A Social Security Lesson From Argentina

Since 1989, Argentina has rapidly introduced revolutionary reforms that have greatly reduced government regulations and controls. Privatization of its social security system is the most important step of the past couple of years. Argentina's experience demonstrates that, even under very difficult economic circumstances, a nation can successfully convert from a pay-as-you-go (PAYG) social security system to a competitive private pension plan with individual retirement accounts.

A PAYG system taxes workers to pay benefits to currently retired persons. The combined social security tax on employees and employers in Argentina had reached 50% of wages, a crushing burden that discourages companies from hiring workers. Private employment has stagnated, and the unemployment rate is up to 17%.

To avoid high social security taxes and onerous labor market regulations, many workers and companies operate in the illegal underground economy. Argentinean economists estimate that nearly half of all workers have either illegal or informal jobs.

Since so many workers do not pay social security taxes, the ratio of retired persons to workers paying social security taxes has been nearly 1-to-1, among the highest in the world. This created a vicious cycle as high social security taxes in the legal economy shifted workers into the underground one, forcing still higher taxes in the legal economy and encouraging further shifts into the illegal one.

The privatization program that started in 1994 gives workers the option of either remaining in the old system or placing their old-age contributions--prescribed at no less than 11% of their wages--into one of many private pension companies. Over 60% of workers have chosen a private fund.

Workers with their own accounts accumulate retirement assets as they add to their contributions and as they earn interest and dividends on the fund's investments. The funds have invested mainly in government bonds, but they will allocate more of their assets toward private equities and bonds as the Argentine economy recovers from its current depression. Their investments in private stocks and bonds will expand the Argentine capital market. High rates of return on these retirement funds should also greatly raise Argentina's savings rate. To prevent excessive risk, the government regulates the allocation of pension-fund assets.

All employer social security contributions still are used to finance benefits to retired persons. But notwithstanding the need both to pay current retirement benefits and to build up new accounts for workers, the combined employer and employee social security levy has been cut by some 10 percentage points. The higher yield on private pension investments means that workers with private accounts can contribute less than they did under the old system and still expect to receive larger benefits when they retire. Moreover, employee social security payments are no longer a tax but an investment in retirement income, so some workers are leaving the underground economy for the legal sector. This adds to employer contributions to the PAYG system.

CHICKEN LITTLES. Economists tend to worry about the transition from a PAYG system to private social security. But Argentina is showing, as Chile has successfully demonstrated for 15 years, that the transition can be managed rather easily, despite the apparent "double taxation," because a private system is so much more efficient than a PAYG system.

Still, naysayers continue to claim that it is not advisable for the U.S. and Europe to privatize their social security systems and to frighten retirees into believing that benefits will be reduced under a privatized system. In fact, the transition should be far easier in the U.S. and Europe than in Argentina, since the former have much more developed capital markets. Also, tax rates needed to sustain benefits to retirees would not have to be so high, since Europe and the U.S. have more workers supporting retirees. It will become more difficult the longer these nations wait, since the number of older retirees is growing faster than the number of workers.

The developed countries should feel humbled by the fact that two emerging countries have pioneered the privatization of social security. Both retired persons and workers in advanced nations would welcome such privatization if they knew how successful the transformation has been in Argentina, a nation with far more difficult economic problems than the most stagnant European economy.

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