August 14, 2004

JUST OUT OF CURIOSITY:

I ran some numbers, but you can go fiddle with it yourself:

Starting Amount:

$10,000

Return You Can Earn On Your Savings:

6%

Length of Time Invested

70 years and months

Additional Amounts Invested $

$2000 Yearly

Results

You will have $2,526,624 at the end of the time period.

MORE:
Privatizing Social Security: The $10 Trillion Opportunity (Martin Feldstein, January 31, 1997, Cato)

The Social Security payroll tax distorts the supply of labor and the form of compensation. These losses are inevitable because of the low return implied by the pay-as-you-go character of the unfunded Social Security system.

Unlike private pensions and individual retirement accounts, the Social Security system does not invest the money that it collects in stocks and bonds but pays those funds out as benefits in the same year that they are collected. (Although the system has been accumulating a fund since 1983 to smooth the path of tax rates, more than 90 percent of payroll tax receipts are still paid out immediately as benefits, and the assets in the Social Security trust fund are only about 5 percent of the Social Security liabilities.)

The rate of return that individuals earn on their mandatory Social Security contributions is therefore far less than they could earn in a private pension or in a funded Social Security system. An unfunded program with a constant tax rate provides a positive rate of return that is roughly equal to the rate of growth of the payroll tax base.

The average growth of real wages since 1960—2.6 percent—can serve as a reasonable estimate of what an unfunded Social Security program can yield over the long-term future. In contrast, the real pretax return on nonfinancial corporate capital (i.e., profits before all taxes plus the net interest paid) averaged 9.3 percent over the same period. Although individuals do not earn the full 9.3 percent pretax return even in Individual Retirement Accounts (IRAs) and 401(k) accounts because of federal and state corporate taxes, a funded retirement system could deliver the full 9.3 percent pretax return to each individual saver if the government credited back the corporate tax collections.

A simplified example will indicate the magnitude of the tax wedge implied by the Social Security program. Consider an employee who contributes $1,000 to Social Security at age 50 to buy benefits to be paid at age 75. With a 2.6 percent yield, the $1,000 grows to $1,900 after the 25 years. In contrast, a yield of 9.3 percent would allow the individual to buy the same $1,900 retirement income for only $206. Thus, forcing individuals to use the unfunded system dramatically increases their cost of buying retirement income. In the example, a funded plan would permit the individual to buy the same retirement income with a 2.5 percent contribution instead of the 12 percent payroll tax. The 9.5 percent difference is a pure real tax for which the individual gets nothing in return.

The distorting effect of this tax is much larger than one might at first think. The net Social Security tax rate is imposed on top of federal and state income taxes. The federal marginal tax rate is 28 percent (for single individuals with taxable incomes over $23,000 and married couples with combined incomes over $38,000), and the typical state income tax rate is 5 percent. The Social Security tax therefore raises the total marginal tax rate to more than 40 percent and substantially exacerbates the distortions and waste caused by the income tax.

The combination of the income tax and the payroll tax distorts not only the number of hours that individuals work but also other dimensions of labor supply like occupational choice, location, and effort. It also distorts the form in which compensation is taken, shifting taxable cash into untaxed fringe benefits, nicer working conditions, etc. These distortions in the form of compensation are in effect distortions in the individual's pattern of consumption. They cause individuals to spend their potential income on things that they value less than those things that they could buy for cash. These distortions are dollar for dollar as important as the distortion in labor supply.

In practice, these distortions are exacerbated by the haphazard relations between benefits and taxes that result from existing Social Security rules. For example, because benefits are based on the 35 years of highest earnings, most employees under age 25 receive no additional benefit for their payroll taxes. Because many married women and widows claim benefits based on their husbands' earnings, they also often receive no benefit in return for their payroll taxes. Because there is no extra reward for taxes paid at an early date, the effective tax rate for younger taxpayers can be a substantial multiple of the tax rate for older employees. The Social Security rules are so complex and so opaque that many individuals may simply disregard the benefits that they earn from additional work and act as if the entire payroll tax is a net tax no different in kind from the personal income tax.

The extra distortion that results from these very unequal links between incremental taxes and incremental benefits would automatically be eliminated in a privatized funded system with individual retirement accounts. Although it could also be eliminated within the existing unfunded system by creating individual Social Security accounts for each taxpayer, the larger labor market distortions that result from the low rate of return in an unfunded system cannot be eliminated without shifting to either a funded public system or a privatized system of individual retirement accounts.

Reduced National Saving

The loss that results from labor market distortions is not the only adverse effect of an unfunded Social Security system or even the largest one. Current and future generations lose by being forced to participate in a low-yielding, unfunded program—i.e., by being forced to accept a pay-as-you-go implicit return of 2.6 percent when the real marginal product of capital is 9.3 percent. Even though capital income taxes now prevent individuals from receiving that 9.3 percent on their personal savings, the public as a whole does receive that full return; what individuals do not receive directly, they receive in the form of reductions in other taxes or increases in government services.

The extent to which an unfunded Social Security system causes a decline in national capital income and economic welfare depends on how individual saving responds to Social Security taxes and benefits and on how the government acts to offset the reductions in private saving. Let's look at some facts.

An individual who has average earnings during his entire working life and who retires at age 65 with a "dependent spouse" now receives benefits equal to 63 percent of his earnings during the full year before retirement. Because the Social Security benefits of such an individual are not taxed, those benefits replace more than 80 percent of peak preretirement after-tax income. Common sense and casual observation suggest that individuals who can expect such a high replacement rate will do little saving for their retirement. Such saving as they do during their preretirement years is more likely to be done as a precautionary balance to deal with unexpected changes in income or consumption. Not surprisingly, the median financial assets of households with a head of household aged 55 to 64 were only $8,300 in 1991, substantially less than six months' income. Even if we look beyond financial wealth, the median net worth (including the value of the home) among all households with a head of household under 65 years of age was only $28,000.

To get a sense of the order of magnitude of the annual loss, it is helpful to begin with the simplest case in which each dollar of Social Security wealth reduces real private wealth by a dollar. The forgone private wealth would have earned about 9.3 percent, whereas the unfunded Social Security system provides a return equal to about 2.6 percent. The population incurs a loss equal to the difference between those two returns. The annual loss of real income would be 6.7 percent of the $9 trillion of Social Security wealth—an amount equal to $600 billion or 8 percent of total GDP.

Of course, each dollar of Social Security wealth does not necessarily replace exactly a dollar of real wealth. To the extent that Social Security induces earlier retirement, individuals will save more than they otherwise would. Social Security also affects private saving by providing a real annuity. And there are some individuals who, because they are irrational or myopic, do not respond at all to the provision of Social Security benefits. A number of research studies have been done on the extent to which Social Security wealth depresses saving and replaces real wealth.[8] Although none of these is a definitive study that establishes a precise measure of the substitution of Social Security wealth for other household wealth, taken together these studies do imply that the Social Security program causes each generation to reduce its savings substantially and thereby to incur a substantial loss of real investment income. Even a conservative estimate that each dollar of Social Security wealth displaces only 50 cents of private wealth accumulation implies that the annual loss of national income would exceed 4 percent of GDP.

The Gain from Privatization

Under the current Social Security system, each generation now and in the future loses the difference between the return to real capital that would be obtained in a funded system and the much lower return in the existing unfunded program. Shifting to a privatized system of individual mandatory accounts that can be invested in a mix of stocks and bonds would permit individuals to obtain the full real pretax rate of return on capital. This would mean a larger capital stock and a higher national income.

In addition, eliminating the payroll tax would reduce the distortions in work effort and form of compensation that currently depress the productivity of the economy and the real standard of living. When the system of funded individual accounts is fully implemented, the mandatory contributions required to fund the current and projected levels of benefits would be only about 3 percent of payroll, far lower than the payroll tax, which is expected to rise from 12.4 percent now to at least 20 percent over the next 35 years.

Conservative assumptions imply that Social Security privatization would increase the economic well-being of future generations by an amount equal to 5 percent of GDP each year as long as the system lasts. Although the transition to a funded system would involve economic as well as political costs, the net present value of the gain would be enormous—as much as $10-20 trillion.


-Piggy-Bank Nation (R. Glenn Hubbard, January 20, 2004, Wall Street Journal)
While the Lifetime Saving Account (LSA) offers substantial simplification benefits, it also offers a vehicle to save more easily for a downpayment on a home, children's education, or for medical expenses. With no withdrawal penalties, the account's greater liquidity will encourage individuals to save, particularly moderate-income households worried about tying up funds for a long period of time. Like the president's proposal to eliminate investor-level taxes on dividends, the LSA lays claim to the idea that income should be taxed only once. Indeed, given the generous contribution limits, most households could avail themselves of a consumption tax akin to the Flat Tax. They would pay taxes once when they earned wages or business income, but not again on returns to saving. This is an important step toward fundamental tax reform, particularly if the administration continues its recognition of the costs of double taxation of corporate income.

As is often the case with a push toward tax reform, opponents will argue that the proposals will generate little new saving, and merely reward saving done anyway, often by affluent households. Indeed, studies of what portion of contributions to current saving incentives--principally IRAs--are new saving are not conclusive.

But studies estimating what fraction of a dollar contributed to an IRA is new saving are asking only part of the question. To assess the impact on capital formation, one should compare the present value of additional private capital formation to the present value of lost tax revenue. Jonathan Skinner of Dartmouth College and I estimated that with even 25 cents of each dollar contribution as new saving, IRA contributions generate $2.21 of new capital per dollar of net revenue cost. If, as suggested by Harvard economist Martin Feldstein, one includes corporate income tax revenue from the higher capital stock made possible by the saving incentives, the ratio rises to $4.84 of net capital per dollar of new revenue cost. If each dollar of contributions contains 40 cents of new saving and one incorporates higher corporate income tax receipts, the savings incentives are actually self-financing.

The expanded savings incentives proposed by President Bush are likely to generate more substantial gains in capital accumulation per dollar of net revenue cost. By simplifying the current patchwork quilt of savings incentives, the Bush plan would increase participation. By significantly increasing contribution limits, a greater share of contributions should consist of new saving--especially over time.

But even these promising calculations don't answer the bigger question. The higher capital stock from saving incentives is not manna from heaven; rather, it is the consequence of households consuming less today to have more resources later, say in retirement. Why should we do this?

It is true that there are substantial efficiency costs of capital income taxation, and saving incentives reduce these costs. But one could more simply exempt all or part of all capital income from taxation, as President Bush did with his proposal to eliminate investor-level taxes on dividends. The Lifetime Savings Account, with its high contribution limits, would already do so for most households. But the question of the Retirement Savings Account (RSA) remains.

The usefulness of this account can be seen in the context of Social Security reform. Any successful reform that restores Social Security's long-term financial footing is likely to reduce average replacement rates (benefits relative to average wages) for young workers and future generations (I am ruling out the doubling of payroll tax rates required to finance the program in the future without such a change.). Accordingly, private saving will likely need to play a larger role. The administration's proposal would provide a significant vehicle for accomplishing this.

Posted by Orrin Judd at August 14, 2004 11:23 AM
Comments

The problem is that you are not taking account of inflation. If you use an inflation rate of 3%, then your result, adjusted for inflation, would be $314,157.

Posted by: Robert Duquette at August 14, 2004 12:47 PM

Robert:

Nope. The S&P500 has returned 6% after inflation over the last forty years.

Posted by: oj at August 14, 2004 12:53 PM

OK, that's different, but it still is not that simple. It depends on what the rate of inflation were. If the rate of return were 9% and the inflation rate 3%, you would end up with about $1,690,000. This is because the amount of your annual contribution, which is fixed at $2000, would lose value in inflation-adjusted terms over the period. In order to earn the equivalent of 6% with no inflation, you would have to increase your annual contribution each year by the amount of inflation.

Posted by: Robert Duquette at August 14, 2004 3:14 PM

Yes.

Posted by: oj at August 14, 2004 3:25 PM

I ran a simple no brainer several years, using MSN Money Portfolio.
The concept was that starting in 1982 you invested $500 once a year at income tax refund time in GE. You did this for ten years, and then, since your financial situation has improved, you begin $1,000 in GE, still in a one time a year buy at tax refund time,(I used March 16th every year).
As of the close of market on Friday the 13th,
the portfolio had total dividend income of $167,000, and a market value of $1.365 million, for a total gain, income plus price appreciation, of $1.382 million.
This from a total investment over 20 years of $15,000.
Why did I pick GE, because in 1982 I actually started this program, and in 1989 I cashed in as I had, erroneously it turns out, found a more productive use for the money in the account.
Bottom line, inflation factoring or monkey entrail reading (technical analysis) are not the criteria. You find really good companies, with a history of growth, revenue and income, paying consistent dividends, economic situation good or bad according to NYT or other doomsayers when Repubs hold the Administration, and you'll make money in the LONG TERM.
BTW OJ, I think 70 years is way too long for your example, at least use a figure like 45 years to accomodate those now, or soon to be, retiring.
One last illustration, since 1996 I've been putting $1,000 a year into five stocks,(equal $$ amounts each, $200) again at my magic tax refund date of March 16. In the eight years, and corresponding $6,000 investment, ( started contributing to 401k with 5% matching by company in 2002 so stopped this investment, but held the stocks) the account is now worth about $21,000, has had income of $1,800, with an average annual return of 23.6%.
Mike

Posted by: Mike Daley at August 14, 2004 9:35 PM

Mike:

Bravo!

The 70 years figure is for a kid born in the coming years who works uintil he's 70. Some of we the living will get shafted a bit on the transition, but coming generations should do handsomely.

Posted by: oj at August 14, 2004 9:44 PM

I read an article by Gary North over a year ago that showed that an individual could have turned $10,000.00 into over a million dollars within 3 decades and with just 3 investment decisions. It's silly (and he admitted as much) but it ran something as follows...
Jan 1970 buy a Gold index fund sell Dec 1979
Jan 1980 buy Nikkei index fund sell Dec 1989
Jan 1990 buy Dow Jones index fund sell Dec 1999

He then recommended again buying Gold index fund Jan 2000 and holding until Dec 2009 at which time he would get back in touch with you.

Posted by: h-man at August 15, 2004 7:16 AM

Gold bugs always think it's time to buy gold because Weimar hyperinflation lurks around every corner.

Posted by: oj at August 15, 2004 11:54 AM

To the Gold-Buggers:
You're talking a trading scenario, which only enriches those trading on your behalf, mutual funds and 401k's mostly, timing the market belongs in the "reading monkey entrails" category.
Buy smartly, with value investing as your guiding light, and hold forever, minus a day, and you'll see returns only exceeded by a Vegas card counter uncaught by the Casinos.
Mike
.

Posted by: Mike Daley at August 15, 2004 9:25 PM

"...The 70 years figure is for a kid born in the coming years who works until he's 70."

First, he starts contributing when he's 0 years old?

Second, he earns 6% a year every year, and doesn't hit any patches like the last five years (especially towards the end)?

Your example depends heavily on compounding, and you conveniently start way too early and then exclude the negative periods which we know exist (from recent history) to produce an unrealistically optimistic result.

You're either just shilling for the system, or you've never had enough money invested to know different.


Posted by: HT at August 16, 2004 12:15 AM

HT:

Yes, the Feds start him out with 10k at birth. Either his family or the taxpayers put in 2k every year thereafter.

Of course he hits patches--but they average out.

Compound interst is precisely the point. We can continue to pay peopple lots when they're old or a little when they're young.

Posted by: oj at August 16, 2004 12:23 AM
« THEY BROKE IT AND DON'T WANT US TO OWN IT: | Main | TRY EXPLAINING THIS TO THE STUPID PARTY: »