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February 03, 2005

The Bush Social Security Plan Explained

Courtesy of Matthew Yglesias:

Matthew Yglesias: Understanding The Bush Plan: Several people I've communicated with seemed not to entirely understand Jonathan Weisman's decription of the Bush administration's "clawback" plan, and since the article is now the subject of a White House counterinsurgency, the meaning of all this deserves to be spelled out in some detail.

The Bush actually operates in three distinct phases, and it's important to understand all three, and to understand them as separate, because only phase two is even remotely construable as an effort to improve Social Security's finances. The first phase is to default on the General Fund's debt to the Social Security Trust Fund in order to make room in the budget (sort of) to make the Bush tax cuts permanent.

Once that's done, Social Security doesn't have nearly enough revenue to cover currently promised benefits. The White House wants to resolve this through some unspecified level of benefit cuts. The idea is that promised benefits will now be brought into line with the (reduced) quantity of funds available. From here on out, Social Security's accounts will be balanced in a cash flow sense. The amount of money paid out each year will be equal to the amount of FICA collected. That's phase two.

Phase three is the proposal to allow workers to divert one third of their payroll taxes into something resembling an account under the Thrift Savings Plan. Once a worker -- call him "Matt" -- chooses to do this, Social Security's cash flow will be messed up. Four percentage points of my wage income that were supposed to be going to pay grandma's Social Security benefits are now sitting in my private account. As a result, the government will need to borrow some money to pay grandma's benefits. The administration believes that that money can be borrowed at a 3 percent rate of interest. When Matt retires, his guaranteed benefits -- already substantially cut during phase two -- will be cut a second time. The size of this cut will be equivalent to the value of Matt's total contributions to his private account, plus 3 percent interest per year. Thus, once Matt retires, he will have access to all of the money in his private account, but his guaranteed benefits will have been cut twice. His little brother, meanwhile, who didn't put money into his private account, will only have his benefits cut once.

Now this is all very complicated. The way Weisman tried to explain it was this: Instead of saying that 4 percentage points of my FICA were diverted into a private account and then the government borrows an equivalent amount of money in order to pay grandma's benefits, say that all of my FICA goes to pay for grandma, but the government lends me an amount of money equal to 4 percentage points of my FICA. When I retire, I get the money in my private account, but I need to repay all those loans with an interest rate of 3 percent. In addition to my private account (with the loan repaid) I then get to collect guaranteed benefits that have only been cut one time. My little brother just gets the once-cut guaranteed benefits.

These two alternative descriptions are absolutely equivalent in all respects. The only difference is that the White House thinks the second description (the one Weisman used) casts their program in a negative light. I actually think it makes their program look better than the first one does. But I'm not paid to work such things out. I also think the second explanation is easier to understand, and I am paid to figure out ways of writing that are easy to understand.

Now, the upshot. The White House says the average worker can expect a 4.6 percent real rate of return on his private account. Under explanation two, this makes borrowing the money at a 3 percent rate turn out to be a smart investment move. You get a 1.6 percent net return. Under explanation two, it's a little hard to see why taking the private account is the right move, but the math comes out the same way, a 1.6 percent net return. Thus, having already implemented phases one and two, the private accounts are a good deal for workers. Phase two and -- especially -- phase one, however, are terrible deals for workers. The cuts undertaken in step two (and made necessary by phase one) are bigger than the gains you can make by starting your account. The important thing, as the chart at the bottom of this page indicates, is that what you're being promised by the Bush administration is worse, on average, not only than what you're being promised right now, but worse than what currently scheduled benefits can afford.

If you are in the top one or two percent of the income pyramid, this may be a good deal for you anyway since phase one allows you to keep your income taxes lower. The other 99-98 percent of us are getting the shaft. Note also that this plan will make Social Security's benefit structure less progressive, though how much less progressive depends on the nature of the unspecified benefit cuts. This is also good for you if you are a manager or major stockholder in a company that will be managing the private accounts. It also might be good for you if you own a great deal of stock already (i.e., you're rich!) and this program winds up increasing the share of national wealth invested in the stock market. The plan will also reduce the national savings rate (new private savings will be 100 percent offset by new public dissavings, but the new accounts will crowd out some non-account private savings) and reduce economic growth.

Posted by DeLong at February 3, 2005 09:27 PM