$2.2 Trillion Down
March 25, 2005; Page A8

Everyone in Washington has now used this week's Social Security and Medicare Trustees' report to justify his or her political program. We suppose that's better than ignoring it. But as we look at the details, the most important figure in the report has received almost no attention.

That number is $2.2 trillion, which is the difference between the current size of the Social Security "Trust Fund" ($1.7 trillion) and what it will grow to become over merely a decade through 2014 ($3.9 trillion). More precisely, that is the amount of payroll tax revenue that workers will pay between now and 2014 that exceeds what will be spent over that same period on retiree benefits. The Trustees predict the payroll tax will continue to exceed benefits through 2017, but their report breaks out the numbers in detail only through 2014. In any case, $2.2 trillion is a lot of money, even in Washington.

And what will happen to that surplus cash during these next 10 years? Every dime of it will be spent by politicians on current government. Not a nickel will be saved; nothing will be invested in accounts with anyone's name on it. Instead of building assets, or contributing to an increase in net national saving and thus investment, all of it will finance current government consumption.

The reform debate so far has too often detoured into the cul-de-sac of "transition costs" and IOUs and what's going to happen in 2041 when the Trust Fund itself is empty -- or is it really 2042? Who cares? The far more urgent issue is how to capture today's surplus payroll tax revenue and put it to more productive use. If Social Security reform means anything, it ought to mean recapturing some or all of that money.

Yet politicians on both sides of the debate rarely talk about this. That's probably because over the years both Republicans and Democrats have been complicit in spending this Social Security surplus on their own pet causes. We can understand why Democrats would want to continue this ruse even today, since most of them want to pretend there's an account in a bank somewhere that taxpayers own.

But what's up with Republicans? Some of them may fear that if this secret gets out to enough voters, they'll have to stop using that excess revenue to make the budget deficit look smaller than it is. But if they believe in smaller government, they should consider this $2.2 trillion revelation to be truth-in-advertising that shows just how spendthrift Washington is.

Letting individuals keep and invest this excess payroll tax money, which they've earned, is the nub of the entire Social Security debate. And we suspect it's the only argument that reformers have that will trump the scare tactics and accounting obfuscation of opponents.

Ants and Grasshoppers

Today's Social Security reform peddler has the charm of a 19th century dentist. The long-run imbalance has morphed into an abscess and personal accounts into the painful but curative analogue of tooth-pulling. When President Bush implied in his State of the Union address that Social Security would run out of funds in 2042 his opponents audibly groaned. Such a focus on long-run projections, however, is unfortunate. It distracts from the true reasons for reform.

To see why, it is useful to step back for a moment and consider the sorry financial deal that Social Security offers current workers.

Suppose that a "retirement genie" alighted on your doorstep and informed you that he had just taken the liberty of reorganizing your finances. To ensure your future safety, the genie transferred all of your savings into a special account with a number of features. First, you cannot touch the monies in the account until you retire. Second, if you and your spouse die, the money is lost unless you have school-aged children. Third, the minute that you retire you will be forced to convert your entire accumulation into an annuity that dribbles the cash out at a low monthly rate. Fourth, the account funds cannot be invested in a well-diversified portfolio of stocks and bonds, but must be parked in a single low-yield government instrument. Finally, you must contribute 12.4% of your earnings into the account every year.

It is hard to imagine that anyone would view these machinations as good news. Indeed, the constraints have a nightmarish quality to them. Since you cannot touch the money until you retire, you no longer have a rainy-day fund, or a down payment for a house. Those whose family histories include significant health risks are punished in one of two ways. If they die before they retire, they never get their benefits. Even when they survive to retirement, they are less likely to live long enough to make the annuity a good deal.

The constraint that the monies not be invested in a well-diversified portfolio violates standard professional practice. Finally, common sense and economic theory suggest that savings should be negative when individuals are young since incomes generally rise throughout adult life. It makes more sense to save when you have relatively higher income. The steady contribution path forces you to live a Spartan life in your youth, often relying on costly credit-card debt.

These constraints are, of course, all features of the current Social Security system. And they have a real cost. To imagine how big this might be, suppose the genie offered to remove all of the constraints on your account. How much would you be willing to pay?

You should be willing to pay a lot. Recently, economists Eric Hurst and Paul Willen of the University of Chicago set out to explore this question in a working paper published by the National Bureau of Economic Research. While the paper does not address all possible considerations, their estimate provides a ballpark figure for how people value the system. They found that fully rational individuals who calculated precisely the true costs of the constraints associated with the current Social Security system might be willing to pay as much as 7.5% of their lifetime consumption to get out. The number is so high because the constraints are painful and because Social Security is the primary wealth of many Americans. The Social Security Administration, for example, recently reported that about two-thirds of retired Americans aged 65 years or older receive at least half of their retirement income from Social Security payments.

A supporter of the status quo might respond that Social Security was not designed to make rational individuals better off. It forces irresponsible "grasshopper" individuals to save for their retirement along with responsible "ants." This way, the ants will not have to feed the grasshoppers when they are old. But recent estimates suggest that about 80% of Americans behave quite rationally, saving much the way the economic models say they should. Economic research has revealed that 80% of Americans are ants. Consequently, today's system forces the vast majority to endure a straight-jacketed program that reduces their lifetime welfare significantly, all for the benefit of a small minority.

In 2004 alone, 7.5% of the consumption of America's ants amounted to about $500 billion. With the welfare cost of an irrational system that high, there is plenty of room to achieve fiscal balance by reducing future benefits. That is because today's workers are so much better off if they are granted more control of their money.

The system's costly constraints were designed for a different world. When Social Security was introduced in 1935, for example, modern portfolio theory had not even been invented, and sensible financial advice was unavailable to the masses. But today, it is easy to conceive of modifications that protect the grasshoppers at a much lower cost, and most of these rely on some form of personal account. Listing the problems of the current system makes the rationale for accounts transparent. Individuals with personal accounts control their own funds, and value the freedom to do so.

A reform that reduces the large annual burden of Social Security's antiquated financial constraints offers our citizens a welfare enhancement regardless of whether it addresses any fiscal imbalances. While fiscal responsibility is a worthy objective in and of itself, in this case it is a sideshow. It does not matter if the current program runs out of funds in 2042, 2075 or never. Social Security should be reformed because a better policy exists today that will significantly enhance Americans' welfare.

Mr. Hassett is director of economic policy studies at the American Enterprise Institute.