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Killing Entitlements Would Make Inequality Worse

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Celebrated economist Martin Feldstein in a recent Wall Street Journal op-ed argued that U.S. wealth inequality is much less than advertised. The reason, Feldstein says, is that future Social Security, Medicare and Medicaid payments are a form of uncounted wealth that dramatically boosts the wealth of the poor by trillions of dollars. If we take entitlements into account, Feldstein says, wealth inequality isn’t so bad. 

It isn't such a novel observation and counting future payments as wealth is OK, as far as the economics goes. Capitalizing a future income stream -- valuing it in terms of its present value and counting it as today’s wealth -- is standard practice in finance, and there’s no reason this can’t be applied to Social Security and Medicare. But if we want to look at wealth in these terms, we have to add a lot more than just entitlements.
QuickTake Income Inequality 

For example, maybe we should add human capital. That refers to the capitalized value of people’s skills and knowledge. In the future, my skills will command a premium, allowing me to have much higher earnings over the course of my life than if I were only able to do manual labor. Rich people, in general, have much more human capital than poor people. They’ve worked in big companies and gone to good schools, which most poor people have not. 

Another big chunk of wealth is network capital (also called social capital). This refers to the value of people’s business contacts and friends. Having a strong network helps you get a job, do business deals, and get investment capital. It is hugely important to people’s long-term earnings potential, so it too should be capitalized into wealth. 

Together, human capital and net capital determine a large portion of people’s future earnings, and future lifetime earnings add up to some pretty substantial numbers. Thus, if we are to measure the kind of inequality that Feldstein wants to measure, we will have to add these in. Adding network capital and human capital will hugely increase wealth inequality. That doesn’t seem to be what Feldstein has in mind. 

After making his point about wealth inequality, Feldstein switches gears, and argues that poor people are getting a low return on their implicit wealth. Feldstein writes:

By my calculations, the implicit real rate of return on [capitalized entitlement wealth] will be less than 3%. That is substantially less than the 5.5% real return earned historically by contributions over a working life to an individual IRA or 401(k) plan invested in a balanced combination of stocks and high-quality bonds. 

Here I believe he is totally wrong. This would be correct only if stocks had no risk. In fact, the risk is very substantial. That 5.5 percent historical return sounds great, but not all retirees enjoy that kind of success. And over time, the high volatility of the stock market means that many retirees will experience stock returns much lower than the average. 

Entitlement wealth, however, is relatively low-risk. Obviously Social Security and Medicare benefits can be cut, which is a real risk. But the volatility of benefits is surely much less than the Standard & Poor's 500 Index, which can easily fluctuate by double-digit percentages in a given year. A far better comparison for entitlement benefits is U.S. Treasuries, which can also fluctuate in value according to interest rates, but which are generally the safest thing around. Treasuries maturing in 30 years now yield about 3 percent, which makes their expected return about as good as the one Feldstein calculates for entitlement benefits. That means America’s poor are getting an OK rate of return, as long as their risk appetite is low -- which it should be, since the absolute level of risk tolerance generally increases with wealth. If entitlements were replaced with individual medical and retirement accounts, as Feldstein suggests, many poor people would be forced to take on much more risk than they otherwise would choose to. 

So wealth inequality is actually a lot higher than Feldstein calculates. Entitlements are the main thing preventing this disparity from being even wider. And the government is giving poor people a decent rate of return. So perhaps entitlement programs shouldn’t be scrapped just yet.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net