I’ve read through all the comments on my previous post, and I wanted to see if I could respond to some of them. In particular, a lot of people objected to me calling Social Security a Ponzi scheme. Other people thought that Social Security would be unsustainable, even with technological progress. So let me explain why I think that Social Security has most of the characteristics of a Ponzi scheme—let’s call it a “Ponzi-like” scheme. Nevertheless, the system of intergenerational transfers—the young supporting the old—is sustainable as long as productivity is rising. A “Ponzi-like” scheme has three characteristics—transfers, obscurity, and unsustainability. 1) Transfer: Early participants are paid off by the investments of later participants
2) Obscurity: The true nature of the scheme is obscured. so that it looks like early participants are receiving a return on their investments, rather than payments from later participants
3) Unsustainability: The scheme is guaranteed to eventually break down, once the number of participatns rises high enough.
Social Security clearly fits the first characteristic, because it is a transfer payment from younger generations to older generations. No one would argue with this. Social Security also fits the second characteristic, obscurity. The true nature of Social Security as a transfer payment is obscured by the Social Security Trust Fund. The Trust Fund seems to be imply that current taxes are being invested for the future. In addition, individuals are sent a record of how much Social Security taxes they have paid, with the implication that your future benefits are linked to how much you have paid in taxes. In other words, Social Security has the formal structure of an investment. In fact, the Trust Fund is completely irrelevant for the long-term functioning of Social Security. Supposedly, the Trust Fund contains government bonds. But when the government has to dip into the Trust Fund to pay off benefits, where does that money come from? Well, the Trust Fund redeems the bonds with the Treasury, which then gets the money from taxes on worker earnings and other national income. In other words, the Trust Fund is just an accounting device, indicating an obligation on the income of the younger generation (not just wages, but capital income as well). And in fact there is no connection at all between what you pay into the system in terms of taxes, and what you receive as benefits. The benefit formulas are written in terms of your average wages during your lifetime, adjusted by wage inflation. No one cares about your tax “contributions.” What about unsustainability, the third characteristic? That’s where Social Security diverges from a Ponzi-like scheme. In fact, Social Security is sustainable indefinitely, as long as there is technological progress and real wages are rising over time. That’s because with rising real wages, the younger generations are better off than the older ones. The exact size of the benefits depends on the rate of growth of productivity. But as long as each generation is better off than the next, it’s possible to tweak the rules to make Social Security work. I worked out the arithmetic for a simple example. Suppose that we have a society with no population growth. People work for forty years, and then are retired for twenty years. In other words, there are two workers for every retiree.
Suppose now that there is no real wage growth over time, and we want to replace 40% of the (working income) of a retired worker (In other words, retiree benefits equal 40% of their average real lifetime wages) Then how much do we tax the younger generation? We would need a tax rate of 20% (both employee and employer contributions) to finance Social Security. That’s obviously too much. (By comparison the current Social Security tax rate is 12.4%).
(Say, workers earn $100,000 a year, and retirees get $40,000 a year. Then each worker would have to pay $20,000).
But the arithmetic changes if real wages are rising. Suppose that real wages are rising by 2% a year, and your Social Security benefits depend on your average real wages during your lifetime (see caveat below). Then the necessary tax rate drops to 16%, because younger workers earn quite a bit more than their parents did.
Let’s summarize. Assuming a 40% replacement rate and two workers for every retiree, here’s how it works.
|A Simple Social Security Example|
|(assuming 40% replacement)|
|If real wage growth is:||0%||1%||2%|
|Social Security tax needed is:*||20%||18%||16%|
|*combined employer and employee|
The main way that the real wage rises over the long term is through technological progress. The more technological progress, the better off the young generations are, and the more they can afford to support the older generations.
Caveat: Currently Social Security benefits are based not on the real wages you earned in your lifetime, as assumed here, but on your real wages, adjusted for the change in overall wages over time. In other words, you benefit from rising real wages in the younger generation, up to the point you retire. A slight tweak in this formula would go a long way to fixing Social Security’s finances.