that is devoted to cutting taxes, the bigger the tax cut can be.

An easy political answer would be to devote one third of the total surplus to each of these three reforms. But that would be a leadership cop-out, for the reforms are not nearly equivalent in terms of the benefits they would produce. In particular, a personal account option for Social Security would produce far, far greater benefits than paying off the national debt. Tax cuts would produce benefits as well, and would complement personal Social Security accounts. In fact, paying off the national debt may well be counterproductive.

Pay off the debt?

Seen in its best light, paying off the national debt would increase savings and thereby promote economic growth. If the government used a billion dollars to buy and retire federal bonds, the former bondholders would then have an extra billion dollars to invest in private capital markets. To the extent that tax revenues came out of consumption rather than savings, private savings and investment would consequently be increased. A second benefit from this policy would be to reduce and ultimately eliminate federal spending on debt interest, now running at about $220 billion per year.

But the problem is that running a budget surplus until the national debt is paid off requires keeping taxes higher than they otherwise need to be. The higher taxes would harm economic growth, probably much more than paying down the debt would help.

We have powerfully convincing experience from the 1920s, 1960s, and 1980s as to how strongly tax cuts can enhance economic growth. This is supported by foreign experience as well, and a by-now vast literature of economic studies. There is no equivalent literature or experience supporting a payoff of the national debt.

Indeed, quite to the contrary, Keynesian economics continues to be the reigning orthodoxy in liberal/left dominated academia. And under Keynesian analysis, running a budget surplus to pay down the debt would slow the economy. Under supply-side analysis, the higher-than-necessary taxes to maintain the surplus would slow the economy as well, creating the obverse of the economic gains from tax cut policies in the 1920s, ’60s, and ’80s.

Another problem is that our nation’s monetary policy is conducted through the sale and purchase of federal bonds by the Federal Reserve. The Fed buys such bonds with newly printed money to increase the money supply and sells the bonds to the public for cash to reduce the money supply. Yet, with no national debt, there would be no federal bonds to buy and sell. Private capital markets also now rely on federal bonds for diversification and a safe harbor for short-term money, in addition to using the market rates on such bonds as benchmarks.

Finally, as a matter of politics, trying to pay off the national debt is more likely to be a snare and a delusion. With that surplus money lying around in Washington, voracious special interests will come up with one spending emergency after another year after year to spend the surplus funds. Those trying to preserve the surpluses to pay off the debt will always appear as cold-hearted accountants in the face of these various teary-eyed demands.

Indeed, the left has transparently embraced paying off the debt to keep all that tax money in Washington until spending is politically safe again. In other words, Clinton and Gore have adopted paying off the debt as their economic mantra precisely to short-circuit the political appeal of a major tax cut. But the rapidly escalating spending agenda offered by Gore and his left-liberal allies raises questions about how sincere they are in following through on this promise. During years of liberal domination, Congress routinely promised to restrain spending (usually to win passage of tax increases). But the spending continued more or less unabated. The promise to pay down the debt could be Lucy holding the football for Charlie Brown again.

By the end of the next fiscal year, before any new policies could become effective, the net federal debt will fall to about 31 percent of GDP. Net federal debt equaled 80 percent of GDP in 1950 and 46 percent in 1960. The federal debt is not currently an economic problem, and trying to pay it off may do more harm than good.

A real tax cut

By contrast, our tax code is currently a problem. Returns to saving and investment are taxed at least four times, through the personal income tax, the corporate income tax, the capital gains tax, and the inheritance tax. Investment is also the only business expense that cannot be deducted in the year the cost is incurred. Instead, the investment must be depreciated over several years.

In addition, the top marginal tax rate has been increased by close to 50 percent since the Reagan years. Wage growth and inflation are also increasing taxes by pushing workers into higher brackets. Federal taxes are now over 20 percent of GDP, the highest level since World War II. Indeed, they are about the same level as in 1944 and 1945, when we were in a life and death struggle with Nazi Germany and imperial Japan.

Abolishing the death tax, reducing or eliminating the capital gains tax, and cutting marginal tax rates would reduce the harsh discriminatory tax burden on savings and investment. Both should consequently rise substantially. Such tax relief would also increase the incentives generally for work, entrepreneurship, and risk-taking.

All of which would be a potent tonic for further increasing our economic growth as well as perpetuating it over the long term. As the increased savings and investment lead to increased productivity, wages would grow faster and new jobs would be created, expanding and deepening the economic boom to include more and more people. Again, both experience and the economic literature indicate that the economic benefits of such tax relief are likely to be far greater than the results from trying to pay off the national debt.

Finally, a major tax cut would produce the added benefit of allowing taxpayers to keep more of their own money. It is too often overlooked that this means more freedom as well as more prosperity. With reduced taxes, people have more freedom of control over their own incomes, and freedom of choice as to how to spend the fruits of their own labor. This is a central attribute of a free society.

A personal account option

The third alternative, however, a personal account option for Social Security, would produce truly overwhelming benefits. When considering Social Security, the initial reaction is to think of the program’s well documented long-term financing problems. But that is not the biggest problem facing the program, not by a long shot.

The biggest problem with Social Security is that even if it somehow pays all of its promised benefits, the program would still be a bad deal for today’s workers. These workers would now get far higher returns and benefits saving and investing through personal accounts in place of Social Security, as workers are increasingly doing in other countries around the world. As a result, such personal accounts would directly and substantially increase the prosperity of working people.

In A New Deal for Social Security (Cato Institute, 1998), Michael Tanner and I show how big a difference this would make. Take the example of a husband and wife entering the work force in 1985, each earning the average income each year for their entire careers. What would happen if this couple could save and invest in the private sector what they and their employers would otherwise pay into Social Security?

We account in the study for private life and disability benefits to replace Social Security survivor and disability benefits. We also account for administrative costs, and show how the transition to the new system could be financed without undermining the workers’ private retirement benefits.

At a 4 percent real rate of return on such investments, which is just over half the average return earned in the stock market over the past 75 years, the couple would retire with almost $1 million in today’s dollars. That fund would pay them more out of continuing investment returns alone than Social Security promises but cannot pay, while allowing them to leave the almost $1 million to their children. Or the funds could be used to buy an annuity paying them over three times what Social Security promises.

At a 6 percent real return, the couple would retire with $1.6 million in today’s dollars. That fund would pay them about three times as much as promised by Social Security, while allowing them to leave the entire $1.6 million to their children. Or it would finance an annuity paying them seven times what Social Security promises, but cannot pay.

The same is true for all workers today — all income levels, family combinations, ethnic groups. Rich or poor, black or white, married or single, with children or without, one earner couple or two earner couple, even low income workers who receive special subsidies through Social Security would receive much more in benefits from the personal investment accounts.

Take the example of a low-income couple with two children. Husband and wife enter the workforce in 1985 and each earn the equivalent of no more than today’s minimum wage each year throughout their careers. Through the personal investment account, at a 4 percent real return, the couple would retire with a fund of $375,400 in today’s dollars. The couple could use this fund to buy an annuity that would pay them 2.44 times what Social Security promises but cannot pay. Or the couple could use part of the fund to buy an annuity matching what Social Security promises, while leaving $220,000 to their children.

At a 6 percent real return, this low income couple would retire with a trust fund of almost $700,000 ($693,395) in today’s dollars. That fund would pay them more than twice (2.26 times) what Social Security promises out of the continuing returns alone, while allowing them to leave almost $700,000 to their children. Or they could use the funds to buy an annuity that would pay them 5.46 times what Social Security promises but cannot pay.

Quite similar results have been found in studies by The Heritage Foundation, the National Center for Policy Analysis, and others. These vastly greater benefits would result not because the private sector would make better investments than Social Security. They result because Social Security makes no real investments at all. Social Security is a tax and redistribution scheme in which almost all taxes paid today are immediately paid out to current beneficiaries on a pay-as-you-go basis. The private, invested system, by contrast, pours its funds into real private capital investment that produces new income and wealth. That increased income and wealth is what finances the far higher returns and benefits of the private system.

If such personal accounts were adopted and expanded quickly enough, they would also avert the long-term Social Security financing crisis, without raising taxes or cutting benefits. The government’s own annual reports indicate that paying all promised Social Security benefits to young workers entering the work force today would require raising the Social Security payroll tax by 50-100 percent. That would increase the current 12.4 percent total Social Security tax rate, including both the employer and employee shares, to around 18-24 percent.

But if workers in the future were relying primarily on personal accounts rather than Social Security, this long-term financing crisis would be averted. Workers would then receive the better benefits from the fully funded personal accounts instead. Indeed, because the private investment returns earned by those accounts would be so much higher than Social Security, the required payments into those accounts could be substantially reduced, providing an effective payroll tax cut.

The personal account option would also expand and enhance economic growth. Increased savings through the accounts would increase capital, productivity, wages, job creation, and overall economic growth. Lightening the payroll tax burden through such reform would further increase jobs, wages, and growth. In a pathbreaking article in the American Economic Review, Harvard economics professor Martin Feldstein, chairman of the National Bureau of Economic Research, estimated that the present value of the future economic gains from a full personal account system would be $10 trillion to $20 trillion. In other words, shifting fully to such a system would produce a gain equivalent to increasing America’s total wealth today by this amount.

All of these benefits would be most important to lower income workers. They most need the higher returns and benefits they would gain from personal accounts. They are also most in need of the general economic benefits of the reform. They most need the new jobs, higher wages, and faster economic growth that would result.

Moreover, averting the long-term Social Security financing crisis through the reform will also be most important to lower income workers. They can least afford the higher taxes or reduced benefits that will otherwise be necessary if we stay on our current course.

Most important, it’s only through reform that these workers will have a chance to participate in the booming capital markets. Indeed, that will be true for blue collar workers overall, most blacks, Hispanics, and other minorities, and in general the bottom half of the population in income. These workers do not have the income to participate in the 401(k)s, iras, and stock options that upper income workers are using to participate in the capital market boom. Consequently, they are just falling farther and farther behind.

With personal accounts, these lower income workers would also become capitalists as well as laborers. The result would be a more equal distribution of wealth as well as income. Indeed, an earlier study by Feldstein indicated that a full personal account system would reduce the nation’s concentration of wealth by one half. For those on the left evangelizing today about a wealth gap in America, the solution is a personal investment account option for Social Security. Indeed, this is the only viable, productive means of achieving their goal.

Ultimately, through this reform, the socialist dream of the nation’s workers owning its business and industry would be effectively achieved. But the result is not likely to be what the socialists envisioned. As the nation’s workers become capitalists, support for pro-growth, free market policies will increase throughout society. The result will be a political revolution creating greater general prosperity for everyone.

But even this is not all. A full, personal account option would ultimately eliminate the current unfunded liability of Social Security, totaling about $9.5 trillion, as worker’s future benefits would be financed through their fully funded personal accounts, rather than unfunded Social Security. Social Security’s unfunded liability is not recognized as part of the reported national debt. But it is, nevertheless, a real government debt which must be paid by future taxpayers absent fundamental reform. As a result, such reform would eliminate far more real government debt than paying off the national debt. Indeed, this would be the greatest reduction in government debt in history.

A full, private account option would also ultimately involve a huge tax cut. Social Security taxes account for about one-fourth of total federal taxes. Through the reform, these funds would be paid into private personal accounts, with part perhaps kept by workers, rather than paid to the government in taxes. As a result, federal taxes would be cut by close to one- fourth. This would be the biggest reduction in taxes in world history.

Moreover, with retirement, survivors, and disability benefits eventually privately financed under the reform, federal spending would be sharply reduced as well. With an eventual, full, private option, federal spending would ultimately be reduced by about one-fourth. This would be the biggest reduction in government spending in world history. Quite simply, the significance and magnitude of this reform dwarfs all others.

The bottom line

The great surplus debate has now become central to the presidential election. Al Gore has come out foursquare for paying off the national debt, and is unalterably opposed to a major tax cut and a personal account option for Social Security. George W. Bush, by contrast, has made a major tax cut and a personal Social Security account option the centerpieces of his economic platform, although he has not ruled out some further reduction in the national debt. Bush’s framework is to use the Social Security surplus to cover the personal account reform, and the non-Social Security surplus to cover the tax cut and some other initiatives, including possibly some continuing reduction in the reported national debt.

This framework would allow for a healthy personal account option. Instead of allowing workers only a choice of putting a small specified portion of the payroll tax into the personal accounts, such as 2 percentage points of the total 12.4 percent tax, workers could be allowed a range of options. They could, for example, be allowed to put from 1 to 6 percentage points of the total tax into the accounts.

Assuming that not everyone will choose to exercise the maximum 6 percent option from day one, which will certainly be the case, then the Social Security surplus alone may be sufficient to cover just such an option for years into the future. Eventually, the shift of taxes into the personal accounts would be offset by the shift of Social Security benefit obligations to those accounts as well.

Ultimately, we must be careful not to view the projected surpluses as a limit to reform rather than an opportunity. There is no reason that the tax cut and the personal Social Security account option has to be limited by the amount of the projected surplus. If greater reforms than the surpluses can accommodate are desirable, they can be achieved by further restraining the growth of federal spending. The CBO projects that just restraining spending growth to the caps adopted in the last major budget deal would increase the projected surplus by another $1.2 trillion over the next ten years. If necessary to achieve the reforms and the consequent benefits outlined above, such modest spending restraint would be well worthwhile.

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