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Friday, July 12, 2019

Only One Chance: Entitlement Reform Done Wrong

I sometimes take flak for criticizing fellow libertarians and conservatives for their efforts at restraining or shrinking government. However, we have such a small window within which to get the reforms right that any attempt must have the absolutely highest probability of success. Here is an example of how to - yes - get it wrong.


The one problem with President Trump's otherwise good tax reform is that it did not give the economy enough of a growth injection. The original idea Trump had would have done that, but his reform got watered down by Republicans in Congress. Instead of being an all-out growth infusion it failed to provide enough of a boost in tax revenue.

As a result, our deficit is now approaching catastrophic levels.

I pointed to the faults in the GOP reform already before it passed Congress. In December 2017 I noted that the tax reform
is not designed to, first and foremost, stimulate growth. Its primary goal is to secure tax revenue, and only secondarily to grow the economy. In its totality, the reform may minimize the next revession and could possibly even help avoid it (though that is unlikely), but it will not boost GDP growth beyond the 2.5-percent territory where se seem to be stuck, temporary growth spurts notwithstanding.
Subsequently, others have tagged on with less analytical observations of the same problem. Now a new book from the Institute for Policy Innovation takes a more comprehensive approach to the cause of perennial deficits: the welfare state.

The book, On the Edge: America Faces the Entitlements Cliff, is authored by Mark E Litow and Merrill Matthews, Ph.D., and claims to provide a sustainable solution to our government's fiscal crisis. The solution consists of reforms to entitlement programs, aiming to confine their growth to what taxpayers supposedly can afford.

I do, of course, appreciate the efforts by fellow libertarian travelers. The IPI bills itself as
a free-market policy think tank that focuses on issues related to economic growth, innovation, limited government and individual liberty.
The problem is that Lipow and Matthews have not done their homework. I hate to point this out, but there is so much at stake here that we cannot afford to make mistakes. The federal government's budget is in terrible shape: as I explained recently, the deficit amounts to one quarter of every dollar spent. In the midst of the strongest economy in 20 years.

The outlook for the next recession is nothing short of abysmal. We will not get any reforms in place to prevent the deficit from expanding in the next recession to 35-40 percent of spending, but by starting on the right reforms we can at least provide some reassurance for the sovereign-debt markets. If investors see that we have started a long-term process to end the deficits, they might not demand as high risk premiums - interest rates - on our Treasury bonds as they otherwise would.

That, however, also means that once we get started on reforms, we darn well better make sure that they deliver. The last thing we can afford as a country is to make a historic pledge to end half a century of deficits, only to fall short of our promise and once again have to go to our creditors and plea for more money.

Short of a war, there is no better way to sink a country than to erode its fiscal status. We are well under way, and close enough to the breaking point that it would be centennially irresponsible to get started on reforms that have no chance of fixing our deficit problem.

It is in this context that I have to take issue with the Lipow-Matthews plan. It simply won't provide the solution they claim to seek. Instead of actually addressing the root cause of the deficit, they provide a half-measure - at best - that appears to be designed more to be politically palatable than fiscally sustainable.

This is not the first time I see fellow think tank scholars do this. I have had run-ins with people at Cato, Heritage, the AEI and other prominent institutions over precisely this habit. Believing that getting "something" passed is more important than getting "the right thing" passed, the free-market movement is increasingly willing to compromise away the good for the expedient. In doing so, tough, they not only sacrifice their ideological principles but also turn their backs on economically and fiscally realistic solutions to our entitlement crisis.

With all this in mind, the Lipow-Matthews plan actually serves an important purpose: it helps us understand what type of reforms to stay away from.

Their problems begin already on page nine, where they declare:
The fact that entitlement programs have become an indispensable part of modern society is not going to change. What can and should change is the way they are designed, managed and funded.
This is a cardinal error in welfare-state analysis. Lipow and Matthews confuse the political and ideological desire to have a welfare state with the economic conditions under which such a welfare state can prevail. In other words, they believe that just because people want a welfare state, it is possible to make that welfare state fiscally sustainable.

Just because I ought to be able to fly, does not mean I can fly, nor does it mean that I should try.

A prudent approach to welfare-state reform starts instead with what the economy needs. As I explained in detail in my book Industrial Poverty, the welfare state erodes its own macroeconomic base. Like the cartoon character who saws off the branch he is sitting on, the welfare state creates its own demise. It slowly chokes off the life support for the economy upon which its very existence depends.

Any attempt to save the welfare state - to make it more efficient and fit inside an economy with an insufficient tax base - will backfire. This is pretty much what the Greeks have been trying to do for a decade, and the Swedes and the Danes before them. It has never worked out, and the reason is in the very nature of the welfare state.

Lipow and Matthews actually, and unintentionally, provide good examples of this phenomenon. The best one is their solution to the perennial funding problems in Social Security and Medicare.

They start off on the right track by pointing out that there is only one way to solve the fiscal challenges of Social Security and Medicare, namely
to move to a system of prefunded accounts that are owned by individuals, not the government. Workers should be allowed to put their Social Security and Medicare payroll taxes into a personal account that would grow with the economy.
They also acknowledge that whatever risks are associated with a private, pre-funded account model should be contrasted against "what the government has done for decades - and continues to do". Congress has raided retirement-security funds to bankroll other spending programs. 

This is a correct observation, but it is the lesser of two problems with Social Security. I addressed the bigger one in my paper on Social Security reform that I originally produced for a Republican legislators' conference in 2007. It is reprinted as a chapter in my book Ending the Welfare State. there I explain how Social Security suffers from an inherent structural flaw, where the rise of individual benefits will always, by design (though not necessarily by intent), outpace the increase in tax revenue. I refer to this phenomenon as "income migration": the base for private benefits is based on individual earnings, which over time rise faster than average earnings, the base for Social Security's tax revenue.

The income-migration problem is inherent to the pay-as-you-go model itself, making that model unsustainable over time. Congress has not acknowledged this explicitly, but de facto in the form of tax hikes and cuts to benefits. The tax hikes are the most conspicuous: the Social Security tax is six times higher now than it was when the system was created, courtesy of 20 tax hikes over time. Therefore, it is not a model on which we should base any reforms; we need an entirely new system. In my book I propose a reform that slowly, over 40 years, replaces the existing model with private accounts.

Lipow and Matthews agree that private accounts is the way to go, but they do not want to leave the current model. In their "ideal" reform proposal they still cling to the government-funding model. After having de facto proposed an IRA-style solution across the board, they circle back to government for another helping:
The bigger question is what to do with low-income workers whose contributions have remained low for their entire working careers, or for those who work occasionally or not at all. For example, though it's not as common as it used to be, some spouses never enter the workforce. As a social insurance program, Social Security's distribution formula is adjusted to bump up benefits to low income workers at the expense of higher-income workers. 
A private-account model would not do this, as the deposits during work-active years would be proportionate to one's income. Individuals can adjust this by lowering their current standard of living in favor of more retirement security, but this does not quite answer the concerns that Lipow and Matthews have for low-income workers. 

They propose two solutions, the first of which is a minimum contribution requirement. Government would simply force people - as it does today - to make a certain deposit every month. The second solution would be a government-calculated "minimum amount necessary for those who have reached retirement age". 

So far so good. The problem is that in both cases they want government to top off the retirement accounts for those who fall short of the necessary funds. Even though their intention is to make people take responsibility for their retirement, they neutralize their own effort by giving everybody access to the taxpayer's purse. All a person needs to do is make deposits into their retirement account that allow them a more lavish lifestyle today - and then, upon retirement, just wait for government to provide for them. 

This model is in fact worse than the current model, as it removes the tax revenue currently designated for Social Security. That money is supposed to go toward the private account, not toward Social Security. 

It is worth noting that Lipow and Matthews also propose an Alternate Plan that allows for investments of current contributions to Social Security (see p. 148 in their book). The taxes paid in are deposited into a pool - a giant savings account - which is then actively invested. 

The one problem they do not address is how they want to transition from today's model to this more private-account oriented model. After all, in today's system the tax revenue that comes in every year is used to pay retirement benefits that year. All the individual taxpayer earns is an IOU from government. The cash is gone as soon as it is paid in. 

My model addresses this with a 40-year phase-in of private accounts. I develop an algorithm for this phase-in, which also benefits individuals with lower incomes more than it benefits those with higher earnings. By the end of the phase-in there is no longer any government involved in funding retirement. 

A complete privatization is the only way to solve the two big problems in Social Security: cash-tapping by Congress, and income migration. Some private-account models may reduce or even eliminate the first problem, but nothing short of a privatization will address the second one. 

It is nice to see fellow travelers in the libertarian free-market movement make an effort at solving the systemic problems created by the welfare state. However, when the solutions offered cannot solve the actual problem it becomes a waste of precious time and scarce legislative effort. It is time for libertarians to stop half-measuring their way forward; all those half measures do is give the fiscally unsustainable and economically destructive welfare state more time to suppress the free-market economy and depress prosperity for all of us. 

My proposal for dynamic private accounts in Social Security is an example of a solution that avoids the half-measure trap. There are many more, to which we will return very soon.

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