The Hindu Business Line : Social security reforms in the US — Lessons from the privatisation debate

A debate is raging in the US over the implications of the social security reforms. Privatisation of the system would aggravate the fiscal crisis, unless taxes are raised and/or promised benefits are cut. Simply borrowing more money to plug the hole arising out of diversion of tax revenue to private accounts will not solve any of the basic problems.

SOCIAL security (equivalent to what in India is called the public pension system) reform is No 1 on the US President, Mr George W. Bush's agenda and he is pushing it with missionary zeal after his re-election.

A heated debate is raging in the US media over the implications of the proposed reforms. The issues are important as they have lessons for other countries (like India) which are also thinking of reforming their pensions systems by partial privatisation on an urgent basis.

For Mr Bush, social security reforms are a part of his broader goal to create an "ownership society". He wants to reverse the vision enshrined in the "New Deal" of President Roosevelt immediately after the Great Depression of the 1930s. Roosevelt fostered a big role for the welfare state, which would take the primary responsibility of looking after the people in their old age, when they are sick or are unemployed.

Mr Bush's ownership society model proposes to give the primary responsibility to individuals to look after themselves after retirement. From now on, a part of the payroll taxes paid by employees and employers (equivalent to India's compulsory PF contribution) would be diverted to individual investment accounts. Each worker (not the government agencies) would decide how to invest his money and how much risk he would like to take by choosing among investment options.

The supporters of the scheme argue that under the new scheme individuals would be able to get a higher return on their savings from the private market than they have got so far when the social security funds have been mostly invested in government securities.

Some even argue that the pension trust funds have been used by the government for other purposes — so there is "all trust, and no fund".

But the individual fund accounts cannot be snatched away by the government.

Moreover, this way, the government (and the future generations of workers and tax payers) would gradually get rid of the fiscal burden of providing a guaranteed pension to retirees.

According to the Bush administration, the social security is "heading towards an iceberg". Unless the course is changed urgently, it will be a disaster as the baby boomers will enter the retirement phase soon and live longer relative to the earlier generations.

The critics of the Bush reform proposal train their guns along several lines. First, they do not see any immediate crisis. They concede that paying guaranteed pension (linked to rising real wages over time) to an ever-increasing number of retirees per current worker is a problem in the long run. (The same is true for India and most other countries.) But it is a relatively minor problem compared to the long run fiscal implications of Bush tax cuts.

The social security trust fund has an accumulated reserve of $1.5 trillion (from net inflows and interest earnings over the last two decades), held in Treasury bonds.

Even without any reforms, the programme would be able to pay full promised benefits to retirees till 2042 (when the surplus will be wiped out) and at least 70 per cent of the benefits after that. The long-run financial gap over the next 75 years would be $3.7 trillion whereas Mr Bush's tax cuts (if made permanent) would cost $11.6 billion. Yet, Mr Bush does not want to reverse his tax cuts.

Second, they feel that the system can be reformed by a gradual increase in payroll taxes and a cut in guaranteed benefits to future retirees over time, rather than by privatisation, which is fraught with great risks.

One way is to have only price indexing to ensure a fixed real income to pensioners but delink the pensions from real wage increase over time.

Under the current system, since the guaranteed pension is a fixed fraction of (roughly) last pay drawn (same as in India) and real wages are going up over time, an increasing amount (in real terms) has to be paid to new retirees.

Third, they argue that the Bush reform by privatisation will hurt the elderly poor. The experience from one country (Chile) that is often cited as a "success story" (private accounts were made compulsory in Chile, unlike the proposed voluntary private scheme in US) indicates that a large fraction of worker's contributions would simply go as fees to private investment companies. This would particularly hurt the poor people with small accounts.

In Chile, management fees take away about 20 per cent of social security revenues, as compared to 1 per cent overhead costs of the current US system.

Even in the UK, a more developed country where partial privatisation of pension systems was enacted during the Thatcher government, the fees to private fund managers absorb about 20-30 per cent of an individual's pension savings (according to the British Pension Commission).

The chances of poor, less knowledgeable people being duped by private fund mangers are also very high.

One possible solution could be that investments for small investors can be restricted to only low-overhead index funds (which invest in a diversified portfolio over all major companies listed in a stock exchange and, hence, yield a return equal to the average performance of the stock market) managed by selected reputed fund mangers.

But, then, the investment decisions would be made by government officials not individuals (unlike "the freedom to invest your own saving," as is being advertised by the Bush administration). In the end, the government in Chile has been forced to provide subsidies from the government budget to save many retirees from abject poverty. The accumulation and return from their individual accounts were not enough to keep them above the poverty line.

So, ultimately, the government budgetary problem on pensions account did not diminish even after 20 years of reform. Persons who would clearly benefit would be the private fund mangers. That is why Wall Street financiers and political leaders looking after their interests are the most ardent champions of the Bush reforms.

Fourth, even though it may not solve the long run fiscal problem, it would immediately increase the government debt. As a part of the current payroll, tax revenue gets diverted to private accounts but the current retirees and near retirees will have to be paid pensions at old rates; the government will have to borrow to meet the shortfall.

According to US Congressional Budget Office estimates, this would require about $15 trillion extra borrowing over the next 45 years after which the new scheme may start to save government money under the best possible scenario. This is several times the $4.3 trillion of government debt outstanding today. Additional borrowing on this massive scale is sure to raise US interest rates, undermine economic recovery, diminish investor confidence in US economy and may precipitate further fall in the US dollar.

The opponents feel that one should not hurriedly make fundamental changes in a time-tested programme.

The programme can be made solvent by a gradual rise in payroll taxes and cuts in guaranteed benefits over time. The suggested Bush reforms by privatisation (though it would be made voluntary to start with but may well be made compulsory to new entrants) would aggravate the fiscal crisis, unless somehow taxes are raised and or promised benefits are cut. Simply borrowing more money to plug the hole arising out of diversion of tax revenue to private accounts will not solve any of the basic problems.

The real cost of reforms are hidden from the public and it is being advertised as the only way out of an immediate crisis. But the medicine may well be far worse than the disease.

According to Dr Paul Krugman, a distinguished liberal economist, the Bush reforms would mean that US budget deficit would exceed 8 per cent of GDP at some point during the next decade. In his words, "that would make Carlos Menem's Argentina look like a model of fiscal responsibility".

So, beware, the supporters of privatisation of social security in all countries (including India)!

(The author, a Professor of Economics at IIM Calcutta, is currently a Visiting Professor of Economics at University of Rochester, USA. His e-mail: alokray15@yahoo.com)

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