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Kotlikoff Fun One

I've seen a lot of people vaguely talking about Kotlikoff and Burns' The Coming Generational Storm which involves a proposal for privatizing Social Security. I didn't realize exactly how odd the Kotklikoff plan was -- and how different it is from the Bush plan -- until I read Paul Krugman's account which, somewhat unfortunately, mixes discussion of the Kotklikoff plan up with discussion of the Bush plan and other things. Here's the key bits:

Kotlikoff and Burns offer a privatization plan that doesn't try to fudge the issue of transition costs. They call for a 12 percent national sales tax to pay benefits to current retirees and older workers. This tax would gradually be reduced as the beneficiaries of the current system died off, but it would remain high for a long time. That should give you an idea of what a responsible privatization scheme would entail. . . .

The plan of Kotlikoff and Burns for personal accounts is useful as an example of what would be necessary to keep fees minimal: it calls for a system in which workers have no control at all over how their personal accounts are invested. Instead, all accounts would be placed in a global index fund administered by the government: "a single computer, situated in the Social Security Administration, would be programmed to buy and sell securities." In essence, the government, not individuals, would be doing the investing, and the personal accounts would simply be an accounting device. The administrative costs of running this system would be very low.

This second feature, in particular, is very odd. It has all the putative drawbacks of simply having the government invest the Social Security Trust Fund in equities, namely potential political interference in the investment process (Nathan Newman has argued semi-persuasively that this is a feature and not a bug, but most economists think it's a bug, my point is simply that it exists just as clearly with the Kotlikoff plan) but lacks the advantages. The good thing about centralized equity investment is that the government is ideally positioned to bear the large risks involved in equity investment. If one cohort happens to retire when the market is down, the government can simply borrow money to cover the promised benefits and then pay it back when the market is up. Generally speaking, the market goes up, so the long-term books will stay balanced. Under Kotlikoff's plan, the size of your retirement benefits will be highly variable and totally out of your control.

If you happen to retire during a downturn, you won't get very much. If you retire during a bubble, you'll reap a windfall. This is normatively objectionable on its own terms, and will also make it exceedingly hard to plan for anything. What you have hear is the illusion of a market-oriented plan, that's actually just a poorly-designed version of a socialist plan.

February 20, 2005 | Permalink

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Comments

"If you happen to retire during a downturn, you won't get very much." Not true. You won't get as much as you thought a couple years before retiring, which is a problem for planning, but you are unlikely to get less in this case than from the current set up. But I do agree that Kotlikoff's is a bad plan.

Posted by: Maestro | Feb 20, 2005 1:48:55 PM

Matt

I think you overstate the problem of retiring in a market downturn.

Investors should not remain fully invested in equities until they retire, then sell everything and live on what they got. Instead, new workers should invest 100% in equities for the first 30 years, say, of their working lives. Then begin to invest in bonds as they approach retirement.

At the time of retirement, if the equity market is down substantially, they will have enough assets in bonds to live on until the equity market recovers. Even if the equity market remains down until the bonds are exhausted, they do not have to liquidate all of their equities at once, only enough to pay living expenses so they still wiil benefit from a market recovery.

Posted by: Robert Brown | Feb 20, 2005 2:29:40 PM

"a single computer, situated in the Social Security Administration, would be programmed to buy and sell securities."

Program trading on a scale never envisioned before. Jeebus, what this would do to the volatility of the market. They put curbs on this stuff for a reason.

Posted by: flory | Feb 20, 2005 3:01:20 PM

Any plan which proposes to shift any part of the burden for Social Security to people and sectors that are not paying now is a political non-starter, the wealthier end of the Republican Party has zero interest in bailing out Social Security, even those who support the system in principle.

You want a simple, relatively cheap tax plan to get us out of "crisis"? Just take the hit on payroll. Why I would want to pay 12% on every product I buy to avoid a 1.89 point increase in payroll is beyond me, even if I had to pay both halves (rather than have my employer pick up half). Per the Census bureau median household income in the US was $43k, but lets just look at what happens at $50k (only eight states have median incomes above that). 1.89% of 50000 is $945. For more than half of American household that would be more than enough to fill the projected gap. For the guy making $10/hour ($21k per year) we are talking $393. And if employers pick up half this guy is only on the hook for $196.

There is a reason why Bush take payroll tax increases right off the table. For most Americans they are way cheaper than assuming their share of trillions of dollars in debt.

Now I have argued and continue to argue that the system is not in actual trouble, we wouldn't need that additional payroll. But the fact is that even under the overly pessimistic and outdated assumptions of the 2004 Report 1.89 points is all it takes to fully fund Social Security.

So that is my plan, take whatever hit the Trustees project in the March 2005 Report (it will be less than 1.89) and wait a year. If the economy outperformed the projection cut the rate accordingly. Given that averaging 2.0% in the outyears more than solves the gap on its own, every year we get normal growth we get a tax cut, every year we get better than normal growth we get a bigger payroll tax cut.

Filling the gap projected in the March 2004 Report by payroll tax puts no single household out more than 1.89% of $90,000 or $1701. And for most people the amounts are well below that. Those are the baselines: privatizers need to make the case that whatever their plan requires it costs less than $393 dollars a year for a guy making $20k, $946 for the household making $50, or $1700 for those earning at the top. This is the gold standard, this produces 100% of promised benefits. And BTW privatizers have to use the same economic numbers.

Their numbers just won't run, they can't produce a better plan with better results. It can't be done. So call the bluff, take the modest hit, and then wait for the economy to prove we didn't need the boost. Simple and effective.

Posted by: Bruce Webb | Feb 20, 2005 3:09:03 PM

If there is going to be a generational storm over burdens older Americans are supposedly imposing on younger Americans, the real issue ought to be the big run-up in the national debt (about doubling under Bush) that we are passing onto them. Since SS can be fixed with SS taxes more or less where they are, perhaps with an increase in the income maximum, it is not really an issue here.

Posted by: Bob H | Feb 20, 2005 6:13:17 PM

To clear up some misconceptions about Kotlikoff's specific plan:

First and foremost, he wants the government to invest in some entire-market index fund (e.g., every publicly traded company weighted in accord with its market capitalization with re-jiggering at decently long intervals in decently spread out ways). He agrees government picking particular stocks or even particular sectors or even the entire market but with constant re-jiggering of the index funds proportions would be a disaster. (He doesn't address the slippery slope argument of once the government starts investing in the market as a whole, some idiot or corrupt bastard is going to come along and demand that we invest in particular sectors and then particular firms. After all, that money that went into the Social Security Trust Fund has ended up not being used to bring the overall national debt down significantly in time for baby boomer's retirement.)

Also, echoing Robert Brown's comments, Kotlikoff's plan has the government incrementally cash out one's savings account over a 10 year period leading up to retirement to average out as much market volatility as is practical.

In closing, Kotlikoff's not a hack and his ideas deserve thoughtful rebuttals. Though I don't agree with his policy proposals, his work gives me significant pause (and more importantly and authoritatively, while people like Paul Krugman don't agree with Kotlikoff's proposals, Kotlikoff's work given them significant pause too). The fact that someone like Kotlikoff thinks the country's fiscal situation---calculated in an honest, unified way---is dire enough to say that in all likelihood,

1) Over the next 75 years, the government cannot afford to give annuities that are indexed essentially to the growth in real wages, and

2) As soon as possible, the government should mandate that its health care expenditures will grow no faster than real wages,

should scare the s$@# out of all of us.

[On that note, let me just say while I understand the political reasoning to take a more extreme position than the facts warrant, that blinking "There is no crisis" ad annoys the hell out of me. There is no social security crisis only as so far one believes the rest of the government will move to essentially balanced budgets and health care cost growth can be brought in line with wage growth. So I'd say, yes, there is a crisis. The fact that President Bush and the Republicans have willfully and enormously exacerbated it, doesn't mean there isn't one. Granted, the crisis could be solved in extremely social democratic ways too... but all that'd be predicated on raising the fraction of GDP that the government takes in as taxes several percentage points beyond the 20% of the 1990s and currently absurdly low 16% after 3 rounds of Bush tax cuts.]

Posted by: Bill Kaminsky | Feb 21, 2005 3:26:15 AM

Bill "there is no crisis" may annoy the hell out of you, but it is true within the parameters of the argument. You can argue that in the end the government is the government and revenues are revenues and have a point of sorts. But the reality is that government in this case is operating in components: we have an identifiable revenue stream in and out of the Social Security Trust Fund and a separate revenue stream flowing into and out of the General Fund. They are separate line items on my pay stub and can properly be taken in isolation. This is particularly true since they don't draw from the same population. In one case we have an income stream that derives only from payroll tax, and that capped at $90,000, in the other case we have an income stream that derives from all income.

Any appeal to the problems of Medicare and the General Fund to justify tinkering with the identified income stream that finances Social Security is fundamentally dishonest. The Social Security system was designed to take workers' money to finance workers insurance and retirement. Capital was not required to pay in and was not expected to get a pay out. Arguing that national financial problems justify raiding the Trust Fund is no more justifiable than arguing that Gov Ahnuld should be allowed to raid CALPERS (the State Retirement plan). CALPERS is doing fine with its investments and the State is in budget crisis. Well the latter is in the end not CALPERS' responsibility.

Social Security is not broke, there is no "Social Security Crisis", and trying to move the goalpost to address the challenges for Medicare and the consequences of Bush tax cuts is not going to work.

And BTW you might want to give some evidence to back this claim:
"1) Over the next 75 years, the government cannot afford to give annuities that are indexed essentially to the growth in real wages,"

Because we have an identified revenue stream, paid entirely by workers, that can afford to pay off wage indexed annuities. The fact that rich people chose to take their slice of the pie now in the form of tax cuts and so put the overall financial health of the country at risk does not give them the rights to raid a worker retirement plan that given ordinary economic growth is actually overfunded.

Got Numbers?

Posted by: Bruce Webb | Feb 21, 2005 8:18:36 AM

Bruce Webb,

I think it is incorrect to completely isolate SS from the rest of government. Yes, SS has a separate funding structure, but it is competing for private sector resources with other parts of government. Since SS is not a separate company competing for those resources in a free market, but is controlled by the same political body that allocates resources to all parts of government, that body must take all funding demands into account over time.

So, if we want to offer a new drug entitlement to medicare or want to spend more on younger people through education, for example, SS must be looked at in light of the new demands on the private sector.

By the way, the payroll tax is constantly used as a rational for giving refundable tax credits to people who do not pay income taxes, so the payroll tax is not politically isolated from the income tax.

Posted by: Robert Brown | Feb 21, 2005 9:48:26 AM

In reply to Bruce Webb:

1) I agree from a moral standpoint one has a strong argument in saying there is no social security crisis. We've always explicitly dedicated payroll tax revenue to Social Security, and the excess of it since the 1982 payroll tax hike has been used to buy bonds under an explicit promise that this excess money would be used to pay down the federal debt in time for the baby boomers' retirement. I agree that saying, "Sorry, it appears government finances on the whole are inadequate... first on the chopping---oops, I mean reform---block is Social Security" is flagrantly immoral, especially when said finances are nearly twice as bad due to income tax cuts passed in the last 4 years.

2) However, I feel there is in fact a strong point to be made that government finances on the whole are inadequate in the specific sense that in virtually all scenarios, there's no way for the the US federal government to keep its its revenues within the post-WWII range of 16 to 21% of GDP (post WWII average = 18.4% GDP, if you're curious) while paying all its current obligations without leading to an explosion in debt as a percentage of GDP sometime between 2020 and 2050.

I by no means wish to imply that this means Social Security needs to be moved away from an annuity system that's largely in line with real wage growth and Medicare growth needs to be explictly limited to real wage growth a la Kotlikoff et al if economic disaster is to be averted. But I do hold that if one doesn't want to take these steps, then one's looking at a significant increase government revenues beyond the post-WWII range to something like 23-25% GDP (or more if health care costs continue to grow much faster than real wages).

Now in my mind that's hardly big government by any developed world standard other than America's own idiosyncratic one. Heck, deep down in my heart, I'd like to see government revenues somewhere in the 25-30% GDP with universal health care coverage and Edmund Phelps/Matthew Miller-style living wage subsidies being bought with the extra money. But I bear in mind that despite this being a significantly smaller fraction of GDP than the European norm, just paying off our own currently fraying retirement safety while keeping the rest of the govenrment's per capita spending constant in real terms---let alone adding universal health coverage and living wage support---would entail a major expansion of US government revenues... especially compared to the current low of nearly just 16% of GDP thanks to many rounds of Bush tax cuts.

Posted by: Bill Kaminsky | Feb 22, 2005 12:58:34 AM

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