Alvaro Tejada

December 13, 2013

Social Security Reform and National Saving
The Social Security Act of 1935 was one of the landmark legislations in American
history. Since its establishment, the Social Security system has faced with challenges
relating to not only public welfare but also its economic impact on the United States.
Today, Social Security is one of the many challenges facing current and future
generations. It is clear that the system is an integral part of society but it also presents
many economic problems that can be devastating. I seek to analyze the impact the current
Social Security system has on national saving, personal saving plus public saving, and its
economic implications. In its inception, the system was on a pay-as-you-go basis funded
by payroll taxes; this system has undergone many changes, particularly the 1983 reform
which transformed the system into a partially funded pension system. It is important to
analyze how Social Security affects saving, and conversely consumption, because
through this analysis it can bee seen how present and future generations will be affected
by the system, by which we can understand how to reform the system or perhaps leave it
as it is.
Social Security provides pensions and insurance for old age and survivors, for the
disabled and for hospital expenses through Medicare. The primary source of income for
Social Security pensions is the payroll tax, which is at 6.2% of a workers wage plus
6.2% on the employer, 2.9% for Medicare (employees and employers each paying
1.45%) 1. From its inception Social Security has been a pay-as you-go system in which
1 United States of America. The United States Social Security Administration. Status of
the Social Security and Medicare Programs. Social Security Board of Trustees, 2013.
Web.
1

payroll taxes collected from current workers are immediately given to current retirees. In
1983, Social Security was reformed to make it into a partially funded system, in which
current payroll taxes would go into a Trust Fund, which will be used to pay retirees. The
Trust Fund has been operating under a surplus since 1983, but an increase in retirement
will cause the assets in the Trust Fund to be depleted by the decade of 2040, according to
current forecasts by the Trustees. The United States government has also been operating
under a budget deficit for the past decade and has used the Trust Fund to finance
expenditures. This system of Social Security places added burden on the United States
government, as it has to comply with the obligations to pay current and future retirees.
The opposite of a pay-as-you-go system is a fully funded system. I shall analyze the
differences in these systems and how they affect national saving.
The pay-as-you-go system was introduced with the passage of the Social Security
Act of 1935. In order to assure that current retirees were compensated, the payroll tax
was adopted. Thus, the retirees of the 1940s had an advantage over younger workers as
they never had to pay taxes into the system yet are full beneficiaries of the system
anyway. After the introduction of a pay-as-you-go system, the initial generations of
beneficiaries raise their current consumption by more than other generations reduce their
current consumption; the elderly have higher propensities to consume than workers and
the wealth transfer is paid for not just by current young workers (with lower propensities
to consume) but also by future generations, who cannot reduce their consumption at the
time the program is introduced because they are not yet alive. Thus, private saving falls,
no public saving occurs in a pay-as-you-go system because none of the taxes are saved,

therefore there is no equal public saving to offset the fall in private saving, therefore
national saving falls.
Martin Feldstein (1974) lead the way in the theory that Social Security (in its not
fully funded system) has a negative effect on social security. Using calculations from
1971, he found that social security taxes reduced disposable income by $51 billion in
1971 prices corresponding to a reduction of personal savings of $18 billion dollars. He
further states that the net social security wealth for 1971 was $1,162 billion, which
implied a reduction in annual saving of $43 billion dollars (Net Social Security Wealth is
equal to the present value of benefits minus the present value of contributions.2 Since the
net social security wealth is positive in Feldsteins analysis, according to Engen and Gale
(1997) social security would raise lifetime utility, and consumption in each period would
rise. They go on to say that private saving would fall by more than the workers
contributed to the social security system, a result of the substitution effect (change in
relative prices) causes private savings to fall by the amount of the contribution and an
additional amount of savings lost/increase in consumption because of the wealth effect.3
Another disadvantage to pay-as-you-go is the lower rate of return workers receive when
they retire as opposed to the market rate of return they could receive had they been
allowed to save (invest) their money elsewhere. According to a 1998 study by Timothy
Cogley, a mature pay-as-you-go system would pay a real return equal to the growth rate
of the tax base, which in the long run is equal to the rate at which the work force grows
plus the rate of productivity growth; this rate is about 2.5% in the United States, on
2 Feldstein, Martin Journal of Political Economy , Vol. 82, No. 5 (Sep. - Oct., 1974), p.
905-926. Web
3 Engen, Eric M. and Gale, William G., (1997), Effects of Social Security reform on
private and national saving, Conference Series; [Proceedings], issue Jun, p. 103-142.
Web.
3

average. 4 The market rate of return (which has averaged 8.5% return over the last 40
years) exceeds this, therefore workers experience a substitution effect due to forced
saving and change in relative prices (rate of return); as stated previously, the substitution
effect creates a loss in private savings (which would have other wise been invested) equal
to the payroll tax paid by workers.
If Social Security affects saving negatively, this can cause a decrease in
investment that decreases capital and concurrently lower wages; output decreases over
time, creating a less productive economy, a phenomenon referred to as crowding out.
This can be noted above, in which a lack of saving would reduce investment in the
market (as workers are forced to invest in the Social Security system) Martin Feldsteins
analysis of saving takes into account the life-cycle hypothesis, in which workers consume
at a young age, save for retirement, and then consume when they are retired. This
analysis of saving can only hold true if this hypothesis holds true; too many variables
exist that can change a persons behavior therefore they have to remain constant. The
Auerbach and Kotlikoff model (by Alan Auerbach and Lawrence Kotlikoff) utilizes OLG,
meaning an overlapping generations model to further provided evidence for Martin
Feldsteins analysis. An OLG model assumes the life-cycle hypothesis and eliminates
variables such as planned giving when comparing two different generations of people
(retired and young workers). In their 1987 work Dynamic Fiscal Policy, they tested an
OLG model utilizing Social Security and found that the addition of social security created

4 Cogley, Timothy. "On the Transition to a Fully Funded Social Security System." Letter.
13 Mar. 1998. Federal Reserve Bank of San Francisco. N.p., n.d. Web. 5 Dec. 2013
4

a decrease in capital and wages.5 These findings share correlation with the assumed
consequences of a decrease in savings that are stated above.
The alternative to a pay-as-you-go system is a fully funded system of Social
Security. A fully funded system is the method utilized by private retirement accounts
(401k), in which an employee pays into an account, with no tax liabilities, and receives
the money paid into the account after retirement, when it is taxable. Under this method, a
workers private saving goes down but public saving goes up by the amount which the
workers private saving decreased, therefore national saving remains unchanged. The
government assumes no risk under this method; it is up to the worker to pay into the
retirement account. If Social Security had been initially set up as fully funded system, the
initial generation would not have received the transfers they received under the pay-asyou-go method, this is because they would have not contributed to the system. The
retirees of that time period would not have received any retirement benefits, the first
generation to receive benefits would have been the young workers during that period who
contributed to the system and would receive benefits upon retirement. The reduction in
saving caused by the wealth transfers (in pay-as-you-go) to the initial generation would
not be present. Therefore saving would not have been affected had the system been fully
funded from its inception. One problem with this was the political repercussion of not
helping the retirees at the end of the Great Depression. This forced the hand of the
government and they had no choice but to revert to a payroll tax and pay-as-you-go
funded system to eliminate political repercussions.

5 Auerbach, Alan J., and Laurence J. Kotlikoff. Dynamic Fiscal Policy. Cambridge
[Cambridgeshire: Cambridge UP, 1987 p. 145-161. Web.
5

The fully funded system has been used as a model for Social Security Reform and
its privatization. Martin Feldstein (1996) proposes that a privatized fully funded system
would require that employees or employers contribute to a retirement account. Unlike the
pay-as-you-go system, which has a fixed rate of payment, in this system employees and
employers can choose the amount they seek to invest. These funds are then invested in
stocks and bonds.6 The substitution effect experienced in the unfunded system does not
exist; private saving is not affected because the amount contributed to the plan is an
amount that a worker would have otherwise saved and it is at a higher rate than the
unfunded social security system. One major problem with a transition form the current
system to a privatized system is the effect on the transitional generation. Feldstein
proposes that the government should borrow funds to cover the benefit expenses for that
generation; at this time, saving remains static and the capital stock does not grow. He
further states that as the system progresses, saving will increase and the capital stock will
increase. The economics behind this proposal make sense, but under the current fiscal
environment, it is difficult to convince the public that the United States government
should borrow more money. The government is already in state in which it uses money
form the current Social Security trust fund to fund other government expenses.
Peter Diamond, an economist from the Massachusetts Institute of Technology,
opposes Feldstein on the privatization of the Social Security System. Diamond (2005)
states that after the assets in the Trust Fund are depleted, reform should not be focused on
overhauling the system, but rather to make solvent7. He proposes that an increase in
6 Feldstein, Martin. 1996. The Missing Piece in Policy Analysis: Social Security
Reform. American Economic Review 86, pp. 1-14.
7 Diamond, Peter A., Social Security, the Government Budget and National Savings
(March 17, 2005). MIT Department of Economics Working Paper No. 05-09. Web.
6

payroll taxes and a decrease in benefits can allow the Trust Fund to accumulate assets and
become solvent. Overall, Diamond claims that national saving will not be affected.
During the initial tax increases, consumption falls and saving rises. After the return on
the increase of trust funds is received, consumption rises. The rise in consumption
matches the increase in national income from the original period, therefore leaving
national saving unaffected. Diamond believes, like many proponents of keeping Social
Security, that peoples decisions regarding retirement, especially the poor who have a
higher marginal propensity to consume, should be made by the government. Whereas
supporters of privatization, like Martin Feldstein, believe people should be able to make
their own choices regarding retirement and the amount they seek to save. The one caveat
for Feldstein system of privatization is that a government mandate still exists regarding
contributions to retirement accounts. Feldstein would also argue that the current system
does not help the poor due to the payroll taxes; payroll taxes are regressive, in that they
proportionally affect the poor more than they proportionally affect the rich. Therefore,
according to Feldstein, the government is not looking out for the interests of the poor by
imposing a regressive system of taxation to fund Social Security.
Proponents of the pay-as-you-go system claim that the effect of Social Security on
national saving is overstated. One such argument can be rooted in the Ricardian
Equivalence principle, which argues that consumer spending/saving is not affected by
government tax changes or public debt. Economist Robert Barro (1974, 1989) argued that
even if the pay-as-you-go system did affect saving, it would be offset by individual
planned giving, or altruism, from the elderly to the young. This transfer from elderly to
young would offset the initial transfer from young to elderly, therefore not affecting

private saving. He further states that any increase in taxes by the government would be
offset by bequests from one generation to the next. Barro does not take into account the
poor for example, who have high marginal propensity to consume from the time they
work and during their retirement. They save very little of their income. The idea of
bequests can only be attributed to those who are most well off in the population. Martin
Feldstein (1976) argued that Barro ignores economic and population growth in his model,
and that in a growing economy public debt negatively effects saving.
Although arguments to the contrary exist, it can been seen that Social Securitys
effect on saving can have drastic effects on the long run economic future of the United
States. I believe the government should transition into a privatized system or at least
partially privatized during the period that the trust fund is beginning to be depleted. In a
partially privatized system, the government invests the funds contributed by employees
and employers into stocks and bonds, unlike a fully privatized system in which firms
handle the investments. One issue with a partially privatized system is the fear that
government may take an ownership position in private companies. The government may
have its flaws, but I believe people have more trust in the government using their money
rather than private firms, judging by the mistakes made during the financial crisis. A fully
funded system would have positive effects on saving. If saving were increased, then
people and firms would have more funds to invest in capital. Capital growth leads to
wage growth and an overall more productive economy. As previously stated, the problem
with privatizing the system is the uncertainty of providing the transitional generation with
benefits. I agree with Feldstein in that the government should borrow money to provide
benefits for that generation. He states that this public deficit would deplete saving

initially and affect capital growth, but when the system kicks into gear it should increase
saving from the required contributions under the new privatized plan.
Since its inception, the Social Security system has served as a partial solution to
the problems posed by social welfare by providing insurance during retirement, but it has
created economic questions and challenges that have to be dealt with by current and
future generations. My analysis has shown that the current Social Security system,
partially funded, has had a negative impact on national saving in the United States. By
changing the system to a fully funded plan, I believe the government can become more
financially solvent and create economic growth through an increase in savings. Worker
would be allowed to make their own decisions regarding their retirement plans, but
incentives would be in place to encourage them to save for retirement (particularly higher
interest rates and a requirement to contribute to a private retirement account). Social
Security is one of the many challenges facing our generation; I believe changes have to
be equitable and efficient. Although some would not agree that social security has any
effect on saving, it is evident that changes have to be made, whether drastic or minor, to
the system in order for the American economy to remain stable.

References

Auerbach, Alan J., and Laurence J. Kotlikoff. Dynamic Fiscal Policy. Cambridge
[Cambridgeshire: Cambridge UP, 1987 p. 145-161. Web.
Cogley, Timothy. "On the Transition to a Fully Funded Social Security System."
Letter. 13 Mar. 1998. Federal Reserve Bank of San Francisco. N.p., n.d. Web.
5 Dec. 2013.
Diamond, Peter A., Social Security, the Government Budget and National Savings
(March 17, 2005). MIT Department of Economics Working Paper No. 05-09.
Web.
Engen, Eric M. and Gale, William G., (1997), Effects of Social Security reform on
private and national saving, Conference Series; [Proceedings], issue Jun, p.
103-142. Web.
Feldstein, Martin Journal of Political Economy, Vol. 82, No. 5 (Sep. - Oct., 1974), p.
905-926. Web.
Feldstein, Martin. 1996. The Missing Piece in Policy Analysis: Social Security
Reform. American Economic Review 86, p. 1-14 .Web.
United States of America. The United States Social Security Administration. Status
of the Social Security and Medicare Programs. Social Security Board of
Trustees, 2013. Web.

10

11