[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]




 
                  SEVENTH IN A SERIES OF SUBCOMMITTEE
        HEARINGS ON PROTECTING AND STRENGTHENING SOCIAL SECURITY

=======================================================================

                                HEARING

                               before the

                    SUBCOMMITTEE ON SOCIAL SECURITY

                                 of the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                             JUNE 21, 2005

                               __________

                           Serial No. 109-26

                               __________

         Printed for the use of the Committee on Ways and Means



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                      COMMITTEE ON WAYS AND MEANS

                   BILL THOMAS, California, Chairman

E. CLAY SHAW, JR., Florida           CHARLES B. RANGEL, New York
NANCY L. JOHNSON, Connecticut        FORTNEY PETE STARK, California
WALLY HERGER, California             SANDER M. LEVIN, Michigan
JIM MCCRERY, Louisiana               BENJAMIN L. CARDIN, Maryland
DAVE CAMP, Michigan                  JIM MCDERMOTT, Washington
JIM RAMSTAD, Minnesota               JOHN LEWIS, Georgia
JIM NUSSLE, Iowa                     RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas                   MICHAEL R. MCNULTY, New York
PHIL ENGLISH, Pennsylvania           WILLIAM J. JEFFERSON, Louisiana
J.D. HAYWORTH, Arizona               JOHN S. TANNER, Tennessee
JERRY WELLER, Illinois               XAVIER BECERRA, California
KENNY C. HULSHOF, Missouri           LLOYD DOGGETT, Texas
RON LEWIS, Kentucky                  EARL POMEROY, North Dakota
MARK FOLEY, Florida                  STEPHANIE TUBBS JONES, Ohio
KEVIN BRADY, Texas                   MIKE THOMPSON, California
PAUL RYAN, Wisconsin                 JOHN B. LARSON, Connecticut
ERIC CANTOR, Virginia                RAHM EMANUEL, Illinois
JOHN LINDER, Georgia
BOB BEAUPREZ, Colorado
MELISSA A. HART, Pennsylvania
CHRIS CHOCOLA, Indiana
DEVIN NUNES, California

                                 ______

                    SUBCOMMITTEE ON SOCIAL SECURITY

                    JIM MCCRERY, Louisiana, Chairman

E. CLAY SHAW, JR., Florida           SANDER M. LEVIN, Michigan
SAM JOHNSON, Texas                   EARL POMEROY, North Dakota
J.D. HAYWORTH, Arizona               XAVIER BECERRA, California
KENNY C. HULSHOF, Missouri           STEPHANIE TUBBS JONES, Ohio
RON LEWIS, Kentucky                  RICHARD E. NEAL, Massachusetts
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin

                    Allison H. Giles, Chief of Staff

                  Janice Mays, Minority Chief Counsel

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.


                            C O N T E N T S

                               __________

                                                                   Page

Advisory of June 14, 2005 announcing the hearing.................     2

                               WITNESSES

Congressional Budget Office, Douglas Holtz-Eakin, Ph.D., Director     6

                                 ______

Baruch College, City University of New York, June O'Neill, Ph.D..    18
Institute for Research on the Economics of Taxation, Stephen J. 
  Entin..........................................................    25
The Heritage Foundation Center for Data Analysis, William W. 
  Beach..........................................................    34
Economic Policy Institute, Lee Price.............................    39
Dartmouth College, Andrew W. Samwick, Ph.D.......................    52
The Center on Budget and Policy Priorities and New York 
  University, Jason Furman, Ph.D.................................    57
CarriageOaks Partners, LLC and The Cato Institute's Project on 
  Social Security Choice, William G. Shipman.....................    64

                       SUBMISSIONS FOR THE RECORD

Delores Guinn, Horshoe Bay, TX, statement........................   100
Thomas S. Marino, La Habra, CA, statement........................   100
Bob Moore, Lawton, OK, statement.................................   101


                  SEVENTH IN A SERIES OF SUBCOMMITTEE
        HEARINGS ON PROTECTING AND STRENGTHENING SOCIAL SECURITY

                              ----------                              


                         TUESDAY, JUNE 21, 2005

             U.S. House of Representatives,
                       Committee on Ways and Means,
                           Subcommittee on Social Security,
                                                    Washington, DC.

    The Subcommittee met, pursuant to notice, at 10:02 a.m., in 
room B-318, Rayburn House Office Building, Hon. Jim McCrery 
(Chairman of the Subcommittee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS

                    SUBCOMMITTEE ON SOCIAL SECURITY

                                                CONTACT: (202) 225-9263
FOR IMMEDIATE RELEASE
June 21, 2005
No. SS-7

                McCrery Announces Seventh in a Series of

                Subcommittee Hearings on Protecting and

                     Strengthening Social Security

    Congressman Jim McCrery (R-LA), Chairman, Subcommittee on Social 
Security of the Committee on Ways and Means, today announced that the 
Subcommittee will hold the seventh in a series of Subcommittee hearings 
on protecting and strengthening Social Security to hear the views of 
Members of the House. The hearing will take place on Tuesday, June 21, 
2005, in room B-318 Rayburn House Office Building, beginning at 10:00 
a.m. or immediately following the conclusion of the full Committee 
hearing.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Subcommittee and 
for inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    The Trustees of the Social Security system consider both 
demographic and economic factors to project the future condition of the 
Social Security Trust Funds. The demographic factors, covered in a 
previous Subcommittee hearing, are the primary reason why the system is 
facing insolvency. However, economic factors, while subject to greater 
variability than demographic factors, are important, too.
      
    Four important economic variables required to project Social 
Security's finances are the rate of real earnings growth, the real 
interest rate, the inflation rate, and the unemployment rate. In 
particular, the earnings growth and inflation rates have direct effects 
on various automatic benefit and tax base adjustments in the program. 
As a result, it is important to examine the interrelationship between 
Social Security and the economy as we look for ways to strengthen 
Social Security's financing.
      
    While these and other economic variables help to determine Social 
Security spending and revenues under current law, it is also important 
to consider the larger impact of the Social Security program on the 
Nation's economy. According to the Social Security Trustees, the 
program's costs are growing faster than the economy and the tax base 
that supports it. Some economists have suggested that the current 
system is inefficient because it induces workers to save less andretire 
early and that strengthening Social Security could have positive 
economic effects.
      
    One way to strengthen Social Security and potentially enhance 
national savings and economic growth is to pre-fund benefits. The past 
two Administrations, as well as the 1994-1996 Social Security Advisory 
Council and the 2001 President's Commission to Strengthen Social 
Security, proposed partially pre-funding Social Security through either 
personal accounts or the collective investment of theSocial Security 
Trust Funds.
      
    In announcing the hearing, Chairman McCrery stated, ``Many people 
think of Social Security in terms of how it affects their personal 
retirement income and their take-home paychecks. However, Social 
Security also affects the economy, and vice versa. As we examine ways 
to strengthen Social Security, we must consider both the individual and 
the broader consequences of options under discussion.''
      

FOCUS OF THE HEARING:

      
    The Subcommittee will examine how economic assumptions are used to 
project the future condition of the Social Security system and 
determine Social Security benefits, along with the merits of, and 
options to, achieve pre-funded benefits.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
    Please Note: Any person(s) and/or organization(s) wishing to submit 
for the hearing record must follow the appropriate link on the hearing 
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technical problems, please call (202) 225-1721.
      

FORMATTING REQUIREMENTS:

      
    The Committee relies on electronic submissions for printing the 
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materials in alternative formats) may be directed to the Committee as 
noted above.

                                 

    Chairman MCCRERY. The hearing will come to order. Good 
afternoon, everyone. Welcome. This is our seventh Subcommittee 
on Social Security hearing on protecting and strengthening 
Social Security. Before we start this morning, I would like to 
take just a moment to acknowledge the work of our former 
Subcommittee Chairman, Congressman Jake Pickle. Jake died this 
past weekend. As you all know, he served a long time in the 
House, about 31 years. He was a lifelong Texan, a World War II 
naval combat veteran, a fiscal conservative. He worked 
tirelessly in the early eighties toward finding a bipartisan 
solution to the Social Security solvency crisis of that day. 
So, I think it is fitting that we pause for a second and 
remember Jake Pickle this morning as we try to follow a path 
toward a solution to the Social Security problems that confront 
us today and in the near future. Social Security, of course, 
occupies a special place among government programs because it 
has a profound impact not only on an individual person's 
finances, one's personal economy, but also on our National 
economy. Today we will examine the larger macroeconomic issues 
associated with Social Security.
    One such issue involves the economic variables used to 
estimate Social Security's finances. The variables include the 
rate of real earnings growth, the real interest rate, 
employment, and the inflation rate. The real earnings growth 
rate affects growth of initial benefits payable to individuals 
as well as the tax base supporting the program. The interest 
rate affects the balance of the Social Security Trust Funds. 
The employment rate affects current revenue and future benefit 
obligations for the program. The inflation rate determines 
adjustments to benefits after they begin.
    From an economic and an individual perspective, a key 
question we face is how best to finance Social Security 
benefits, whether to stick with the current pay-as-you-go 
financing structure under which today's workers' payroll taxes 
support today's retirees, or whether we begin to save real 
assets to help pay benefits in the future--also known as 
prefunding Social Security. Through voluntary prefunded 
personal accounts, we would have the opportunity to not only 
strengthen Social Security, but encourage savings, which could 
in turn greatly expand the pool of capital available for 
investment, leading to more economic growth and jobs. I welcome 
our very distinguished panel this morning, and I look forward 
to hearing your views and responses to our inquiries. Now, I 
would ask my colleague Sandy Levin, the Ranking Member of the 
Subcommittee, if he would like to make some opening remarks.
    Mr. LEVIN. Thank you very much, and it is most appropriate 
that you started off our hearing today to remember Jake. He was 
a wonderful and, in his own way, colorful character. If he were 
with us today, I am sure he would have a story or two to 
enlighten our hearing. He had an intense dedication to the 
Social Security system, and I was relatively new when he--very 
new when he was in full bloom in 1983. He stayed that way 
throughout his years here. So, Jake, as we delve further into 
this, we remember you well and we miss you. In announcing 
today's hearing, our Chairman suggested that one way to 
strengthen Social Security is to prefund, as you put it, 
benefits, and that doing so could enhance national savings and 
economic growth. This is an important discussion. I am glad we 
are having it, and we very much welcome this very distinguished 
group of experts.
    This is not, however, a new discussion. In 1983, we made 
the decision to shift from a pure pay-as-you-go Social Security 
system to one that was partially prefunded. As a result, we 
currently have over $1.7 trillion in the Social Security Trust 
Fund. This year alone, Social Security will earn $169 billion 
more than is needed to pay this year's benefits. Although those 
surpluses invested in U.S. Treasury bonds are enough to secure 
Social Security's future for many years, some of their economic 
benefit has been muted because Congress often borrowed Social 
Security surpluses to pay for other priorities rather than 
using them to increase national savings by paying down the 
national debt. For example, President Bush's current budget and 
the budget resolution passed by the House and Senate majorities 
proposed to spend every dime of this year's surplus to finance 
other priorities, including over $100 billion in tax cuts. As 
we demonstrated in the late nineties, when President Clinton 
led us in saving the surplus for Social Security and we built 
up a $5.6 trillion projected budget surplus, fiscal discipline 
can have real economic advantages as well as ease the pain of 
keeping future obligations. Unfortunately, the current 
Administration squandered the surplus in Social Security funds 
on a massive tax cut aimed at the very wealthy, undoing 
progress we had made toward prefunding Social Security's 
obligations.
    So, as we discuss prefunding today, we should keep in mind 
that privatization and prefunding are two different things. A 
guaranteed benefit pension system can be prefunded, as all 
State pension systems and private pensions in the United States 
are, and a privatized system can be essentially unfunded, as 
under President Bush's Social Security privatization plan, by 
borrowing all the money for future accounts and passing on the 
cost to future generations. I hope our witnesses can help us 
better understand the real costs and benefits of prefunding, 
and the various ways it can be achieved. Social Security's 
guaranteed benefits, whether prefunded or pay-as-you-go, are 
critical to millions of current and future retirees and 
families. I would just add, if anyone has any doubt about that, 
they should read the articles in the New York Times, especially 
the one on Sunday. It would be particularly disingenuous for 
those who made decisions to move off a fiscally responsible 
path to use their own poor policy choices to justify 
privatizing Social Security and putting guaranteed benefits at 
risk for millions of Americans. So, we look forward to your 
testimony. Thank you, Mr. Chairman.
    Chairman MCCRERY. Thank you, Mr. Levin. This morning's 
rather large panel is quite a distinguished one. We have with 
us this morning Dr. Douglas Holtz-Eakin, who is the Director of 
the Congressional Budget Office (CBO); Dr. June O'Neill, 
formerly of the CBO and currently Wollman Distinguished 
Professor in Economics at the Zicklin School, Baruch College, 
New York; Stephen J. Entin, President and Executive Director, 
Institute for Research on the Economics of Taxation; William W. 
Beach, Director, Center for Data Analysis, The Heritage 
Foundation; Lee Price, Research Director, Economic Policy 
Institute; Dr. Andrew Samwick, Professor of Economics and 
Director of the Nelson A. Rockefeller Center, Dartmouth College 
in New Hampshire; Dr. Jason Furman, Senior Fellow, Center on 
Budget and Policy Priorities and Visiting Scholar of New York 
University; and William G. Shipman, Chairman, CarriageOaks 
Partners, Manchester-by-the-Sea, Massachusetts, and Co-Chairman 
of The Cato Institute's project on Social Security Choice. 
Welcome, all of you. Thank you very much for joining us this 
morning. Dr. Holtz-Eakin, we are going to begin with you, if 
you would. All of your written testimony will be included in 
the record in their entirety. If you could try to summarize 
that in about 5 minutes, we would appreciate it. Thank you.

      STATEMENT OF DOUGLAS HOLTZ-EAKIN, PH.D., DIRECTOR, 
                  CONGRESSIONAL BUDGET OFFICE

    Mr. HOLTZ-EAKIN. Thank you, Mr. Chairman, Mr. Levin, and 
Members of the Committee. The CBO is pleased to be here today. 
The written testimony that we have submitted has four basic 
points. Point number one is to summarize the financial outlook 
for Social Security under current law and identify the 
financing problems. This is not news and I will leave that to 
written testimony. The second point is to document the role of 
economic performance in contributing to and solving the 
financing problem, the particular contribution of wage rates, 
interest rates, and the like. Point number three is to reverse 
the direction and look at the role of fixing the Social 
Security and larger budgetary issues that face the United 
States in providing better economic performance. Then the 
testimony closes with a bit of a discussion about the virtues 
of moving sooner, as opposed to later, in addressing these 
pressing financing problems.
    Let me take those in order. The first is the role of 
economic performance in the Social Security finances. As the 
Chairman mentioned at the outset, there are some key variables 
which are used for projecting the outlook for Social Security 
under either current law, or in a reform program. They are the 
earnings growth, interest rates, inflation, and the mix of 
unemployment and employment for any given labor force.
    Earnings growth is by far the most important. Earnings 
growth is driven by productivity advances in the United States. 
Earnings will rise with productivity and take a mix of taxable 
earnings and untaxed compensation. Those rises in earnings will 
increase both taxes received by the system, and also benefits 
due in the system. The rise in productivity that drives 
earnings will come from two sources. One is the continuous 
progress of innovation in the United States, which is captured 
in the economist's term ``total factor productivity.'' The 
second is the additional productivity that comes with the 
accumulation of wealth and capital resources, the provision of 
workers with greater amounts and higher quality factories, 
machines, and the like, which raise productivity, and thus 
earnings. There is a timing difference. Increases in 
productivity and earnings first are reflected in taxes, and 
then later show up as higher benefits from the higher earnings. 
In any event, it is unlikely, given the historic pace of 
productivity growth and the likely variation around that 
historic pace, that we can grow our way out of the Social 
Security financing problem. The figure that we brought as a 
display in this regard shows, at the top, the outlays under 
current law for Social Security. These are scheduled benefits 
as a fraction of GDP. The bottom dark line is scheduled 
receipts as a fraction of GDP in the system, and the light blue 
shaded area shows the variation in productivity that would be 
about 80 percent likely under historic growth rates of 
productivity. So, there is an 80 percent chance, given what we 
know, that productivity will lie somewhere in that band and 
produce outlays somewhere in that band.
    As you can see, while it is the case that higher 
productivity growth could ameliorate the Social Security 
financing problem, it is extremely improbable that it will by 
itself be a solution to the mismatch between scheduled 
benefits, at the top, and revenues, at the bottom. That is the 
most central economic variable affecting the future of Social 
Security as it is currently constructed. The second key 
variable is real interest rates. While they don't affect this 
picture of the current annual benefits or the current annual 
receipts, they do affect system financial measures such as 
trust fund exhaustion. To the extent that interest rates are 
higher, bonds in the trust fund accumulate greater interest, 
and the trust fund lasts longer. A rough rule of thumb is that 
in our projections raising real interest rates by 1 percentage 
point would allow the trust fund to last a little under a 
decade-and-a-half longer, a little under 15 years. Going the 
other direction, if interest rates were lower by a full 
percentage point, trust funds would be exhausted about that 
much sooner.
    The second thing that interest rates are important for are 
measures of actuarial balance. Interest rates are used to 
discount the future back to the present. To the extent that 
interest rates are higher, future deficits count less in those 
computations compared to current surpluses, and the actuarial 
balance does not look as bad. The reverse is also true. To the 
extent that interest rates are lower, future deficits will 
count more heavily and the actuarial balance will move in the 
other direction. I will leave to Members and the staff the 
comments we have written on the inflation and unemployment 
rates in our projections. They are less central to either 
measured or actual performance of the system in the future.
    The second aspect is to look at achieving better 
performance and fixing the budgetary problems facing the United 
States. Not just Social Security, but fixing the larger demands 
in Medicare and Medicaid would improve the future economic 
performance of the United States. There, the key issue is that 
by saving more in the present as a nation, we can accumulate 
greater national wealth, produce greater national income, and 
enlarge the pie available to fund all of the private-sector and 
public-sector demands. We did some illustrative calculations 
that raising the national saving rate by 2 percentage points 
might raise the capital stock by 15 percent by 2050, raise GDP 
per person by 4 percent over that period. Even simply saving 
the current Social Security surplus, genuinely saving it as 
national saving increases, could raise GDP per capita by 1.5 
percent over the next 50 years. That prefunding could take 
place in the government, it could take place in the private 
sector, and the central issue is a design one which allows any 
resources devoted to prefunding not be offset by government or 
private sector actions.
    Then finally, the testimony closes with a short discussion 
that is intended to illustrate the benefits of moving sooner as 
opposed to later. One can think of current-law Social Security 
as a wait-and-reform strategy. In our projections, when the 
trust funds exhaust in 2052, benefits are at that point 
mechanistically cut by about 22 percent. That is a wait-and-
reform strategy of a rather meat-cleaver fashion. One could 
imagine moving sooner. This display shows, simply for 
illustration, the difference between benefits received over the 
lifetime of beneficiaries. If one waits and reforms, that is 
the dark line that shows those cohorts born in 1950-1959 
getting fully scheduled benefits but later cohorts getting much 
less. Or with the light blue lines, imagining a 10 percent 
across-the-board cut in benefits now, which would share the 
burden, providing less for the older cohorts but allowing 
younger cohorts, those who are 15 and younger at the moment, to 
receive greater benefits over the life of their participation 
in the program. We are pleased to have the chance to both 
submit the written testimony, and to be here, and we look 
forward to your questions.
    [The prepared statement of Dr. Holtz-Eakin follows:]

Statement of Douglas Holtz-Eakin, Ph.D., Director, Congressional Budget 
                                 Office

    Mr. Chairman, Congressman Levin, and Members of the Subcommittee, I 
appreciate the opportunity to appear before you today to discuss Social 
Security and the economic factors that influence its financial outlook.
    As you know, Social Security is the single largest Federal program. 
In 2004, the Social Security system received $569 billion in tax 
revenue and paid out $493 billion in benefits. The program provided 
benefits to more than 47 million people--about two-thirds of them 
retired workers and the rest disabled workers, survivors of deceased 
workers, workers' spouses, and minor children.
    Although today the program takes in more revenue than it spends, 
that situation will not continue once large numbers of baby boomers 
begin claiming retirement benefits. In coming years, the Social 
Security system will face mounting financial pressures as its outlays 
start to grow much faster than its revenue. The Congressional Budget 
Office (CBO) projects that scheduled Social Security outlays (those 
implied by the current benefit formula) will rise from 4.3 percent of 
gross domestic product (GDP) in 2004 to 6.4 percent in 2050.\1\ 
Revenue, however, is scheduled to average less than 5.0 percent of GDP.
---------------------------------------------------------------------------
    \1\ See Congressional Budget Office, Updated Long-Term Projections 
for Social Security (March 2005).
---------------------------------------------------------------------------
    The aging of the population will place similar pressures on the 
government's two big health care programs, Medicare and Medicaid. 
Without changes in spending or revenue policies, Federal debt could 
begin to grow at an unsustainable pace. Faster economic growth would 
help reduce some of that budgetary imbalance, but it is highly unlikely 
that economic growth alone could solve the problem. Conversely, slower 
growth would exacerbate the situation. Prefunding future retirement 
obligations by increasing national saving could noticeably reduce the 
burdens that an aging population would impose on future workers, and 
taking action sooner rather than later could lessen some of the 
uncertainties that future retirees face.
The Financial Outlook for Social Security
    The next decade will see the beginning of a significant, long-
lasting shift in the age profile of the U.S. population. Over the next 
50 years, the number of people ages 65 and older will more than double, 
while the number of adults under age 65 will grow by less than 20 
percent. That shift reflects demographic trends that have been evident 
for years and that are expected to continue, such as the aging of the 
baby-boom generation, increases in life spans, and a relatively low 
fertility rate.
    Those trends imply that the number of workers per Social Security 
beneficiary will decline significantly, from 3.3 in 2004 to 2.0 in 
2050. Because Social Security depends on revenue from current workers 
to finance benefits, that demographic shift will have a profound impact 
on the system's finances.
Social Security's Finances
    In 2009, the Social Security surplus--the amount by which the 
program's dedicated revenue in a year exceeds the benefits paid in that 
year--will start to diminish. In 2020, that surplus will disappear, and 
outlays for benefits will begin to surpass the system's annual revenue 
(see Figure 1). To pay full benefits, the Social Security system will 
eventually have to rely on interest on the government bonds held in its 
trust funds--and ultimately, on the redemption of those bonds. In the 
absence of other changes, bonds can continue to be redeemed until the 
trust funds are exhausted, which will occur in 2052, CBO projects. But 
where will the Treasury find the money to pay for the bonds? Will 
policymakers cut back other spending in the budget? Will they raise 
taxes? Or will they borrow more?

    Figure 1. Social Security Revenue and Outlays Under Current Law

                          (Percentage of GDP)

[GRAPHIC] [TIFF OMITTED] T3926A.001

                  Source: Congressional Budget Office.

    Note: The projections in this figure employ the Social Security 
 trustees' 2004 intermediate demographic assumptions and CBO's January 
 2005 economic assumptions. Revenue includes payroll taxes and income 
  taxes on benefits but not interest credited to the Social Security 
   trust funds; outlays include trust-fund-financed Social Security 
  benefits and administrative costs. Under current law, outlays will 
begin to exceed revenue in 2020; starting in 2053, the program will no 
      longer be able to pay the full amount of scheduled benefits.

                                ------                                

    Once the trust funds are exhausted, the Social Security 
Administration will no longer have the legal authority to pay full 
benefits. As a result, it will have to reduce payments to beneficiaries 
to match the amount of revenue coming into the system each year. 
Although the exact size of that reduction is uncertain, CBO estimates 
that benefits will have to be cut--both for current recipients and for 
new beneficiaries--by about 22 percent to match the system's available 
revenue.
    The key message from those numbers is that with benefits reduced 
annually to equal revenue, as they will be under current law when the 
trust funds run out, some form of the Social Security program can be 
sustained forever. Of course, many people would not consider a sudden 
22 percent cut in benefits to be desirable policy. In addition, the 
budgetary demands of bridging the gap between spending and revenue in 
the years before that cut could prove onerous. But Social Security is 
sustainable from a narrow programmatic perspective. What is not 
sustainable is continuing to provide the present level of scheduled 
benefits given the system's present financing (see Figure 2).

 Figure 2. Social Security Revenue and Outlays with Scheduled Benefits 
                                Extended

                          (Percentage of GDP)

[GRAPHIC] [TIFF OMITTED] T3926A.002

                  Source: Congressional Budget Office.

    Note: The projections in this figure employ the Social Security 
 trustees' 2004 intermediate demographic assumptions and CBO's January 
 2005 economic assumptions. Revenue includes payroll taxes and income 
  taxes on benefits but not interest credited to the Social Security 
       trust funds; outlays include Social Security benefits and 
 administrative costs. In this outlay projection, currently scheduled 
  benefits are assumed to be paid in full after 2052 using funds from 
                  outside the Social Security system.

                                 ______
                                 
Implications for the Budget and the Economy
    CBO's projections offer some guidance about the potential impact of 
those developments on the budget. Under CBO's assumptions, the Social 
Security surplus (excluding interest on bonds in the trust funds) will 
reach about $100 billion in 2007. By 2025, however, the surplus will 
have turned into a deficit of roughly $100 billion (in 2005 dollars). 
That $200 billion swing will represent a significant challenge for the 
budget as a whole, especially in light of the current budget deficit.
    The demand on the budget from Social Security will take place at 
the same time as--but is projected to be eclipsed by--the demand from 
Medicare and Medicaid. Currently, outlays for Social Security benefits 
are slightly more than 4 percent of GDP, as is Federal spending on 
Medicare and Medicaid combined. But whereas Social Security outlays are 
projected to grow to 6.4 percent of GDP by 2050, spending on the two 
health programs could reach a total of 20 percent of GDP if current 
trends in health care costs continue.
    Without changes in policy, therefore, Federal spending is likely to 
increase sharply in coming decades. Unless taxes rise well above their 
historical levels, the gap between spending and revenue will widen, 
expanding the amount of Federal borrowing. The resulting increase in 
government debt could seriously harm the economy. It could crowd out 
private capital formation, and although its impact on capital 
accumulation could be muted by borrowing from abroad, foreign borrowing 
is no panacea. The debt owed to foreigners would still have to be 
serviced. In the end, Federal debt would reduce the disposable income 
of U.S. residents and erode future living standards.

Effects of Economic Assumptions
    Projections of the future financial status of Social Security 
depend on a number of demographic and economic assumptions. In its 
projections, CBO uses the demographic assumptions of the Social 
Security trustees and its own economic assumptions. CBO's economic 
assumptions for the next 10 years are described in The Budget and 
Economic Outlook (January 2005); the assumptions for later years are 
consistent with those used in the 10th year of the projection.
    Assumptions about four economic factors affect the finances of the 
Social Security system: the growth of earnings, the interest rate used 
to compute the interest credited to the trust funds, employment, and 
inflation. Of those four, earnings growth has the largest impact on 
Social Security's outlays and revenue. The interest rate affects Social 
Security's finances because it determines the amount of interest paid 
to the trust funds, but that interest is an intragovernmental transfer 
and has no effect on the total budget. The other factors have important 
implications for overall economic performance, but they do not affect 
Social Security's finances significantly.

Earnings Growth
    Real (after-inflation) earnings growth--and its main underlying 
determinant, productivity growth--is the key economic determinant of 
Social Security's finances as well as of the performance of the economy 
in general. Social Security benefits are based on earnings during a 
person's working years. Workers with higher lifetime earnings receive 
higher benefits, as do their dependents and survivors. The benefit 
formula is also structured to ensure that as average earnings grow, 
benefits for new recipients grow at approximately the same rate. As 
long as the system pays scheduled benefits, Social Security benefits 
will replace the same portion of earnings for future generations as 
they do for today's beneficiaries (for workers who claim benefits at 
the normal retirement age). However, the purchasing power of those 
benefits will be greater than that of benefits paid today.
    Although initial Social Security benefits are indexed to earnings, 
higher-than-expected earnings growth would improve Social Security's 
financial position. Higher real earnings immediately result in higher 
payroll tax revenue, but outlays do not increase until the workers with 
higher earnings claim benefits, which can be years or even decades 
later. The benefits paid to current recipients are indexed to prices, 
not earnings, so overall outlays do not increase in lockstep with real 
earnings.
    In the long run, workers' compensation grows with productivity. 
Productivity growth in turn stems from two factors: increases in the 
amount of capital per worker and, more important, technological 
advances that raise the amount of goods and services that can be 
produced with a given level of capital and labor--so-called total 
factor productivity (TFP). Workers do not receive all of their 
compensation in the form of earnings; some is received in nontaxable 
forms, such as health benefits. CBO assumes that the increasing share 
of compensation received as nontaxable benefits will slow the annual 
growth rate of taxable earnings by 0.1 percent. For its part, TFP is 
assumed to increase at an average annual rate of 1.25 percent over the 
long term. With the growth in nontaxable compensation and other 
technical factors that affect earnings accounted for, that assumption 
implies that earnings will grow by about 1.2 percent annually.
    Uncertainty about earnings growth results in uncertainty about the 
size of future Social Security shortfalls--but there is little, if any, 
uncertainty that shortfalls will exist. On the basis of analysis of 
historical variation in TFP, CBO has projected the range of probable 
outcomes for Social Security outlays that lies between the 10th and 
90th percentiles for TFP (see Figure 3). By definition, there is a 10 
percent chance that TFP will be above the 90th percentile and a 10 
percent chance that it will be below the 10th percentile. CBO projects 
that the gap between Social Security spending and revenue will equal 
1.39 percent of GDP in 2050. The 10th percentile projection for that 
year is a deficit of 2.1 percent of GDP, and the 90th percentile 
projection is a deficit of 0.7 percent of GDP. Moreover, even the 99th 
percentile projection (which implies only a 1 percent chance that TFP 
will be so high) shows the Social Security system running a deficit of 
0.3 percent of GDP.

Figure 3. Social Security Revenue and the Potential Range of Scheduled 
              Outlays with Uncertainty About Productivity

                          (Percentage of GDP)

[GRAPHIC] [TIFF OMITTED] T3926A.003

                  Source: Congressional Budget Office.

  Notes: The dark lines in this figure indicate CBO's projections of 
  expected revenue and outlays based on the Social Security trustees' 
   2004 intermediate demographic assumptions and CBO's January 2005 
  economic assumptions. In those projections, annual Social Security 
 outlays (for benefits and administrative costs) exceed revenue (from 
payroll taxes and income taxes on benefits but not interest credited to 
the Social Security trust funds) starting in 2020. Currently scheduled 
  benefits are assumed to be paid in full after 2052 using funds from 
                  outside the Social Security system.

   The shaded area indicates the 80 percent range of uncertainty for 
projected outlays, assuming that total factor productivity varies as it 
has in the past. (The 80 percent range of uncertainty means that there 
 is a 10 percent chance that actual values will be above that range, a 
10 percent chance that they will be below it, and an 80 percent chance 
  that they will fall within it. The uncertainty range is based on a 
                   distribution of 500 simulations.)

                                 ______
                                 
Interest Rate
    The real interest rate has no direct effect on annual Social 
Security revenue and outlays. However, it does affect trust fund 
measures and summarized measures, such as the 75-year summarized 
balance (the difference between the present values of projected revenue 
and outlays over 75 years).
    The interest rate used to calculate the interest credited to the 
trust funds is equal to an average of the rates on privately held 
Treasury bonds.\2\ A higher rate results in a later trust fund 
exhaustion date. CBO assumes that the real interest rate will be 3.3 
percent. If that rate was 1 percentage point higher (4.3 percent), the 
exhaustion date would be extended from 2052 to 2066. A rate of 2.3 
percent would accelerate the exhaustion date to 2045.
---------------------------------------------------------------------------
    \2\ Specifically, the interest rate on new special obligations 
equals the average market yield on all outstanding, marketable U.S. 
obligations that are due or callable more than four years in the 
future. See Jeffrey L. Kunkel, Social Security Trust Fund Investment 
Policies and Practices, Actuarial Note 142 (Social Security 
Administration, Office of the Chief Actuary, January 1999).
---------------------------------------------------------------------------
    In the computation of summary financial measures, future outlays 
and revenue are discounted using the real interest rate. A higher 
discount rate would weight past and current surpluses more heavily and 
would give less weight to future shortfalls. With a higher real 
interest rate, the summarized balance would show an improvement.
    From the perspective of the total budget, the interest rate is 
important because it determines the amount of interest that the Federal 
Government will owe to members of the private sector and foreign 
governments that hold Treasury securities.

Employment
    Higher levels of employment increase total earnings and thus 
revenue from Social Security payroll taxes. They also lead to higher 
Social Security benefits in the future. On net, however, higher 
employment levels improve Social Security's financial position because 
the higher revenue precedes payment of the associated benefits, often 
by many years.
    The percentage of the population working is determined by two 
factors: the labor force participation rate, which measures the portion 
of people working or seeking work, and the unemployment rate, which 
measures the share of people in the labor force who are unemployed. 
Over the long term, reasonable variation in either factor is not likely 
to have a large impact on the financial outlook for Social Security. In 
its most recent long-term Social Security projections, CBO assumed an 
average unemployment rate of 5.2 percent. If the average rate turned 
out to be 6.2 percent, the Social Security deficit in 2050 would be 
1.38 percent of GDP rather than the projected 1.39 percent. The effects 
of reasonable variation in labor force participation are of the same 
magnitude.

Inflation
    In general, the economy benefits from low and stable inflation. 
However, in a mechanical sense, high inflation actually improves Social 
Security's finances. Assuming that real earnings growth is constant, 
higher inflation will immediately result in higher earnings and higher 
payroll tax revenue. But Social Security benefits will not be adjusted 
for inflation until the following year.\3\ Of course, higher inflation 
can also have broader negative effects on the economy that may worsen 
Social Security's finances.
---------------------------------------------------------------------------
    \3\ The annual cost-of-living adjustment that applies to payments 
beginning in January is determined by the increase in the consumer 
price index for urban wage earners and clerical workers (CPI-W) from 
the third quarter of two years before to the third quarter of the 
previous year. For example, the adjustment made to payments in January 
2005 was determined by the increase in the CPI-W from the third quarter 
of 2003 to the third quarter of 2004.
---------------------------------------------------------------------------
    In its most recent long-term Social Security projections, CBO 
assumed an average inflation rate of 2.2 percent. If the average rate 
turned out to be 3.2 percent, the Social Security deficit in 2050 would 
be 1.29 percent of GDP instead of 1.39 percent, as projected.

Consistency of Projections
    A concern that arises among some analysts is the consistency of 
economic projections, including CBO's, that envision much slower growth 
of GDP than was experienced over the past 50 years and projections of 
earnings growth that are at the same pace as historical experience. The 
projections of lower GDP growth stem from projections of slower labor 
force growth. CBO does not anticipate that the fertility rates 
experienced during the baby boom will recur. Moreover, since 1950, the 
labor force participation rate of women has risen from 40 percent of 
the rate for men to 80 percent, an increase that is numerically 
impossible to repeat. However, the continued rise in productivity will 
be reflected in growing earnings per worker, and the flexible 
adjustment of a market economy will ensure sustained high rates of 
employment.

Prefunding Future Obligations and Economic Growth
    Any strategy to prepare the United States for an aging population 
must deal with a key fact: the goods and services that retirees will 
consume in the future will have to be produced by the U.S. economy or 
imported from abroad at that time. From that perspective, what matters 
is not the financial structure of the Social Security program but the 
capacity of the economy and the distribution of economic output. 
Various options for changing Social Security will have different 
effects on the economy and on the division of resources between the 
elderly and other people. To the extent that those options boost the 
future size of the economy by increasing the nation's accumulation of 
assets, they will make it easier to support a larger portion of the 
population in retirement.
    Just as individuals prepare for their retirement by saving in 
advance, a nation can prepare for an aging population by prefunding its 
future obligations. That goal can be accomplished by increasing 
national saving, which is the combined saving of the private sector and 
the government. A rise in national saving increases the pool of funds 
available for investment at home and abroad, thus adding to the stock 
of productive capital and providing resources to purchase assets from 
other countries. As investment in businesses' structures and equipment 
increases, workers become more productive, real wages rise, and the 
United States is able to produce more goods and services. Moreover, the 
income from additional foreign assets supplements the income produced 
domestically.
    Prefunding could have a noticeable effect on the future production 
of goods and services. In 2004, net national saving amounted to only 
2.2 percent of net national product (though it averaged 6.1 percent 
from 1980 to 2000), and CBO projects that it will average 3.9 percent 
between 2005 and 2015.\4\ If net national saving was permanently 
increased by 2 percentage points of net national product, the nation's 
capital stock would be 15 percent larger in 2050, CBO estimates. With 
more capital, workers would earn higher wages, and real GDP per capita 
would rise by 4.3 percent. Even a more modest goal of simply saving 
Social Security's noninterest surplus instead of spending it could 
raise real GDP per capita by 1.5 percent in 2050.\5\
---------------------------------------------------------------------------
    \4\ Net national saving is national saving minus depreciation of 
the capital stock. Net national product is gross national product minus 
depreciation.
    \5\ That calculation assumes that private savers would respond to 
the change in government saving as they have in the past.
---------------------------------------------------------------------------
    In principle, prefunding could be carried out by either the private 
sector, the government, or both. Households could prefund their future 
retirement by saving more; the government could prefund its future 
obligations by reducing the budget deficit. However, not all policies 
intended to increase private or government saving are equally effective 
in raising total national saving. For example, higher income tax rates 
might increase government saving but might also serve to reduce private 
saving. Similarly, tax incentives to stimulate private saving might 
involve revenue losses to the government, which reduce the amount of 
government saving. Conversely, curbing the growth of entitlement 
benefits might raise both government saving and private saving, as 
beneficiaries saved more to offset the reduced benefits. For example, 
indexing initial Social Security benefits to prices instead of to 
wages, as the President's Commission to Strengthen Social Security 
proposed as part of its Plan 2, would raise both private and government 
saving initially and could boost the capital stock by between 4\1/2\ 
percent and 6\1/2\ percent in 2050, CBO estimates. In the end, what 
matters for the growth of the capital stock and the economy is the 
combined impact of a policy change on government saving and private 
saving--not the effect on either one alone.
    In practice, could the government actually maintain the potential 
budget surpluses that would be generated from a tax increase or 
spending cut? That question has provoked a great deal of controversy, 
particularly in the context of Social Security's cash flow surplus. 
From a technical standpoint, the question is impossible to answer 
because it is impossible to know how other policies would have been 
changed if the Social Security surplus did not exist. The ultimate 
question of whether a surplus in the Social Security program causes 
policymakers to spend more on other programs--or tax less--is thus not 
one that is easy to answer.
    Some analysts point to the reduction in Federal debt in the late 
1990s as evidence that the government could save if it tried; others 
argue that the experience of the past few years shows the enormous 
difficulty of maintaining budget surpluses over an extended period, 
even despite efforts to put Social Security surpluses in a ``lock 
box.'' Indeed, many proponents of personal savings accounts argue that 
diverting the Social Security surpluses to personal accounts could 
create a more effective ``lock box.'' In their view, such accounts 
would raise total national savings and effectively prefund future 
retirement obligations by making it more difficult for policymakers to 
spend resources.
    The effectiveness of accounts in increasing national savings, 
however, would depend on how the accounts were financed and on the 
rules governing both accumulations in and withdrawals from them. For 
example, if it was too easy to take money from an account before 
retirement, participants might not accumulate as much as they would 
under a more restrictive arrangement. Administrative costs could also 
reduce the amount of net savings created by the accounts. Furthermore, 
some individuals might respond to personal accounts by reducing other 
private saving. Indeed, experience with 401(k) plans suggests that 
although low-income people increased their saving in response to tax 
incentives that favor such plans, most high-income people responded by 
shifting their assets from other accounts into their 401(k) plan rather 
than by increasing their total saving. Combining a tax incentive for 
saving with lower future Social Security benefits, however, could limit 
the risk that people would reduce other saving dollar for dollar, 
because those who did could have less income in retirement.
    Some analysts have also suggested that private accounts might 
strengthen marginal incentives to work because people would see the 
link between their contributions to the accounts and their eventual 
retirement benefits more clearly than they do under the current system. 
That effect might not have a large impact on the labor supply, however. 
Although perceptions of improved marginal incentives would tend to 
boost the labor supply, perceptions of higher--and possibly more 
certain--retirement income would tend to reduce it (because people 
would not have to work as much to reach a given standard of living). 
The net effect on the labor supply would depend on the balance between 
those two factors and might not be large.

Making Changes Now or Later: Economic and Budgetary Effects
    Uncertainty is an economic cost in its most fundamental form, and 
in the current context, there is uncertainty about the future of Social 
Security: what the program will look like and who will be affected by 
changes to it. The sooner that uncertainty is resolved or reduced, the 
better served will be current and future beneficiaries, who must make 
various decisions about their retirement. Phasing in changes to Social 
Security allows for gradual accommodation, giving people time to modify 
their expectations and to adjust their work and saving behavior. For 
example, younger workers who learned that they would receive lower-
than-anticipated retirement benefits would have many years to respond. 
They could work or save a little more each year. If the same benefit 
cuts were announced as those workers neared retirement, however, 
workers might be forced to make dramatic changes and still might not 
have time to accumulate sufficient savings.
    One way to gauge the advantage of acting earlier is to examine 
potential changes to the current pay-as-you-go Social Security system. 
As noted above, CBO projects that the Social Security trust funds will 
become exhausted in 2052 under current law. After that, the Social 
Security Administration will lack the authority to pay benefits in 
excess of the system's annual revenue, meaning that outlays will have 
to be reduced immediately by 22 percent to match that revenue, CBO 
estimates. Put another way, current law constitutes a ``wait and 
change'' strategy. Until 2052, beneficiaries would continue to receive 
scheduled benefits; however, those benefits would have to be cut by 22 
percent in 2053, and larger reductions would be needed in later years.
    Alternatively, policymakers could reduce the benefits paid to 
earlier cohorts so that the benefits paid to later cohorts would not 
have to be cut as much. To illustrate that point, CBO examined a 
hypothetical policy that would reduce all new Social Security benefit 
awards by 10 percent (relative to those currently scheduled) beginning 
with people retiring or becoming disabled in 2012.
    In general, lifetime benefits for current workers (those born 
before 1980) would be lower under this policy than if no changes were 
made to the program (see Figure 4). However, assuming other government 
finances were held constant, such a change would allow greater benefits 
to be paid to later generations than under current law. The reduced 
benefits paid to earlier generations would result in government 
savings, probably in the form of lower debt, that could be used to pay 
higher benefits to later generations.

Figure 4. Lifetime Social Security Benefits Under Current Law and with 
               a 10 Percent Benefit Cut Beginning in 2012

                   (Percentage of scheduled benefits)

[GRAPHIC] [TIFF OMITTED] T3926A.004

                  Source: Congressional Budget Office.

                                 ______
                                 
    Such a policy could also substantially slow the growth of Federal 
debt held by the public over coming decades. Compared with current law, 
a 10 percent cut in new benefit awards starting in 2012 could reduce 
Federal debt by 25 percent of GDP by 2050 (see Figure 5). That debt 
reduction could also bring economic benefits from more private saving, 
faster capital accumulation, and higher economic growth. Enacting the 
same policy 10 years later would also reduce Federal debt, but the 
effects would be smaller.

 Figure 5. Change in Federal Debt Held by the Public from a 10 Percent 
                    Cut in Social Security Benefits

                          (Percentage of GDP)

[GRAPHIC] [TIFF OMITTED] T3926A.005

                  Source: Congressional Budget Office.

                                 ______
                                 
    The mechanistic approach of CBO's example is not intended as a 
recommendation or a comprehensive gauge of options. More-realistic 
proposals would include multiple provisions (such as tax increases, 
benefit reductions, or both) and would most likely be instituted 
gradually. This example is merely a convenient means of demonstrating 
the implications of earlier changes versus later ones.
    Such policy changes entail a variety of trade-offs about how to 
allocate the burden of bringing Social Security into long-term balance. 
One trade-off involves making decisions about the value of consumption 
today relative to the value of consumption tomorrow. The more that 
consumption is delayed, the more that resources are available for 
capital investment, which can boost economic growth. Another set of 
trade-offs involves balancing fairness across income classes and 
generational cohorts. In some respects, those trade-offs cannot be 
neatly separated into decisions about income groups and generations, 
since the prospect of rising wages is likely to make future generations 
more affluent than current generations, on average.
    Whatever the policy--benefit reductions, tax increases, transfers 
of resources from other Federal programs, or a combination of those 
approaches--earlier action would distribute the burdens of the change 
over more generations. For both workers and beneficiaries, gradual 
changes are generally preferable to precipitous and disruptive actions, 
such as sudden, large reductions in benefits or sudden, large increases 
in taxes. Moreover, if changes were announced in advance and phased in 
gradually, workers and beneficiaries would have more time to prepare 
and to appropriately adjust their decisions about work and saving.

                                 

    Chairman MCCRERY. Thank you. Dr. O'Neill?

    STATEMENT OF JUNE O'NEILL, PH.D., WOLLMAN PROFESSOR OF 
  ECONOMICS, BARUCH COLLEGE, CITY UNIVERSITY OF NEW YORK, NEW 
                              YORK

    Ms. O'NEILL. Mr. Chairman, Members of the Subcommittee, I 
appreciate the opportunity to appear before you today. For many 
years we have known that some time in the future the Social 
Security benefits currently scheduled would not be fully funded 
by scheduled tax increases. Yet the point in time when the 
system will run deficits always seemed far in the future, a 
distant period when Baby Boomers become retirees. We are now 
rapidly approaching that period. Social Security has grown to 
become the largest program in the national budget. Yet, despite 
its size, Social Security has seen surpluses, not deficits, for 
the past two decades, a fact that may have lulled some people 
into thinking: What's the problem? The emergence of surpluses, 
however, is partly the result of a favorable but temporary 
demographic episode, and partly the result of legislation that 
raised taxes. The baby bust generation of the thirties has been 
reaching retirement age over the past decade, a trend that 
slowed the growth in retirees. At the same time, the Baby 
Boomers were still enlarging the size of the work force, and 
therefore of taxpayers. Also, on the revenue side, legislation 
enacted in 1983 increased Social Security taxes by an amount 
that produced surpluses for many years.
    The quandary faced by the Greenspan Commission that 
recommended the 1983 legislation is endemic to the problem of 
funding a pay-as-you-go system. Social Security is required to 
balance costs and revenues over a 75-year fiscal horizon. 
Benefits are scheduled, and automatically indexed, but 
legislating the taxes to fund these benefits depends on long-
run projections based on aspects of the economy that cannot be 
known with any certainty. If tax revenues to pay for the 
benefits are set too low, the system will run deficits. If 
taxes are set too high, there will be surpluses. The Greenspan 
Commission erred on the side of surpluses, which turned out to 
be surpluses for the first 30 years but, after that, deficits 
for the long run. The commission may have believed that the 
surpluses would be saved to help fund the subsequent retirement 
of the Baby Boomers. Instead, the surpluses have been used 
routinely to fund other programs and have helped to mask 
deficits on the non-Social Security side of the budget.
    The period of Social Security surpluses is now expected to 
come to an end sometime between 2015 and 2020 as more and more 
Baby Boomers are added to the beneficiary population; at that 
point, annual deficits will replace surpluses. Expressed as a 
percentage of GDP, the Social Security shortfall, or gap, is 
estimated to increase rapidly, reaching 1.5 percent of GDP in 
2035, and growing after that. How will we meet this shortfall? 
Some hold to the belief that we will not face a financing 
problem for four decades from now. That belief is based on the 
accounting practices of the Social Security system that treat 
the balances in the so-called ``trust fund'' as though they 
were actually available to fund the revenue shortfall. The 
Social Security Trust Fund does not hold assets purchased in 
private markets that can be sold to pay benefits. The balances 
in the trust fund are bookkeeping entries showing the 
accumulated surpluses borrowed by the Treasury from the Social 
Security system, plus interest.
    In other words, the trust fund holds promises. The only way 
to make good on those promises is to increase general revenues 
or increase the publicly held debt. This will obviously entail 
a growing fiscal burden starting in another 10 to 15 years, 
when Social Security begins running deficits. Thus, our actual 
problem will begin at least two decades before the projected 
date of legal trust fund insolvency. Current projections of the 
trustees indicate that the trust fund balances will be 
exhausted about 2041--the CBO has it a decade later--at which 
point Social Security would be declared legally insolvent. The 
one practical effect of legal insolvency is that, by law, 
benefits must be held to the level of Social Security revenues 
once the balances of trust fund promises are depleted. Current 
estimates indicate that insolvency would trigger a precipitous 
reduction in benefits of 26 percent in 2041. Those are trustee 
estimates; CBO has a later-date insolvency, and somewhat lower 
initial decline in benefits. If Congress at that time chose to 
change the law and legislate higher taxes to close the gap, a 
payroll tax increase of 34 percent would be required, an 
increase in the combined payroll tax from about 13 percent to 
about 18 percent.
    One lesson to be learned from the financial history of 
Social Security is that we would not be in this fix if we had a 
prefunded system. If the Baby Boomers had started out making 
contributions into their own individually held accounts, their 
savings would have been invested in assets that eventually 
provide retirement income. Social Security, which is funded as 
a pay-as-you-go basis, shares many of the same problems faced 
by the defined benefit plans of the troubled airline and auto 
workers pensions. Benefits are promised, but the funding that 
will be needed to pay for them is not necessarily there when 
the time comes.
    The trust fund has no mechanism for prefunding benefits, 
nor would it be feasible or desirable for the Federal 
Government to purchase and hold assets from private markets. 
The only way for the Federal Government to prefund benefits is 
through individual accounts, in which each worker's 
contribution would go directly into an investment that cannot 
be directed to pay for other government programs but would grow 
in value over time and eventually contribute to the worker's 
own retirement income. For reasons such as these, prefunded, 
defined contribution plans have become the dominant type of 
pension plan in the private sector and the proportion of 
workers participating in defined benefit plans has sharply 
declined.
    Several concerns have been raised about the substitution of 
prefunded individual accounts for a portion of traditional 
Social Security benefits. Some argue that because workers 
cannot be certain of the ultimate value of the private 
accounts, they are better off with the safe benefit promised 
under our current system. Benefits under the current program 
are not risk-free. Today's young workers cannot be sure what 
the level of taxes and benefits will be over the next 40 years. 
The state of the economy and the world situation, as well as 
the political inclinations of the public and of future 
lawmakers, are uncertain, yet are bound to affect the future 
benefits that can actually be paid. Risk is present in private 
market investments, but can be minimized by well-known 
techniques of diversification. Moreover, based on past history, 
the average return to private investment securities can be 
expected likely to exceed the return that Social Security 
benefits will bring relative to tax payments made.
    Another concern is the transition cost that arises when a 
portion of taxes is diverted to private accounts and additional 
funds from either general revenues or government-issued debt 
must be obtained to fund the benefits of existing retirees. 
However, these transition costs are not a dead-weight loss. 
When the workers who have contributed to individual accounts 
retire, no tax payments will be needed to pay for the portion 
of their benefits that was prefunded. The transition costs may 
be viewed as an economic investment that will lower government 
costs in the future and will benefit saving and encourage 
economic growth.
    In my view, there are two significant changes that should 
be made. One is to begin a transition to at least a partially 
prefunded system. With prefunding we can look forward to a 
period when a significant portion of Social Security benefits 
will not be subject to unfavorable demography and constant 
political crises. Workers would gain by receiving a higher 
return on their savings in a more flexible form. Society would 
gain from increased economic growth. The second change needed 
is to contain the costs of the pay-as-you-go portion of the 
system while maintaining an adequate safety net. Under our 
current wage indexed system, benefits are automatically set to 
replace about 40 percent of the average retiree's earnings no 
matter how high the earnings get of all future retirees. In 40 
years, the average worker at retirement is expected to receive 
a benefit that is 50 percent higher than that of the retiring 
worker today. A plan such as progressive indexing would reduce 
the growth of benefits awarded to the average retiring worker 
while enhancing the benefits of low-wage earners.
    The provision of benefits at the high levels currently 
scheduled goes far beyond Social Security's original mission of 
poverty prevention. In signing the original law, President 
Roosevelt said, ``We can never ensure 100 percent of the 
population against 100 percent of the hazards and vicissitudes 
of life. We have tried to frame a law which will give some 
measure of protection to the average citizen and to his family 
against the loss of a job and against a poverty-ridden old 
age.'' At this point in time, doing nothing is not a sensible 
option. It ultimately would result in a sudden sharp decline in 
benefits when the program reaches legal insolvency. Major 
changes in retirement plans must be made enough in advance so 
that workers have time to adjust their work plans and savings. 
The time for planning and for reform is now. Thank you.
    [The prepared statement of Dr. O'Neill follows:]

  Statement of June O'Neil, Ph.D., Wollman Distinguished Professor of 
    Economics, Baruch College, City University of New York, New York

    Mr. Chairman and Members of the Subcommittee:
    I appreciate the opportunity to appear before you today to discuss 
problems concerning the Social Security system. For many years 
projections of the long-term financial status of Social Security have 
indicated that the benefits scheduled under current law cannot be fully 
funded by scheduled tax revenues. Yet the point in time when the system 
will run deficits always seemed far in the future--a distant period 
when baby boomers become retirees. We are now rapidly approaching that 
period.
     I will give a brief overview of the projected financial status of 
the program under current law and then comment on the economic issues 
raised by a mandatory retirement saving plan that is financed on a pay-
as-you-go basis, under which the benefits of current retirees are 
funded by the taxes of current workers. Issues related to the financial 
status of Social Security and its ``trust fund'' frequently get the 
most attention. But fundamental questions need to be addressed 
concerning the economic costs of maintaining Social Security in its 
current form.

Projected Financial Status
     Social Security currently is the largest program in the Federal 
budget. This year the program is estimated to spend $515 billion 
dollars, an amount that exceeds defense expenditures and accounts for 
23% of total Federal outlays. In another five years Social Security 
will begin to grow more rapidly as the oldest wave of baby boomers 
starts retiring. By 2015, social security is projected to be 70% larger 
than it is today, accounting for 26% of the budget. Combined with 
Medicare, the two programs are expected to consume almost half the 
Federal budget in 2015. (Medicare is growing faster than Social 
Security and it is estimated that in 2015 will be about 85% as large as 
Social Security and eventually will overtake it.)
    Despite its size, Social Security has not incurred funding problems 
for the past two decades. Although Social Security expenditures have 
been large, tax revenues from the payroll tax and from taxes paid on 
social security benefits have been even larger, generating substantial 
annual social security surpluses. The surpluses are partly the result 
of favourable economic conditions and favourable demography and partly 
the result of legislated tax increases. Regarding demography, the baby 
bust generation of the thirties has been reaching retirement age over 
the past decade while the baby boomers were still enlarging the size of 
the work force. In addition, increases in tax rates and coverage 
legislated in 1983 set in motion a flow of revenues that either 
accidentally or by design, produced surpluses for many years. 
Presumably the Greenspan Commission that recommended the bailout 
package---Social Security was at that time close to default--believed 
that any surpluses would be saved to help fund the subsequent 
retirement of the baby boomers. But the surpluses have been used to 
fund other programs. At present the annual Social Security surplus is 
approaching $100 billion. It has significantly helped to mask the 
deficit in the non-Social Security side of the budget for most of the 
past two decades.
    Figure 1 shows the past record and current projections of scheduled 
benefit payments and tax revenues from 1990 to 2080, based on the 
Trustees 2005 projections. The long period of Social Security surpluses 
is now expected to come to an end around 2015 as more and more waves of 
baby boomers are added to the beneficiary population. Between 2015 and 
2020 the Social Security surplus fades and turns to deficits. If no 
changes in the program are legislated, the overall Federal budget will 
experience considerable strain from the added burden of funding the 
growing Social Security shortfall.
    Expressed as a percentage of GDP, the small Social Security surplus 
of 0.2% in 2015 is estimated to turn into a shortfall or gap between 
scheduled benefit payments and tax revenues of 0.4% in 2020 (Figure 2). 
The gap then climbs quickly to 1.5% of GDP in 2035 and increases more 
slowly after that, reaching 1.9% of GDP in 2080.
    How will we meet this shortfall? Some hold to the belief that we 
will not face a financing problem for more than three decades from now. 
But that belief is based on the accounting practices of the Social 
Security system that treat the balances in the so called ``trust fund'' 
as though they were actually available to fund the revenue shortfall. 
Unfortunately, the Social Security trust fund does not, and could not 
hold assets purchased in private markets that can be sold to pay 
benefits. The balances in the trust fund are bookkeeping entries 
showing the accumulated surpluses borrowed by the Treasury from the 
Social Security system plus the interest that would have been earned on 
those balances from investing in various Treasury securities. In other 
words, the trust fund holds promises. But the only way to make good on 
those promises is to raise general revenues or increase the publicly 
held debt. This will obviously entail a heavy fiscal burden starting in 
another 10 to 15 years, when social security begins running deficits. 
Thus our actual fiscal problem will start at least two decades before 
the projected date of legal trust fund insolvency.
    Eventually the trust fund balances are projected to be exhausted, 
at which point Social Security would be declared legally insolvent. The 
Social Security trustees currently estimate that insolvency will occur 
around 2041, a date that undoubtedly will be altered many times. The 
one practical effect of insolvency on the program is that by law, 
benefits must be held to the level of social security revenues, once 
the balances of trust fund promises are depleted. If the law remains 
unchanged, that would mean a precipitous reduction in benefits of 26% 
in 2041 and 32% in 2079 (Figure 3). It should be noted that a change in 
the law that closed the gap between benefit costs and revenues in 2040 
with a payroll tax increase would require a 34 percent increase (an 
increase in the combined payroll tax from 13.3% to 17.8%). The size of 
that tax increase would have to continue growing after 2040 to keep 
pace with increasing costs.

Basic Economic Issues
    One major conclusion suggested by the pessimistic Social Security 
outlook is that we would not be in this fix if we had a pre-funded 
system. If the baby boomers had started out makingcontributions into an 
individually held account, their savings would have been invested in 
assets that eventually provide retirement income. But Social Security, 
which in many ways is similar to the troubled airline and autoworkers' 
defined benefit pension programs, is funded on a pay-as-you-go basis. 
The trust fund has no mechanism for pre-funding benefits. Nor would it 
be feasible or desirable for the Federal Government to purchase and 
hold assets from private markets. The only way for the Federal 
Government to pre-fund benefits is through individual accounts in which 
each worker's contribution goes directly into an investment that cannot 
be directed to pay other government programs, but would grow in value 
over time and eventually contribute to the worker's own retirement 
income. For reasons such as these, pre-funded, defined-contribution 
plans have become the dominant type of pension plan in the private 
sector as the proportion of workers participating in defined-benefit 
plans has dropped sharply.
    Several concerns have been raised about the substitution of pre-
funded individual accounts for a portion of traditional Social Security 
benefits. Some argue that because workers cannot be certain of the 
ultimate value of their private accounts they are better off with the 
``safe'' benefit promised under our current system. But benefits under 
the current program are not risk-free. Today's young workers cannot be 
sure what the level of taxes and benefits will be over the next 40 
years. The state of the economy and the world situation as well as the 
political inclinations of the public and of future lawmakers are 
uncertain, and are bound to affect future benefits. Risk is present in 
private market investments, but can be minimized by well-known 
techniques of diversification. Moreover, based on past history, the 
average return to investment expected, even with conservative 
strategies, is likely to exceed the return that Social Security 
benefits bring relative to the tax payments made.
    Another concern involves the transition costs that arise when a 
portion of taxes is diverted to private accounts and additional funds 
from either general revenues or government issued debt must be obtained 
to fund the benefits of existing retirees. However, these transition 
costs are not a deadweight loss. When the workers who have contributed 
to individual accounts retire, no tax payments will be needed to pay 
for the portion of their benefits that was pre-funded. The transition 
costs should be viewed as an investment that will lower government 
costs in the future and will benefit saving and encourage economic 
growth.

Decisions We Must Make 
    In my view there are two significant changes that need to be made. 
One is to begin a transition to at least a partially pre-funded system. 
The die is cast for the financing problems of the near term. But with 
pre-funding we can look forward to a period when Federal retirement 
benefits will not be subject to unfavourable demography and constant 
political crises. Workers would gain by receiving a higher return on 
their savings and in a more flexible form. Society would gain from 
increased economic growth.
    The second change needed is to contain the costs of the pay-as-you-
go portion of the system program while maintaining an adequate safety 
net. Under our current wage-indexed system, benefits are automatically 
set to replace about 40 percent of the average retirees earnings, no 
matter how high the earnings get of our future retirees. For example, 
the earnings level and benefit award of the average worker retiring in 
40 years is expected to be 50 percent higher than that of the retiring 
worker today. A plan such as progressive indexing would reduce the 
growth of benefits awarded the average retiring worker while enhancing 
the benefits of low wage earners.
    Providing benefits at the high levels currently scheduled goes far 
beyond Social Security's original mission of poverty prevention. In 
signing the original law, President Roosevelt said: ``We can never 
insure one hundred percent of the population against one hundred 
percent of the hazards and vicissitudes of life, but we have tried to 
frame a law which will give some measure of protection to the average 
citizen and to his family against the loss of a job and against 
poverty-ridden old age.''
    At this point in time, doing nothing is not a sensible option. In 
fact, it ultimately would result in a sudden sharp decline in benefits 
when the program reaches legal insolvency. Major changes in retirement 
plans must be made enough in advance so that workers have time to 
adjust their work plans and savings.

   Figure 1: Scheduled OASDI Cost and Revenue As a Percentage of GDP

                         (2005 Trustees Report)

[GRAPHIC] [TIFF OMITTED] T3926A.006

  Figure 2: Social Security Gap (Scheduled Benefit Costs--Tax Revenue)

                   As a Percentage of GDP (2005-2080)

[GRAPHIC] [TIFF OMITTED] T3926A.007

  Figure 3: OASDI Income and Cost Rates Under Intermediate Assumptions

                         (2005 Trustees Report)

                  (As a percentage of taxable payroll)

[GRAPHIC] [TIFF OMITTED] T3926A.008


                                 
    Chairman MCCRERY. Thank you, Dr. O'Neill. Mr. Entin?

    STATEMENT OF STEPHEN J. ENTIN, PRESIDENT AND EXECUTIVE 
 DIRECTOR, INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION

    Mr. ENTIN. Thank you, Mr. Chairman, Members of the 
Subcommittee. I thank you for the opportunity to testify on the 
issue of Social Security reform. If your only concern is about 
the national budget and keeping the Old-Age and Survivors 
Insurance (OASI) program solvent for a few more years with 
minimal political fallout, then Congress must either raise 
taxes or cut benefit growth in some manner, as in 1977 and 
1983. Those efforts did not improve the economy; they did not 
help your constituents on a permanent basis. We need to take 
into account not only how the economy affects Social Security, 
but how Social Security affects the economy, and how proposed 
solutions might impact your constituents and the economic 
performance of the Nation.
    I would suggest that if you want to deal with the economic 
situation as well as the technical budget situation within 
Social Security, then your best bet would be to treat Social 
Security as an insurance program and a safety net, and 
strengthen those aspects of the system, but to spin off the 
retirement feature. Social Security is not real saving. Let 
younger workers put some of their tax money into real saving 
vehicles that offer a much higher rate of return and that, 
unlike Social Security, make the economy grow. I would also 
like to ask you, quite literally, why are we making a Federal 
case out of retirement saving? The government's interest in 
this is to keep people out of poverty in their old-age and to 
prevent them from needing public assistance. If this is the 
case, the mandated saving should only extend to achieving the 
socially acceptable minimal level of retirement saving. Any 
Federal retirement system should let people stop adding to the 
government-mandated accounts when they are big enough to 
provide whatever basic level of lifetime income Congress deems 
appropriate.
    Mae West once said, ``Too much of a good thing is 
wonderful.'' She wasn't talking retirement saving or Federal 
intervention in personal finances. Carve-outs should be large 
enough and accounts should earn enough to allow people to 
replace all of their Social Security retirement benefits. They 
should not be so large as to displace private pensions or 
Individual Retirement Accounts (IRAs). You don't have to do the 
whole thing. Some of the plans that have been offered are too 
small. They involve small carve-outs, low-yielding assets, and 
low-yielding retirement annuities. The personal accounts would 
offer only part of the Social Security retirement benefit, 
leaving a residual burden on the OASI system and future 
Congresses. The President's Panel Plan Two and the Graham Plan 
would have that drawback. Some plans are too big. They match 
the relatively high benefits and replacement levels promised 
low-income workers, but they overshoot for middle-and upper-
income workers. The Ryan-Sununu Plan has an average carve-out 
of 6.4 percent; it could, if invested in stocks, yield 
replacement rates of 80 to 100 percent of pre-retirement 
income. You don't need to go that far. Perhaps something on the 
order of a 4-percent carve-out tilted a bit toward the low-
income, a bit less toward the upper-income, would do the job 
and would still induce most people to use the personal 
accounts.
    Should you trim the benefit growth? Well, if you don't have 
personal accounts and just patch up Social Security, you are 
going to have to do that anyway. If you make the carve-outs and 
the private plans big enough to attract everyone into them, 
then it would in theory not be necessary to trim the promised 
benefits since nobody would be claiming them. If you don't trim 
the promised benefits, they get very high, as Dr. O'Neill has 
mentioned and as the chart I have reproduced from the trustee's 
Report in the back of my testimony shows. So, if you fail to 
trim the benefits it makes it harder for the new personal 
accounts to better the Social Security promises, and fewer 
people would switch into them. Wage indexing of the benefit 
formula and the projected 128-percent increase in real wages by 
2080 would send benefits for some couples very, very high. An 
upper-income married couple could be getting over $109,000 a 
year from Social Security in today's money. We can't afford 
that, and the payroll tax hike that would be necessary to 
provide such a benefit would be outrageous. There are many ways 
to trim benefits. I have mentioned some in my testimony.
    The economic outcome depends on how you do it. Do not cap 
the carve-out; you won't be giving any labor incentives to 
people above the limited amount of money covered by the amount 
of payroll tax diversion. The President's Panel Two Plan and 
the Graham Plan effectively omit labor incentives for people 
above $25,000 and $32,500. The Ryan-Sununu Plan extends its 
carve-out all the way up to $90,000 and has more labor force 
incentives. You mustn't neglect the labor force impact because 
the saving in investment impact is not so certain. The latter 
would depend on what you do with the money and how you handle 
the financing. The labor force effects of lowering the payroll 
tax are very well-known. As I mentioned, how you fund the 
transition is going to affect the economic outcome. Trimming 
government spending would free real resources and money to help 
the private sector expand and Gross National Product (GNP) 
would be about 2 to 3 percent higher over time. Borrowing would 
not do that. Raising other taxes, especially on capital at the 
margin, could cause GNP to fall by about 8 percent by the time 
the Baby Boomers is done retiring.
    Don't assume that simply establishing personal accounts and 
prefunding will boost growth in tax revenues by increasing 
national savings and investment. Some of the saving would 
displace other saving. Businesses that borrow the saving might 
be fully invested in the United States, and expand abroad. If 
you couple the Social Security reform with better tax treatment 
of capital formation, you could ensure that the saving would 
occur, that it would not be borrowed back by the government if 
you trim government spending, that it would be invested in the 
United States, and then you might end up with GNP about 6 or 7 
percent higher; over twice the gain from just having the 
personal accounts alone. Social Security reform and tax reform 
go hand in glove. Thank you.
    [The prepared statement of Mr. Entin follows:]

   Statement of Stephen J. Entin, President and Executive Director, 
          Institute for Research on the Economics of Taxation

    Congress has been asked to deal with the projected outyear deficits 
in the Social Security Old Age and Survivors Insurance program (OASI), 
and to help future generations better meet their retirement needs. It 
would be wise to take action now, while policy changes would have time 
to work, rather than wait until a crisis forces less benign choices on 
a future Congress. Before taking action, however, the Subcommittee 
needs to be clear about several things. What are the problems that you 
are trying to address? What policy options are available and what do 
they do? How can they be matched to the objectives?

What are the problems that you are trying to address?
    Is your objective merely to deal with Congressional concerns about 
the Federal budget consequences of the OASI deficits? Is it merely to 
keep OASI solvent, more or less in its current form, for some period of 
time after the retirement of the baby boom generation, with minimal 
political fall-out? If these are the goals, Congress must either raise 
taxes dedicated to OASI, raise other taxes, trim OASI benefits, or trim 
other spending. There are an infinite number of ways to do this. Some 
combination of changes must be selected. In 1983, a compromise was 
agreed to under the cover of the Greenspan Commission. It merely bought 
time. It did not solve the System's long run problems, and paid no 
attention to the proposal's effects on the economy and the well-being 
of the population.
    Are there additional objectives this time around? Should the 
solution enhance the retirement income of future generations? Should it 
improve the functioning of the economy? Should it give people more 
freedom and responsibility for their own welfare? Should it provide a 
permanent fix, throughout the 75 year planning period and beyond, 
rather than a temporary one as with the 1977 and 1983 Amendments? If 
so, you must address the solvency and budget issues in certain ways and 
not others, and go beyond solvency to address these other issues. In 
doing so, be very careful how you design your program to make it 
effective, affordable, and devoid of unintended consequences.
    The interests of the public go beyond the narrow concerns of the 
Congress in these matters. Over the years, this Subcommittee has tried 
to study and address these more fundamental interests. Members of both 
parties have offered thoughtful and effective proposals. The 
Subcommittee's recent attention to the problem is most encouraging.

Hybrid nature of Social Security: a sound safety net, a shaky 
        retirement system
    Social Security combines a social safety net program and a 
retirement income program. The social safety net includes insurance 
features, such as disability and survivors' benefits, and income 
transfers to low income earners. The original purpose of Social 
Security was to prevent poverty among the elderly, a stark problem in 
Depression-era America.
    To attract political support for what was then a revolutionary 
national welfare arrangement, President Roosevelt and Congress extended 
retirement benefits to most workers, not just to the needy. The 
immature system, with many workers and few retirees, could offer middle 
and upper income workers a good return on their contributions to gain 
support for the safety net system. The retirement benefits were to be 
only one leg of a three-legged retirement income program, however. The 
other two legs were pensions and private saving.
    Today, the system is mature. A full complement of retirees is 
drawing benefits, and the recipients are living longer than ever 
before. The birth rate is down, and there are fewer workers per 
retiree. Today, the Social Security system remains an effective anti-
poverty program and safety net. As a retirement program, however, it is 
now a bad deal, and getting worse. Today, the carrot for younger 
workers to support the safety net is to allow them to buy their way out 
of the retirement system, rather than to remain in it, and to put some 
of their tax money into real saving vehicles that offer a much higher 
rate of return.
    Social Security is a pay-as-you-go tax-transfer system, in both its 
safety net and retirement features. Income is payment for production. 
When a transfer system shifts income from taxpayers to beneficiaries, 
it is effectively taking output from those who produced it and giving 
it to others. A real retirement system, by contrast, involves real 
saving. It is funded, not pay-as-you-go. People devote some of their 
current earnings to saving. They consume less than they produce, and 
support capital formation, boosting productive capacity. The capital 
adds to future output, and when the savers retire, they are still 
producing goods and services via the capital they own. Their income is 
not a transfer from others, it is payment for additional output they 
are currently making happen. Substituting Social Security benefits for 
real saving has depressed capital formation (or made it more dependent 
on foreign saving), and has retarded productivity, wages, and GDP for 
decades. If done correctly, switching back to a system of real saving 
would boost capital formation and Americans' ownership of capital. It 
would boost productivity and wages too.

Role of government in retirement saving decisions today
    Why are we making a federal case out of retirement saving? What 
reason is there for the Federal Government to concern itself with the 
saving and retirement decisions of individuals? The usual justification 
is a concern over moral hazard. Society will not stand by and let 
people suffer extreme poverty in old age. But society does not want 
people to take advantage of that fact, and does not want to pay for 
people who could have taken care of themselves. Thus, the government 
feels it has a right to force people to save when young to avoid 
needing assistance when old, and perhaps to make them buy an annuity so 
they won't fritter away the money or outlive it when they retire. This 
is a rather paternalistic attitude, piling one intervention (mandated 
saving) on top of another (the safety net). If this is the case for 
Federal involvement, the mandate should only extend to achieving the 
socially acceptable minimum level of retirement income. The government 
should not require people to do more, nor should it coopt other forms 
of saving.

How much saving should we mandate?
    Mae West once said, ``Too much of a good thing is wonderful.'' But 
she wasn't talking about retirement saving, or federal intervention in 
personal finances.
    The program should let people stop adding to the government 
mandated accounts when they are big enough to provide whatever basic 
level of lifetime income the Congress chooses to set. Once an account 
holder is able to buy a minimum required annuity, or can fund a staged 
payout over his or her remaining life expectancy, that should be 
enough. The plan should then allow people to use the payroll tax 
diversion for anything they wish, i.e. an unfettered tax cut. (This 
feature is in the Chilean plan.) The plan should not make people 
contribute up to a specified retirement age no matter how large the 
accounts get.
    Most plans only require individuals to annuitize a basic level of 
benefits, and leave them free to allocate the rest of their assets as 
they like, and that is good. But there is no public purpose served by 
forcing people to accumulate excessive funds in the government program 
in the first place. Let people use pensions, IRAs, and other saving 
plans for such purposes. Do not nationalize the retirement savings 
industry. Give people their freedom once they have met their mandated 
retirement needs.

How big a carve-out is needed? Should it be invested in high- or low-
        yielding assets?
    Carve-outs should be large enough, and accounts should earn enough, 
to allow people to replace all their Social Security benefits. They 
should not be so large as to make transition financing unnecessarily 
difficult or to displace private pensions or IRAs.
    Some plans are too small. Some plans recommend small carve-outs to 
minimize the apparent transition cost to the Federal budget. Some would 
make available low-yield investment options consisting mainly of 
government or corporate bonds. Such plans may be convenient for budget 
makers, and may satisfy people with a profound distrust of financial 
markets, but they do a disservice to the people.
    Locking people into low-yielding assets as they work and save, and 
into low-yielding retirement annuities, would guarantee them a heavy 
saving burden when young and a low income when old. Their personal 
accounts might then deliver less than currently promised benefits, or 
even the reduced benefits that a trimmed down OASI system might offer. 
Their personal accounts would offset only a part of their Social 
Security benefit, leaving a residual burden on the OASI system. For 
example, the relatively small carve-outs and the contribution caps in 
the President's Panel plan 2 and the Graham plan, and presumed 
investment guidance, could keep the accounts from matching current 
benefit levels for many people. The carve-out should be large enough, 
and the investment options should be high-enough yielding, to generate 
a fund at retirement that can replace fully whatever retirement benefit 
would be available by remaining in Social Security. If Congress decides 
to trim the growth of future Social Security benefits for those who 
choose to remain dependent on the Social Security system, a lower 
carve-out would be needed to make the personal accounts more attractive 
than Social Security benefits.
    Some plans are too big. Some plans propose large carve-outs to 
match the benefits and replacement rates given to low income workers, 
who receive higher replacement rates than higher earners under OASI. 
For example, the Ryan/Sununu plan has an average carve-out of 6.4%, 
and, in a blended stock-bond fund, could match low income benefits 
currently promised. Another plan would let people put all 12.4% of the 
OASDI tax aside, including the Disability Insurance portion. Such 
carve-outs would over-shoot benefits and replacement rates currently 
promised to average and higher income workers, and far over-shoot what 
Social Security can pay at current tax rates, unless people could stop 
contributing to them once enough saving to generate a socially mandated 
basic retirement income floor was attained. (See tables 2, 3, and 4, 
below. Multiply the carve-out rates in the various plans by the 
potential replacement rates each percent of income saved could 
generate, and compare the results to what Social Security is 
promising.)
    Furthermore, the accounts are assumed to be invested in fairly 
conservative blended funds before retirement, and low-yielding bonds 
afterwards. Such large carve-outs, if invested more in stocks, and in 
balanced annuities, would yield much larger retirement benefits. 
Replacement rates could reach 80 percent to 100 percent of pre-
retirement income, and could coopt pensions, IRAs, and other private 
saving arrangements. We should not be proposing to take over the bulk 
of retirement saving in the revised Federal program. Too large a carve-
out would also increase the transitional borrowing requirement or the 
amount of spending restraint needed to avoid the borrowing.
    Just right? An average four percentage point carve-out, designed to 
be higher for low income workers, and lower for high income workers, 
should be more than sufficient to induce most people to use personal 
accounts, especially if benefit growth is trimmed to avoid payroll tax 
increases, and if stock investments are encouraged. (See Table 4, 
Alternative plan.)

Should promised benefit growth be trimmed?
    If Congress makes the carve-outs and the resulting personal 
accounts so big that they will exceed everyone's promised Social 
Security benefits, and everyone will opt for them in lieu of benefits, 
it does not matter whether the regular benefits are trimmed or not. 
However, failure to trim benefit growth would make it harder for the 
personal accounts to beat what Social Security is promising, and less 
likely that people will switch. Bigger carve-outs would be needed, with 
a bigger explicit transition cost for the federal budget. That is 
something of an illusion, since we are shedding a corresponding Social 
Security promise (cutting the current unfunded obligation by $10.5 
trillion at a cost of $2 trillion to $4 trillion). Still, it is less 
costly to trim the program back to what current taxes can now pay for. 
Furthermore, trimming benefits would reduce government intervention in 
the saving decision. Smaller benefits would mean that more people would 
get all their system-related income from individual accounts instead of 
SSA.
    The attached table VI.F10 from the Social Security 2005 OASDI 
Trustees Report shows the projected growth in real retirement benefits 
under current law. These numbers are after inflation. Wage indexing of 
the benefit formula, coupled with a projected increase of 128% in real 
wages by 2080, will send real benefits soaring in line with wage 
growth. Add fifty percent for married couples getting a spousal 
benefit, and double the numbers for two worker couples each earning at 
the illustrative levels. Upper income couples could be getting over 
$109,000 a year, in today's dollars. To meet these benefits, the 
payroll tax would have to rise by six percentage points, a major blow 
to low income workers. Surely, some trimming of benefit growth could be 
done without injuring future cohorts.

If we are to trim benefits, how shoujld we do it?
    Price versus wage indexing. The 1972 Social Security Act Amendments 
included an automatic mechanism that over-adjusted benefits for 
inflation, and replacement rates soared. Prior to the 1976 election and 
the 1977 Amendments, a panel headed by actuary William C. Hsiao 
addressed the error. Unions, SSA, and HEW recommended wage indexing 
worker's earnings histories and the ``bend points'' of a new benefit 
formula, keeping benefits growing with wages over time. The Hsiao panel 
and OMB recommended using a price index for those elements to keep the 
system solvent over time. The resulting benefits would still have risen 
in real terms, just not as fast as with wage indexing. (See the Report 
of the Consultant Panel on Social Security to the Congressional 
Research Service, Prepared for the Use of the Committee on Finance of 
the U.S. Senate and the Committee on Ways and Means of the U.S. House 
of Representatives, 94th Congress, 2nd session, August, 1976.) In an 
election year, President Ford opted for the more generous wage 
indexing. He lost the election anyway.
    This old form of price indexing the benefit formula differs from 
the current proposals for price indexing benefits in the President's 
Panel plan 2 and the Graham plan. The new proposals would hold benefit 
growth to the rate of inflation, starting in 2009. (It would keep wage 
indexing earnings and bend points, but lower the replacement factors in 
each bend point to offset inflation.) Cohort over cohort, future 
average wage workers would get the same real benefit as today's average 
wage worker; future low wage workers would get the same real benefit as 
today's low wage worker, and so on across all earnings levels.
    A progressive price indexing plan has been suggested by Professor 
Robert Pozen. Benefits for the bottom 30% of the earnings distribution 
would be calculated as under current wage indexing. Benefits for the 
highest earners would be limited to price increases (as in this new 
form of price indexing). Benefits for workers between the 30th 
percentile and the top would be gradually scaled from the wage-indexed 
level to the price indexed level.
    In 1994, Ways and Means Chairman Dan Rostenkowski and Social 
Security Subcommittee Chairman J. J. Pickle introduced measures to 
eliminate projected Social Security deficits. The Rostenkowski bill 
(H.R. 4245) slowed benefit growth for workers with average income and 
above by adding an additional bend point with a 10% replacement factor, 
and holding the growth of the top two bend points to a percent below 
wage growth for 50 years. The results roughly resemble the Pozen plan. 
The Pickle bill (H.R. 4275) gradually raised the normal retirement age 
to 70, which is another way to trim benefit growth. Other proposals 
would ``index'' normal retirement age to rising life expectancy.

To annuitize or not to annuitize, another key question
    Too much of an annuity is a bad deal for retirees. One cannot leave 
an ordinary annuity to one's heirs; payments die with the recipient. 
Annuities can be designed to cover more than one beneficiary, or to 
guarantee a minimum return if the annuitant dies early, but such 
arrangements are expensive and complex. People should have 
alternatives, such as a paced withdrawal in line with life expectancy. 
If Congress insists on annuities, once a minimal anti-poverty annuity 
is purchased, a person should be free to use the rest of the account's 
assets as he or she wishes. But then, why make people accumulate that 
excess in the government sponsored plan in the first place?

Economic benefits demand careful design
    Do not cap the carve-out. The most certain economic benefit from 
diverting a portion of the payroll tax to personal accounts will come 
from the added incentive to work and hire. For that to occur, however, 
the incentive must exist ``at the margin,'' i.e., extend to the next 
dollar one might earn by working longer or harder. To that end, the 
carve-out must not be capped. The President's Panel plan and the Graham 
plan only reduce the effective payroll tax rate at the margin on 
incomes up to $25,000 and $32,500, and give no incentive to people with 
higher incomes. The Ryan-Sununu plan reduces the tax rate and extends 
the work incentives all the way up to the maximum covered wage of 
$90,000.

How the transition is funded will affect the economic outcome
    Trimming government spending growth would free real resources to 
expand the private sector of the economy, funded by increased private 
saving. Borrowing would not free real resources, and would take back 
much of the saving in the personal accounts to pay for government 
operations. It would leave the economy slightly worse off over time. 
Raising other taxes, especially on capital, at the margin, would weaken 
the economy and reduce investment, employment and wages. For a more 
extensive discussion, see my testimony to the House Budget Committee 
Social Security Task Force, May 18, 1999. The attached Chart 1, adapted 
from that testimony, shows the impact of the various financing options 
on GNP.

To maximize gains in a global market, combine with tax reform
    One cannot assume that simply establishing personal accounts will 
boost growth and tax revenues by increasing national saving and 
investment. Some of the saving will displace other saving that people 
are already doing. Some of the saving may be borrowed by the 
government. Some of the saving will back out some of the saving flowing 
in from abroad, or will flow abroad. Businesses that borrow the saving 
may be fully invested in the United States under current tax and 
regulatory regimes, and may expand abroad instead.
    To ensure that the personal accounts increase U.S. saving, 
investment, wages, employment, and output, Congress should: trim 
spending instead of borrowing to fund the transition; accord the 
accounts the same tax incentives given to pensions and IRAs; improve 
the tax treatment of investment by moving toward expensing of 
investment outlays and by extending the relief from the double taxation 
of corporate income provided by the 15% tax rates on capital gains and 
dividends. In short, Social Security reform and fundamental tax reform 
work hand in glove. Each reinforces the other. Chart 2, adapted from my 
Task Force testimony, shows the impact of adopting expensing as well as 
personal accounts. The resulting increase in GNP is substantially 
larger than without adding that feature.

Some tables to guide the design of a proposal
    Table 1 lists historical rates of return on various assets that 
could be included in investment options for personal accounts. Compare 
these to the 2% return in OASI, which is the sum of population growth 
and productivity/real wage growth. Table 2 presents mixes of assets 
that would result in various rates of return. It also shows how much 
retirement income could be replaced, for each percent of income saved 
while working over a 45 year period, if invested in these mixed funds. 
Table 3, top section, shows the replacement rates that Social Security 
is promising to people at various levels of income, and how much it can 
actually deliver at current tax rates. The bottom section shows how 
much of a carve-out would be needed to match the Social Security 
replacement rates in personal accounts, at the various rates of return. 
Table 4 shows the carve-outs contained in various Congressional 
proposals.

        Table 1: Average Annualized Returns on Assets, 1926-2004
                          (Ibbotson Associates)
------------------------------------------------------------------------
                                                 Nominal        Real
------------------------------------------------------------------------
Large company stocks                                10.4%          7.2%
------------------------------------------------------------------------
Small company stocks                                12.7%          9.4%
------------------------------------------------------------------------
Long term corp. bonds                                5.9%          2.8%
------------------------------------------------------------------------
Long term govt. bonds                                5.4%          2.3%
------------------------------------------------------------------------
Intermediate term govt. bonds                        5.4%          2.3%
------------------------------------------------------------------------
U.S. Treasury bills                                  3.7%          0.7%
------------------------------------------------------------------------
Inflation                                            3.0%          n.a.
------------------------------------------------------------------------


 Table 2: Returns on various portfolios of assets, and replacement rates
                       for each % of income saved
------------------------------------------------------------------------
Portfolio mix: Percent
  Stocks and Percent      0/100     40/60     60/40     75/25     95/5
        Bonds*
------------------------------------------------------------------------
Approximate real           2.5%      4.5%      5.5%      6.5%      7.5%
 return during
 accumulation
------------------------------------------------------------------------
Payout as % of pre-        4.0%      6.5%      8.6%     11.3%     15.0%
 retirement income
 (replacement rate),
 annuity in bonds
 (real return of
 2.5%), for each % of
 income saved*
------------------------------------------------------------------------
Payout as % of pre-        4.8%      7.8%     10.3%     13.5%     18.0%
 retirement income
 (replacement rate),
 annuity in mixed
 portfolio (real
 return of 4.5%), for
 each percent of
 income saved*
------------------------------------------------------------------------
*Stocks roughly 2:1 large company: small company; Bonds roughly 2:3
  corporate: government. Assumes income rise 1.1% a year in real terms.
  Assumes 20 years average lifespan in retirement.


   Table 3: Social Security replacement rates for retirees with various earnings histories, as promised under
                                current law and as funded under current tax rates
----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
Income categories, 2005:                                 low wage*    average wage*    high wage*    max. wage*
                                                         ($15,820)        ($35,157)     ($56,251)     ($90,000)
----------------------------------------------------------------------------------------------------------------
Promised replacement rate:                                     55%              41%           34%           27%
----------------------------------------------------------------------------------------------------------------
Funded replacement rate:                                       38%              28%           23%           18%
----------------------------------------------------------------------------------------------------------------
Percent of income (required carve-out) that must be saved in working years in various portfolios to equal Social
 Security's promised/funded replacement rates (above). Top line assumes an annuity with a 2.5% real return (all
 bonds) and bottom line assumes an annuity with a 4.5% real return (60/40 stocks/bonds)*
----------------------------------------------------------------------------------------------------------------

      

0/100                                              2.5%    13.9%/9.6%    10.3%/7.1%     8.6%/5.8%     6.8%/4.5%

stocks/bonds                                       4.5%    11.6%/8.0%     8.6%/5.9%     7.1%/4.8%     5.7%/3.8%
----------------------------------------------------------------------------------------------------------------
40/60                                              2.5%     8.4%/5.8%     6.3%/4.3%     5.2%/3.5%     4.1%/2.8%

stocks/bonds                                       4.5%     7.0%/4.8%     5.2%/3.6%     4.3%/2.9%     3.4%/2.3%
----------------------------------------------------------------------------------------------------------------
60/40                                              2.5%     6.4%/4.4%     4.8%/3.3%     4.0%/2.7%     3.2%/2.1%

stocks/bonds                                       4.5%     5.4%/3.7%     4.0%/2.7%     3.3%/2.2%
                                                                                        2.6%/1.8%
----------------------------------------------------------------------------------------------------------------
75/25                                              2.5%     4.9%/3.4%     3.6%/2.5%     3.0%/2.0%     2.4%/1.6%

stocks/bonds                                       4.5%     4.1%/2.8%     3.0%/2.1%     2.5%/1.7%     2.0%/1.3%
----------------------------------------------------------------------------------------------------------------
95/5                                               2.5%     3.7%/2.5%     2.7%/1.9%     2.3%/1.5%     1.8%/1.2%

stocks/bonds                                       4.5%     3.1%/2.1%     2.3%/1.6%     1.9%/1.3%     1.5%/1.0%
----------------------------------------------------------------------------------------------------------------
*Uniform low wage earner at 45% of average wage; high wage earner at 160% of average; maximum earner at covered
  wage cap. Figures for 2005, Social Security OASDI Trustees Report.


           Table 4: Carve-out Rates Under Various Reform Plans
------------------------------------------------------------------------
  Income categories, 2004:     low wage  ave. wage  high wage  max. wage
------------------------------------------------------------------------
Social Security Panel Plan        4.0%       2.8%       1.8%       1.1%
 2: 4% of wages up to $1,000
 contribution (covers 1st
 $25,000 of wages)
------------------------------------------------------------------------
Graham: 4% of wages up to         4.0%       3.7%       2.3%       1.4%
 $1,300 contrib. (covers 1st
 $32,500 of wages)
------------------------------------------------------------------------
Ryan/Sununu: 10% of 1st           8.2%       6.4%       5.9%       5.6%
 $10,000 of wages, 5% of
 remainder up to max. wage
------------------------------------------------------------------------
Alternative: 10% of 1st           7.1%       4.3%       3.4%       2.9%
 $10,000 of wages, 2% of
 remainder up to max. wage
------------------------------------------------------------------------

[GRAPHIC] [TIFF OMITTED] T3926A.009
                                                               
[GRAPHIC] [TIFF OMITTED] T3926A.010
                                                               

                                 

    Chairman MCCRERY. Thank you, Mr. Entin. Mr. Beach?

   STATEMENT OF WILLIAM W. BEACH, DIRECTOR, CENTER FOR DATA 
               ANALYSIS, THE HERITAGE FOUNDATION

    Mr. BEACH. Thank you very much, Mr. Chairman. My name is 
William Beach, with The Heritage Foundation. Mr. Levin, Members 
of the Subcommittee, it is a pleasure to be with you this 
morning. I am going to continue to be a footnote to Steve Entin 
and talk about taxes. My testimony today focuses on how raising 
taxes to pay for Social Security's expected financial 
shortfalls would likely affect major economic indicators. That 
is, what does the mainstream economic theory tell us about the 
likely effects on the general economy if Congress increases 
dedicated revenue flows to finance projected shortfalls between 
Social Security's income and its outlays? Research conducted by 
myself and my colleagues at The Heritage Foundation's Center 
for Data Analysis (CDA), shows that either raising tax rates or 
increasing the taxable income amounts comes with an economic 
price. Of course, so does the President's plan, but the 
economic costs are considerably different.
    Social Security's trustees estimate that increasing the 
payroll tax rate by 1.9 percentage points to 14.3, roughly, 
percent, in total might be sufficient to make Social Security's 
Old-Age, Survivors and Disability Insurance (OASDI) programs 
solvent over the 75-year test period. This is the sort of small 
change that many opponents of reform, that is of structural 
reform, paint as a reasonable solution to Social Security's 
developing crisis. Using a mainstream model of the U.S. 
economy, Mr. Chairman, we at the Center for Data Analysis 
simulated the economic effects of a 1.9 percent point increase 
of the payroll tax on the general economy. It should come as no 
surprise to this Committee that a tax increase of this 
magnitude would increase the cost of labor in the economy and 
therefore have an impact on jobs. The CDA study found that a 
1.9 percentage point increase in the payroll tax would reduce 
potential employment by roughly 277,000 jobs per year, on 
average, over the next 10 years, relative to the baseline--a 
baseline that we adopted from the CBO. There are spillover 
effects on economic growth as well. Increasing the payroll tax 
would reduce U.S. GDP, a broad measure of economic activity, by 
roughly $35 billion per year, on average, over the next 10 
years.
    Overall, raising the payroll tax would have a major impact 
on U.S. households. On average, every American would have 
roughly $302 less in disposable income per year for each of the 
next 10 years, amounting to over $1,200 less for a family of 
four. Raising the payroll tax rate is only one variant of the 
revenue-enhancement approaches to reform. Other proponents of 
tax increases argue that the amount of wages subject to the tax 
should be increased. This increase is what is called the 
maximum taxable income amount. It would in fact increase 
revenues, but again, come at an economic cost. The cost of 
eliminating the cap--let's just take that, for example--would, 
among other things, result in a very large increase, perhaps 
the largest tax increase in U.S. history, subjecting millions 
of Americans to a massive hike in overall payroll tax rates 
and, I fear, a very significant increase in the capital taxes. 
Among its effects, this would be a very large increase in 
taxes, as I have said--roughly $607 billion over 5 years, and 
$1.4 trillion over our 10-year period in our model.
    It would, oddly enough, fail to save Social Security from 
bankruptcy. Social Security would start paying out more in 
benefits than it collects in 2025, only eight years later than 
under the current system. Attached to my written testimony is a 
graphic to that effect. It would increase the top effective 
Federal marginal tax rate on labor income to over 50 percent, 
its highest level since the seventies. It would reduce the 
take-home pay of 9.8 million workers by an average of $4,200 in 
the first year alone after the cap is removed. It would weaken 
the U.S. economy by reducing the number of job opportunities 
and personal savings significantly. In fact, in fiscal year 
2015 in our model, in the number of job opportunities lost 
would exceed 965,000 jobs. Personal savings, adjusted for 
inflation, would decline by $55 billion.
    Opponents of real or structural Social Security reform are 
right in the sense that we can make small changes to the 
system--there is certainly that. They are, in a sense, 
misleading because they are not talking about the economic 
consequences of those small changes, particularly on the tax 
side. The changes may indeed be small, or seemingly small, but 
the numbers involved are, in the last analysis, enormous. 
Raising the payroll tax or the maximum taxable income limit 
enough to fully fund Social Security would put a damper on 
savings, jobs, and economic growth, to the great detriment of 
working Americans. Raising taxes enough to take Social 
Security's cash flow problems off the table would require even 
more sacrifice. I am happy to answer questions.
    [The prepared statement of Mr. Beach follows:]

Statement of William W. Beach, Director, Center for Data Analysis, The 
                          Heritage Foundation

    The salutary news from Capitol Hill this summer is the steady 
movement toward reforming Social Security's Old-Age Program. Despite 
news stories and public opinion polls, many Members of Congress in both 
parties have pushed forward with serious debate over Social Security 
financial future and analysis of ways to make that future more secure. 
Everyone who cares about Social Security's retirement programs applauds 
that effort.
     Indeed, it appears likely that the principal bill writing 
committees of the House and Senate may complete work on reform 
legislation over the next few months. Given that increasing 
probability, it is important now to consider the ramifications of 
reform plans on a host of factors, not the least of which is U.S. 
economic activity.
    My testimony today focuses on how raising taxes to pay for Social 
Security's expected financial shortfalls would likely affect major 
economic indicators. That is, what does mainstream economic theory tell 
us are the likely effects on the general economy if Congress increases 
dedicated revenue flows to finance projected shortfalls between Social 
Security's income and its outlays?
    Why start with the question rather than with one focusing on the 
economic effects of using higher taxes to fund the transition costs to 
an improved Social Security retirement program? Clearly, Congress will 
need many answers to this question. However, I believe it should first 
ponder an often heard ``reform'' to the current system that its 
advocates claim would avoid any necessity for embracing Personal 
Retirement Accounts: raise taxes to fill in the financing shortfalls 
either by increasing the payroll tax rate or raising the maximum 
taxable income amount.
    Research conducted by me and my colleagues at Heritage's Center for 
Data Analysis indicate that either approach to revenue enhancement 
comes with an economic price. Of course, so does the President's plan. 
The economic costs, however, are significantly different.
    President Bush proposes to solve the problem of Social Security's 
unfunded liabilities by enacting a reform plan that includes personal 
retirement accounts (PRAs). Proponents of PRAs argue that this sort of 
reform would increase national savings, bolster employment, and improve 
economic growth, all while closing Social Security's funding gap. 
Opponents of the President's approach argue that Social Security's 
funding problems do not demand wholesale reform and that Social 
Security's shortfall is only a ``challenge'' that can be addressed by 
making small changes to the current program.
    One such change that has been proposed would be to raise payroll 
taxes enough to render Social Security solvent. Opponents of real 
reform are right that raising payroll taxes could close a portion of 
Social Security's funding gap, but they are wrong in saying that doing 
so would require only a small change. Raising payroll taxes would make 
Social Security a worse deal for millions of working Americans, harm 
the economy, and cost thousands of jobs, and still would not fix Social 
Security.
    Social Security faces an unfunded liability of $3.7 trillion in 
today's dollars over the next 75 years. This number represents the 
amount that the system, despite having promised the money to America's 
workers, will be unable to pay. Short of major reforms, raising taxes 
or cutting benefits are the only ways to close this funding gap.
    Right now, workers pay a 6.2 percent tax on their wages up to 
$90,000 to fund Social Security. Employers pay an additional 6.2 
percent tax. This division in the payroll tax is artificial, however, 
as employers regard their part of the payroll tax as an expense of 
hiring, just like wages and other benefits: In other words, it is money 
that the employer is willing to spend on his workers. Though workers 
see only a 6.2 percent deduction on their pay stubs for Social 
Security, they really pay the whole 12.4 percent tax in terms of 
foregone wages.
    Social Security's Trustees estimate that increasing the payroll tax 
by 1.89 percentage points, to 14.29 percent in total, would be 
sufficient to make Social Security's Old Age, Survivors, and Disability 
programs solvent.\1\ This is the sort of ``small change'' that 
opponents of reform paint as a reasonable solution to Social Security's 
developing crisis.
---------------------------------------------------------------------------
    \1\ The Trustees base this estimate on a 75-year time horizon.
---------------------------------------------------------------------------
    The average worker might disagree. If payroll taxes were increased 
by 1.89 percentage points, a worker earning $35,000 would forego an 
additional $662 in pay every year. Raising payroll taxes by 1.89 
percentage points would cost this worker, on average:

      As much as he spends on gasoline over three months;
      As much as he spends in two and a half months on 
clothing;
      As much as he spends in one month on food for consumption 
at home; or
      As much as he spends in two months on food outside of the 
home.\2\
---------------------------------------------------------------------------
    \2\ Data taken from U.S. Department of Labor, Bureau of Labor 
Statistics, Consumer Expenditure Survey.

    In other words, this ``small change'' in the payroll tax would have 
a major impact on most workers' household budgets.
    Using the Global Insight U.S. Macroeconomic Model, economists at 
The Heritage Foundation's Center for Data Analysis simulated a 1.89 
percentage point increase in the payroll tax.\3\
---------------------------------------------------------------------------
    \3\ These estimates are preliminary and subject to change. CDA used 
the Global Insight, Inc., U.S. Macroeconomic Model to conduct this 
analysis. The methodologies, assumptions, conclusions, and opinions in 
this report are entirely the work of Heritage Foundation analysts. They 
have not been endorsed by and do not necessarily reflect the views of 
the owners of the model. This analysis was conducted by Tracy Foertsch 
and Rea Hederman of the Center for Data Analysis.
---------------------------------------------------------------------------
    It should be no surprise that a tax increase of this magnitude 
would increase the cost of labor in the economy and thereby have an 
impact on jobs. The CDA study found that a 1.89 percentage point 
increase in the payroll tax would reduce potential employment by 
277,000 jobs per year, on average, over the next 10 years relative to 
the baseline.
    There are spillover effects on economic growth as well. Increasing 
the payroll tax would reduce U.S. gross domestic product (GDP), a broad 
measure of economic activity, by $34.6 billion per year, on average, 
over the next 10 years.
    Overall, raising the payroll tax would have a major impact on U.S. 
households. On average, every American would have $302 less in 
disposable income per year for each of the next 10 years, amounting to 
over $1,200 per year for a family of four. Personal savings would also 
decline in the aggregate by $46.9 billion per year, on average, over 
the next 10 years. Ironically, this decline in savings would make worse 
the very problem that Social Security is intended to fix--workers 
retiring with insufficient savings.
    Raising the payroll tax rate is only one variant of the revenue 
enhancement approach to reform. Other proponents of tax increases argue 
that the amount of wages subject to the tax should be increased. This 
increase in what is called the maximum taxable income would, indeed, 
increase revenues.
    However, the amount of the increase falls far short of 
expectations. Using SSA's own projections, Heritage analysts found that 
eliminating the cap would generate only enough revenue to delay the 
date of the system's insolvency by eight years, from 2017 to 2025. 
Under the current law, by 2041, the OASI program would receive only 
enough revenue to pay 74 cents on every dollar in promised benefits.\4\
---------------------------------------------------------------------------
    \4\ Social Security Administration, The 2005 Annual Report of the 
Board of Trustees of the Federal Old-Age and Survivors Insurance and 
Disability Insurance Trust Funds, March 23, 2005, p. 8, at 
www.socialsecurity.gov/OACT/TR/TR05/tr05.pdf (April 11, 2005).
---------------------------------------------------------------------------
    Yet the cost of eliminating the cap would be substantial. It would 
result in the largest tax increase in the history of the United 
States,\5\ subjecting millions of American families to a massive hike 
in their payroll taxes and further reducing the already dismal rate of 
return to Social Security.\6\ It would also negatively affect America's 
economic prospects, slowing U.S. output growth and eliminating hundreds 
of thousands of employment opportunities.
---------------------------------------------------------------------------
    \5\ Heritage Foundation calculation based on data from Social 
Security Administration, The 2004 Annual Report of the Board of 
Trustees of the Federal Old-Age and Survivors Insurance and Disability 
Insurance Trust Funds. This projection is a purely static estimate that 
does not include the shifting of income from taxable to nontaxable 
compensation that is likely to occur if the tax cap is removed. Income 
shifting would decrease the amount of revenue available to pay 
benefits.
    \6\ See William W. Beach and Gareth E. Davis, ``Social Security's 
Rate of Return,'' Heritage Foundation Center for Data Analysis Report 
No. CDA98--01, January 15, 1998, at www.heritage.org/Research/
SocialSecurity/CDA98-01.cfm.
---------------------------------------------------------------------------
    Specifically, eliminating the cap on taxable wages would:

      Result in the largest tax increase in U.S. history, 
raising $607 billion (in nominal dollars) over five years and just over 
$1.4 trillion over 10 years.\7\
---------------------------------------------------------------------------
    \7\ These revenue projections do not account for the negative 
effects of higher payroll taxes on economic growth and employment. They 
also do not account for any likely shifting of income from taxable 
wages and salaries to nontaxable fringe benefits like health insurance. 
As a result, the amounts of federal payroll taxes ultimately collected 
are likely to be less.
---------------------------------------------------------------------------
      Fail to save Social Security from bankruptcy. Social 
Security would start paying out more in benefits than it collects in 
taxes in 2025, only eight years later than under the current system. 
(See Chart 1.)
      Increase the top effective federal marginal tax rate on 
labor income to over 50 percent, its highest level since the 1970s.
      Reduce the take-home pay of 9.8 million workers by an 
average of $4,206 in the first year alone after the cap is removed.
      Weaken the U.S. economy by reducing the number of job 
opportunities and personal savings.

    By fiscal year (FY) 2015, the number of job opportunities lost 
would exceed 965,000, and personal savings (adjusted for inflation) 
would decline by more than $55 billion.
    But the problem is even more fundamental: Social Security's very 
structure is such that even all this sacrifice would not be enough to 
save it. Currently, the system is in a cash-flow surplus, which means 
that it takes in every year more money in taxes than it pays out. But 
these extra funds don't really accumulate. Instead, the government 
spends them and issues the Social Security Trust Fund special bonds, 
which are really just IOUs to pay back the money at a later date.
    According to Social Security's Trustees, the system is set to have 
a negative cash flow beginning in 2017. To pay out promised benefits, 
it will have to cash in the government's IOUs, and the money to pay 
them will have to come from somewhere--either higher general revenue 
taxes (e.g., income taxes), lower government spending, or, ironically, 
more government debt. Because of the way the Trust Fund operates, 
raising payroll taxes would only delay the date when Social Security's 
cash flow goes negative. Future tax increases or benefit cuts would 
still be on the table.
    Opponents of real Social Security reform are right, but also deeply 
misleading, when they say that the current system can be saved by 
making only small changes: The changes may indeed be small, but the 
numbers involved are enormous. Raising the payroll tax or the maximum 
taxable income limit enough to fully fund Social Security would put a 
damper on savings, jobs, and economic growth to the great detriment of 
working Americans. And raising taxes enough to take Social Security's 
cash-flow problem off the table would require even more sacrifice.

[GRAPHIC] [TIFF OMITTED] T3926A.011


                                 

    Chairman MCCRERY. Thank you, Mr. Beach. Mr. Price?

  STATEMENT OF LEE PRICE, RESEARCH DIRECTOR, ECONOMIC POLICY 
                           INSTITUTE

    Mr. PRICE. Thank you, Mr. Chairman and Members of the 
Subcommittee. I welcome the opportunity to appear before you 
and talk about this vitally important program and ways to think 
about addressing its problems. We economists generally agree on 
the theory, and largely agree to start the debate with the 
numbers coming out of the Social Security actuaries. We 
strongly disagree, I'm afraid, on this panel, with key 
interpretations of the data, and on the value judgments 
necessary for you to make in reaching policy decisions. So, I 
am going to spend my short 5 minutes on three major 
disagreements that I have with what I understand to be 
positions of several other panelists here and some people on 
this debate.
    One is, I think the general approach of focusing the 
Federal Government on prefunding is misguided. Number two, I 
think that the coming burden of having more elderly people is 
quite manageable. Finally, I think that the costs of private 
accounts far outweigh the benefits as they have been proposed 
so far.
    Let's talk about prefunding. Here I want to make clear that 
I am not talking about prefunding within the Social Security 
account system and creating a system that people think makes 
sense. We did prefunding in 1983, and we said we would have 37 
years, the actuaries said in 1983 we would go into cash deficit 
in 2020. The CBO says we are going to go into cash deficit in 
2020. That was prefunding, it was planned, there is no crisis 
there. We need to think about the next 75 years and figure out 
how to handle that program. I am talking about whether our 
society today should prefund to prepare for the generation 30 
and 40 years from now. On that, I think thrift can be 
overrated. Our per capita income today is only 55 percent of 
what it will be in 40 years. Per capita income today in 
Mississippi is about 55 percent--our lowest per capita State--
55 percent of Connecticut. Now, should we tell the people of 
Mississippi that they need to be thrifty to help the 
consumption of the people in Connecticut? No. I don't think the 
logic makes any difference why people today should be 
sacrificing to raise money for the people who are going to have 
80 percent higher income than them 40 years from now.
    I think we ought to be focusing on our fiscal policy, on 
what makes sense for us today, managing our economy well today. 
We are not doing a good job of that. It should be based on what 
matters for our generation, not for 30 and 40 years from now, 
when we will be much richer. So even, though thrift is 
overrated, so can recent profligacy. We should be focusing on a 
fiscal policy that keeps our external debt to GDP from rising. 
They are both rising way out of sight. I have some charts in my 
report that confirm that. To the extent that we are 
contributing to national savings, those would be sensible 
things to focus on. They matter to us today. We should be 
concerned about today's generation.
    Just as a quick aside, I just find that the history of the 
last 25 years, as some of the panelists here describe it, is 
just not the way I would read it. We were able to have 
substantial deterioration of our fiscal situation in the early 
days without a Social Security surplus. We spent most of from 
the mid-eighties to the early nineties improving our fiscal 
situation with the Social Security surplus, and I don't think 
that the problems we have had in the last 4 years of a rapidly 
deteriorating fiscal situation. As the CBO charts can show it, 
when you standardize, take away cyclical effects, we have had a 
huge 3.5 percent of GDP deterioration in our fiscal situation 
from policy. Those policies were bad for us today, and they are 
not--we shouldn't be worried about those so much because of the 
future, they are not good policy today.
    Now, I have passed out some colored charts here, I think 
people say, well, we're going to have all these old people. I 
take 6 numbers from the actuary's report, and the ratio of 
people over 65 to the people 20-64 is going to rise 85 percent 
in the next 40 years. That sounds terrible when you just look 
at it in isolation. People don't often talk about, well, we are 
going to have productivity that is 91 percent as much; we are 
going to have fewer kids. The most burdensome people using up 
resources in our economy are the people who are working. They 
are using up more resources. They are traveling more, buying 
more cars, doing more--eating at fancier restaurants. The 
resources that we are using for older people are fairly modest 
in the economy as a whole. When we look at the total 
population, which is the right way to think about it, not the 
blinders on just the elderly, the total population relative to 
working-age population, that is going to rise 8 percent in the 
next 40 years. That is entirely manageable with an economy that 
is going to have productivity that is 90 percent higher. We can 
manage this as an economy.
    Now, that doesn't say we don't have serious fiscal 
problems, because you have the combination of a fiscal program 
in this government that is focusing on health care, primarily 
on elderly, and so when you combine having more elderly with 
rising health care costs, that is where the problem is, not in 
Social Security. We are focusing on entirely the wrong problem. 
It is not the demographic problem that presents a huge problem 
for us in the economy. It is health care. It is health care in 
the private sector for working people, just as much as for 
older people. We should be addressing health care and thinking 
about, you know, my wife is a physician. The technology that 
she is using today is totally different both in diagnosis and 
treatment from what she was taught 20 years ago. The technology 
20 years from now has yet to be invented. We should be talking 
about how we change technology. Every other industry that has 
had rapid technological change--and surely medical technology 
is changing rapidly--has falling costs. We ought to be focusing 
our resources. We spend $30 billion a year at the National 
Institutes of Health (NIH) trying to find some guidance, in 
pages and pages of research guidance for NIH--that we should 
find ways to improve health but reduce the resources to do it. 
It is not there. We are improving health, but we are doing it 
and changing technology to eat up more and more resources.
    We ought to be addressing health care costs and the 
technology 10, 20, and 30 years from now, and not be so focused 
on demography. We are going to have tremendous prosperity in 
the future. We can handle a few more old people, 8 percent more 
population, per working person. We do have to address health 
care for the private sector, for working people, as well as for 
the elderly and the budget.
    [The prepared statement of Mr. Price follows:]

  Statement of Lee Price, Research Director, Economic Policy Institute

    Chairman McCrery, Ranking Member Levin, and members of the 
subcommittee, thank you for this opportunity to appear before you to 
discuss the economic conditions used to predict the future of Social 
Security and the merits of pre-funded benefits.
    The late Herb Stein, who chaired the Council of Economic Advisers 
under Presidents Nixon and Ford, wisely recommended that we think in 
terms of ``GDP budgeting.'' That is, we should not look at the federal 
budget in isolation, but in terms of how it is shaping the economy as a 
whole. Too often, our discussion falls into the trap of focusing solely 
on changes to government inflows and outflows and we fail to consider 
either the compounding or the dampening responses in the larger 
economy.
    The fiscal challenge presented by Social Security represents a 
subset of the larger challenge of how our society will provide for more 
elderly people in the future. The consumption of future retirees will 
come almost entirely from the output of their working contemporaries. 
Retirees must finance their consumption through capital income, 
government transfers, or the generosity of their family and community. 
As we consider changes to Social Security, we should keep in mind the 
picture beyond the budget figures: How much pre-funding is realistic? 
Who stands to gain and who stands to lose? How much consumption should 
we sacrifice today to increase the consumption of more prosperous 
Americans in the future?
    To prepare for a higher share of elderly people in our population, 
government policy should not focus on pre-funding but on providing 
stable macroeconomic conditions to facilitate strong economic growth. 
That means reducing the federal deficit enough to prevent the debt to 
GDP ratio from expanding. It also means managing the government's 
contribution to national saving in a way that keeps our foreign debt 
from rising as a share of GDP. We have done a poor job on both fronts 
in recent years. The federal budget should keep those two debt burdens 
under control and leave private actors to decide how much saving they 
want to do for themselves.
    After weighing the effects on these broader questions of the 
proposals by the President and others to change Social Security, I 
conclude:

      Our society can manage the increase in the population 
over 65 relatively easily as an economic matter and with relatively 
modest difficulty as a fiscal matter because of productivity gains and 
the benefits of a smaller population under 20.
      Because middle--and low-income Americans rely so heavily 
on Social Security income, changes to the program should be made 
cautiously.
      The President's proposal on Social Security does not 
raise national saving and therefore does not improve the capacity of 
our economy to handle the coming increase in the population over 65.
      To ``pre-fund'' the costs of the Baby Boom's retirement, 
our society would have to produce more than we spend and, like the 
fabled ants, build up assets here and abroad to ease the transition to 
a more elderly society. Instead, we are worse than grasshoppers because 
we are eating up everything we produce and more.
      The federal budget contributed significantly to national 
saving in 2000 and 2001, but has subtracted from national saving in 
recent years.
      The President's proposal on Social Security requires 
substantial new federal borrowing with the goal of having middle-income 
retirees and survivors rely more on volatile capital income and less on 
more stable Social Security benefits.
      Were the President's proposal adopted, most Americans 
should decline the opportunity to create a personal account. Most 
people would come out losers most of the time because of the volatility 
of equity prices, interest rates, and inflation, plus the tendency to 
make bad investment decisions.
      Revenues of the Social Security trust fund are determined 
by the growth of wages \1\ below the cap. The outlook for the trust 
fund has deteriorated since the early 1980s largely because wage growth 
has slowed and wages have become more unequal. The recent drop in the 
share of the population employed has hurt revenues.
---------------------------------------------------------------------------
    \1\ Technically, wage, salary, and self-employment income are all 
subject to Social Security taxation. For simplicity, this statement 
often uses the term ``wages'' as short hand for all those forms of 
income.
---------------------------------------------------------------------------
      Future growth of trust fund revenues will depend on the 
growth of employment (for which immigration and the share of the 
population employed are the wild cards) and the growth of wages under 
the cap (for which productivity, the wage share of output, and 
spillover above the cap are important).
Demography presents a manageable economic problem
    Doomsayers like to emphasize the demographic fact that the 
population over the age of 65 will soon grow much faster than the 
working age population. The numbers in this year's Social Security 
trustees report indicate that the ratio of the population over 65 to 
the population 20 to 64 will rise by 85% between 2005 and 2045. That 
extra burden sounds back-breakingly heavy when taken in isolation, but 
relatively modest when put in the proper context. First, consider the 
fact that the trustees' intermediate scenario projects productivity 
gains of 91% over that same period. That means that future workers will 
have far more income to share with the elderly.
    Next, consider the fact that the working age population is not 
supporting just the elderly. Children are far more numerous than the 
elderly and their population will fall relative to the working age 
population. The trustees' intermediate numbers show only a 21% increase 
in the ``dependency ratio,'' the ratio of the total of children plus 
the elderly relative to the working age population.

[GRAPHIC] [TIFF OMITTED] T3926A.012

    Working age people must support themselves, too. They consume more 
per person than any other age group and their share of the population 
is shrinking. The ratio of the total population to the working age 
population offers the best measure of the economic challenge posed by 
demography. That measure rises by only 8% over the next 40 years. With 
productivity gains of 91%, future workers will have ample room to 
support an additional 8% more people per worker and still enjoy far 
greater prosperity than we have today.\2\
---------------------------------------------------------------------------
    \2\ For further analysis, see Spriggs and Price. 2005. 
``Productivity growth and Social Security's future.'' EPI Issue Brief 
No. 208, Washington, D.C.: Economic Policy Institute.

[GRAPHIC] [TIFF OMITTED] T3926A.013

    Demography has more pronounced effects on the federal budget than 
on the wider economy. As currently structured, programs aimed at 
children and middle-age people should shrink while those for the 
elderly grow. From that perspective, it is the compounding effect of 
demography with rising health care costs that presents a serious budget 
challenge. Assuming that the elderly should continue to obtain decent 
health, we should be developing policies that slow ballooning health 
care costs economy wide and not just squeeze on the federal budget part 
of the balloon. Taking the longer view, we can be confident that the 
medical technologies of two and three decades from now have not yet 
been invented. Other industries are raising quality while cutting 
costs. So can medical care. The Federal Government should use its 
considerable influence to foster new medical technologies that decrease 
rather than increase resource use. If we could change the path of 
medical technologies to make a significant dent in resource use in the 
future, that would have an enormous effect on future standards of 
living.

Proceed with caution: Middle-income Americans count on Social Security
    Most people who have spent their working lives as middle-income 
Americans have come to rely on Social Security for their retirement 
income. One-third of Americans over the age of 64 receive at least 90% 
of their cash income from Social Security. For another one-third, 
Social Security supplies between 50% and 90% of income. Note that some 
of those people receive $20,000 from Social Security and $18,000 from 
all other sources. Such people would not be in poverty without Social 
Security, but they would notice a significant cut in benefits. The 
share of people with over half of their income from federal programs 
would no doubt be higher if we could also take into account the value 
of their health benefits.\3\
---------------------------------------------------------------------------
    \3\ For further detail, including numbers by state, for women, for 
minorities, and for persons over 74, see Ettlinger and Chapman. 2005, 
``Social Security Income and the Elderly.'' EPI Issue Brief No. 206, 
Washington, DC.: Economic Policy Institute.

[GRAPHIC] [TIFF OMITTED] T3926A.014

    The privatization plan put forward by the President would 
substantially cut benefits for middle-income Americans who opt out of a 
private account. As we explain later, the effective cut is probably 
even deeper for most of those who opt in to a private account.
    Middle-income Americans nearing retirement saw their retirement 
income prospects improve markedly between 1989 and 2001, but not for 
the reasons often assumed. The boom in the stock market largely passed 
them by. Christian Weller and Edward Wolff recently analyzed the 
Federal Reserve's Surveys of Consumer Finances for trends in sources of 
wealth for those approaching retirement.\4\ For those between the ages 
of 56 and 64, they found median private pension wealth (including both 
defined benefit and defined contribution plans) actually declined from 
$54,000 in 1989 to $48,000 in 2001. Median non-pension financial wealth 
went from $15,100 to $23,200. Despite increases in home values, 
increases in mortgage debt caused net home equity to rise only modestly 
(from $65,700 to $70,000) for the median household.
---------------------------------------------------------------------------
    \4\ Weller, Christian and Edward Wolff. 2005. ``Retirement Income: 
The crucial role of Social Security.'' Washington, DC.: Economic Policy 
Institute..
---------------------------------------------------------------------------
    For the broad swath of middle-income Americans approaching 
retirement, Social Security accounted for most of their gains in wealth 
between 1989 and 2001. Weller and Wolff examined the sources of 
improved wealth for the middle 60% of households (those between the 
20th and 80th percentile). This wider group includes some people who 
benefited modestly more from the stock market boom than those at the 
median. Yet, they found that, even for this broad group, the gains in 
estimated Social Security wealth dominated. Social Security wealth rose 
by $77,600, private pension wealth by $24,100, and all other forms of 
wealth by $28,500. For this group, the effect of the stock market was 
dwarfed by the effect of the strong labor market that caused wages to 
rise and, in turn, raised middle-income Americans' prospective Social 
Security retirement income.
    It is no coincidence that Social Security is the largest program in 
the federal budget and that so many Americans rely so much on it. While 
the budget numbers have alarmed many politicians and economists, we 
cannot lose sight of what major changes to the program would mean to 
actual people who rely on it.

Fiscal policy switched from pre-funding to de-funding future 
        consumption
    Pre-funding requires sacrifices. Whether in the budget or in the 
economy as a whole, it entails less consumption today for the sake of 
more consumption in the future.\5\ Rather than sacrifice now to pre-
fund part of the consumption of future retirees, we have effectively 
been de-funding future consumption in recent years. The evidence for 
de-funding is clear, by both the government and the overall economy. 
The deterioration of our fiscal balance since 2001 reflects decisions 
favoring current consumption over future consumption. Likewise, the 
collapse in our current account balance financed by the deterioration 
of our net international asset position reflects economy-wide decisions 
to consume more now and less in the future.
---------------------------------------------------------------------------
    \5\ As discussed later, the case for public policy to impose 
sacrifice today on behalf of more prosperous future generations is 
problematic.
---------------------------------------------------------------------------
    The CBO has devised a measure to identify the effects of policy 
changes by excluding the effects of the business cycle and other 
transient effects. Fiscal policy is moving in the direction of pre-
funding when this measure (the standardized-budget surplus or deficit) 
is rising and in the direction of de-funding when this measure is 
falling.

[GRAPHIC] [TIFF OMITTED] T3926A.015

    With help from the 1983 Social Security legislation, overall fiscal 
policy moved in the direction of pre-funding from the mid-1980s through 
2001. We have moved in the direction of de-funding since 2001. The CBO 
estimates that the standardized budget had a balance of -3.0% of GDP in 
1983 and hit a low of -4.8% in 1986. The policies that drove the 
standardized balance down between 1983 and 1986 had largely been 
adopted at the time of the Social Security agreement. Over the next 15 
years, the standardized budget had an average deficit of 1.5% of GDP. 
While not a surplus the size of the Social Security surplus, that 
record showed an effort to pre-fund, or at least to stop de-funding 
future retirement costs.
    We should put the fiscal decisions since 2001 into the context of 
today's discussion of pre-funding Social Security. The standardized 
budget fell from a 1.1% of GDP surplus in 2001 to a 2.6% of GDP deficit 
in 2004, for a decline of 3.7% of GDP. The entire 75-year shortfall in 
Social Security has been estimated to be 0.7% of GDP by the SSA 
actuaries and 0.4% by the CBO. In other words, the fiscal policy 
changes between 2001 and 2004 worsened our fiscal balance by five to 
nine times as much as it would take to fully fund Social Security for 
75 years.
    In relationship to our deficit today and projected into the future, 
the funding shortfall for Social Security remains modest. If the goal 
is to address our long-term fiscal issues, we should paying more 
attention to health care and revenues, but not in the way those issues 
have been addressed in recent years.\6\ Indeed, the enactment of 
permanent tax cuts and under-funded prescription drug benefits stand 
out as decisions that favor consumption earlier rather than later, and 
they grow in cost. Over the next 75 years, the tax cuts have been 
estimated to create a shortfall of 2.0% of GDP. The prescription drug 
bill added another hole estimated at 1.4% of GDP. Clearly, our 
government has had other priorities than to pre-fund some of the Baby 
Boom's retirement.
---------------------------------------------------------------------------
    \6\ For further analysis of the relative unimportance of Social 
Security in our larger fiscal challenges, see Sawicky, Max. 2005. ``Big 
deficit, little deficit: The Bush budget and Social Security.'' EPI 
Snapshot May 23, 2005, Washington, DC.: Economic Policy Institute and 
Sawicky, Max. 2005. ``Collision Course: The Bush budget and Social 
Security.'' EPI Briefing Paper No. 156, Washington, DC.: Economic 
Policy Institute.

[GRAPHIC] [TIFF OMITTED] T3926A.016

Economy-wide we've been de-funding for some time
    Although our fiscal policy was moving in a favorable direction for 
pre-funding for the decade and a half prior to 2001, the same cannot be 
said for our nation as a whole. Last Friday, the government reported 
that we ran a current account deficit of $780 billion at an annual rate 
in the first quarter, a record 6.4% of GDP. In other words, we are 
spending 6.4% more than we produce as a nation. In contrast, Japan and 
Germany justify their large surpluses as appropriate preparation for 
the fast growth of their retired population.

[GRAPHIC] [TIFF OMITTED] T3926A.017

    Some have argued that an increased current account deficit is 
justified if it finances more investment in the U.S. That argument has 
both factual and theoretical flaws. As a factual matter, investment has 
not been particularly strong. Second, even if there were greater 
investment, it would be raising GDP (output within our borders) but 
would not be raising the future income of Americans. To finance our 
habit of increasing consumption faster than our output and income, we 
are selling off assets in the U.S. at a rapid rate. Those assets give 
persons abroad an increasing claim to our future output. The value of 
foreign-owned assets here now exceeds the value of U.S.-owned assets 
abroad by $3 trillion, a quarter of our GDP. And we are going into hock 
abroad at a rapid rate. As we sell off our assets to maintain our trade 
deficit habit, we mortgage off our future GDP to people abroad.\7\
---------------------------------------------------------------------------
    \7\ The net liability position did not rise in 2003 because of the 
rise in the dollar against currencies (particularly the Euro) with 
large U.S. assets abroad. Ultimately, large current accounts translate 
into deeper net liabilities.

[GRAPHIC] [TIFF OMITTED] T3926A.018

No pre-funding with private accounts
    To my knowledge, no Social Security proposal under debate today 
provides for any significant pre-funding by reducing current national 
spending to finance higher benefits in the future.
    The President's proposal creates private accounts with borrowing 
and not spending cuts. As the Administration has conceded, this 
proposal does not raise saving and therefore has no pre-funding. 
Because the President's latest budget actually raises the deficit over 
the next five years, it makes no effort at pre-funding the retirement 
of the Baby Boom.
    Likewise, the proposal to create private accounts to the extent of 
the current $163 billion Social Security surplus would involve even 
more borrowing initially than the President's plan. A serious pre-
funding plan would have an attainable sacrifice initially and grow over 
time. The plan to finance private accounts with the Social Security 
surplus starts out large and dwindles to nothing in a decade.

Pre-funding and fairness
    Because the people who pay for pre-funding often differ from the 
people who benefit, we should carefully consider questions of fairness 
in proposals for pre-funding. Two fairness questions come to mind. 
First, what are the implications of changing the pre-funding 
arrangements of 1983? Second, how much should we sacrifice to future 
generations who will be far more prosperous than we are today?
    Pre-funding played an important part in the 1983 compromise on 
Social Security. To achieve 75-year actuarial balance with the Baby 
Boom generation's retirement already looming, the 1983 agreement raised 
payroll tax revenues above expected benefit payments for the first half 
of the period to offset a revenue shortfall in the second half. To 
claim progressive benefits in retirement, the Baby Boom would have to 
pre-fund the system with regressive taxes. Now, after 22 years of 
paying regressive payroll taxes to pre-fund the system, Baby Boomers 
born after 1949 are being told that they must accept benefits cuts 
because of a newly found crisis: a cash shortfall. In fact, the 
actuaries projected in 1983 that program costs would first exceed 
revenues in 2020, the same year that CBO now projects. Despite many 
claims to the contrary, it's hardly a crisis when the date for the end 
of the cash surplus has been known for 22 years.
    Although thrift may always seem virtuous, the economic and moral 
case for pre-funding is debatable. Consider this thought experiment. 
The Social Security trustees report projects that our per capita income 
will rise about 80% over the next 40 years. Per capita income in 
Connecticut exceeds that of Mississippi by about the same percentage 
today. No one would expect the people of Mississippi to sacrifice today 
so that the people of Connecticut can consume more today. Does it make 
any more sense for people today to sacrifice to raise consumption even 
higher in the future? It's one thing for us to decide to save as 
individuals, but it's another thing for you as representatives to 
decide that the nation must cut today's consumption for the sake of 
higher future consumption.

Most would lose money with the President's private accounts because of 
        big risks
    It is unlikely that most people would come out ahead if they chose 
to set up a private account as proposed by the President. People would 
be asked to bear substantial risks that they would not face if they 
opted out of creating a private account. In simulations by Professor 
Robert Shiller, investors in the President's plan would be expected to 
lose money 71% of the time. Using historical performance of global 
market indexes and projections of likely returns in a recent survey of 
experts by the Wall Street Journal, he estimated a median return of 
2.6% above inflation, less than the 3.0% charged by the President's 
plan. (Note that Shiller's calculations do not reflect the decisions of 
actual people who, as explained below, tend to underperform a balanced 
portfolio of indexes.)
    Some features of the President's proposal--and the attendant 
risks--have not received the attention that they deserve. Once a person 
opts to start contributing to a private account, she must do so until 
benefits are triggered by retirement, death or disability. If a 25-
year-old decides to climb on board, they are strapped in to a roller 
coaster ride and cannot get off before they retire, die, or become 
disabled.
    Consider the multiple ways that the President's plan exposes 
private account holders to risks of inflation. First, take the fact 
that people are charged interest at the rate of 3% plus inflation for 
any Social Security taxes diverted into a private account. Economists 
and accountants like to subtract inflation in making long-term 
forecasts because they don't have confidence in forecasting inflation. 
But the President's plan asks a 25-year-old who puts $1,000 into a 
private account to take a risk about the inflation charge for the 42 
years until he retires. In the long term, stocks and bonds may adjust 
to higher inflation, but not in the short to medium term. For example, 
unanticipated inflation in the 1970s was accompanied by a bear market 
in stocks and a slump in bonds.
    Second, there is the risk of inflation after benefits begin. 
Current Social Security benefits are indexed for inflation, which puts 
the risk of higher inflation primarily on the government. Recognizing 
the risks involved, the private market has been reluctant to provide 
inflation-protected annuities. If they are offered in the future, they 
will come at a hefty price in terms of reduced annuity payments.
    Another risk involved with private accounts comes from the 
volatility of interest rates. When a person retires, her monthly 
annuity payment depends on the amount of money used to buy the annuity 
and the current interest rate. The lower the interest rate at the time 
of retirement and annuity purchase, the lower the annuity payment until 
death. A person who traded in a stock portfolio for an annuity in early 
2000 would have a much higher annuity than someone who did so in recent 
years not only because stock prices have declined but because interest 
rates did, too.
    Finally, in deciding whether to create private accounts with Social 
Security funds, Congress should consider the evidence that most people 
manage their investments poorly. Because they appear to buy and sell 
based on trends, they tend to buy high and sell low. This result holds 
not just for specific stocks but for broad mutual fund categories of 
the type proposed by the President.
    Ironically, those most eager to manage their investments seem to do 
the most poorly on average. Recent polls suggest that men are more 
likely to support private accounts than women. But note that recent 
research has found that men were more active traders and had 
significantly lower returns on their accounts than women.
    Private accounts have been touted as a ``sweetener'' to help the 
public accept sizeable benefit cuts that deepen over time. Given all 
the risks involved, however, people should assume that opening a 
private account will reduce their retirement income even further.

Average wage trends have hurt the Social Security trust fund
    Two adverse trends in the labor market have had a substantial 
negative effect on the Social Security trust fund since 1983. The 
Social Security actuaries have estimated a 75-year shortfall of 1.92% 
of payroll. The Social Security trustees have lowered their projected 
growth rate for real wages from 1.5% in 1983 to the current projection 
of only 1.1%. Slower wage growth causes revenues to fall more than 
benefits within the 75-year window. SSA actuaries project that real 
wage growth of 1.5% in the next 75 years would narrow the projected 
shortfall by 0.40% of payroll--about a fifth of the projected 
shortfall.
    The increased inequality of wage income has contributed even more 
to the shortfall. The cap on wage and salary income subject to Social 
Security taxes (now $90,000) has been rising with average annual 
earnings. Although the share of earners above the cap has remained 
about 6%, their earnings have risen much faster than average. As a 
result, the share of wage and salary income not subject to Social 
Security has risen from 10% to more than 15%. (Recent evidence for 2004 
suggests this untaxed share has widened further.) SSA actuaries 
estimate that covering 90% of wage and salary income over the next 75 
years would narrow the shortfall by 0.75% of payroll--two-fifths of the 
projected shortfall.
    We would face a shortfall about 40% as large as they one projected 
today if, all else equal, real wages were still expected to rise at the 
rate projected in 1983 and wage and salary income had not become more 
unequal.\8\
---------------------------------------------------------------------------
    \8\ For further analysis, see Bivens, L. Josh. 2005. ``Social 
Security's fixable financing issues: Shortfall in fund is not 
inevitable.'' EPI Issue Brief No. 207, Washington, DC.: Economic Policy 
Institute.

[GRAPHIC] [TIFF OMITTED] T3926A.019

Future health of the trust fund depends on a healthy labor market
    Social Security revenues are a function of how many people are 
employed and how much of their wage income is subject to Social 
Security taxes. The number of people employed is a function of the 
population and the share of the population employed. Immigration 
appears to present a bigger question mark for future population growth 
than domestic demography (births and deaths). The trustees projected 
immigration of 900,000 a year for each of the next 75 years in their 
intermediate projection and 1.3 million a year in their low-cost 
projection. With the population of the U.S. and the rest of the world 
growing and global transportation and communication becoming cheaper, 
it seems implausible that immigration would remain fixed. If 
immigration grows at a modest 1% per year from recent levels, it will 
more than triple the intermediate projection and double the low cost 
projection within 75 years.
    As a matter of logic and recent experience, the employment to 
population ratio matters more to future employment than the 
unemployment rate. In recent years, the unemployment rate has gone 
haywire as an indicator of potential employment. The chart below 
compares the employment to population ratio for each age level for 2000 
and 2004. Note that in both years employment falls sharply well before 
age 62. This belies the comfortable assumption that people hold a 
steady job until they start claiming Social Security benefits at age 
62.\9\
---------------------------------------------------------------------------
    \9\ For further analysis of this point, see Gould, Elise. 2005. 
``Many already lack a steady job before the Social Security retirement 
Age.'' EPI Snapshot June 15, 2005, Washington, DC.: Economic Policy 
Institute

[GRAPHIC] [TIFF OMITTED] T3926A.020

[GRAPHIC] [TIFF OMITTED] T3926A.021

    Note also that the ratio was uniformly lower in 2004 for ages up to 
the mid-50s and uniformly higher for older ages. The second chart 
indicates the size of the 2000-2004 change for each age level. The 
decline was 2% to 4% of the population from the mid-20s to the mid-
50s.\10\ That represents a decline in employment for more than 3 
million prime working age people. If we can restore normal job growth 
in the range of 300,000 jobs a month instead of the anemic 170,000 jobs 
of the last six months to a year, it would do wonders for the trust 
fund coffers. If the employment to population ratio remains depressed, 
it bodes poorly for the trust fund.
---------------------------------------------------------------------------
    \10\ Separate analysis shows no difference in the decline for men 
and for women.
---------------------------------------------------------------------------
    Wage income subject to Social Security taxes is affected by 
productivity, labor's share on income, the wage share of compensation, 
and the share of wages below the cap. Fortunately, productivity has 
improved markedly in the last decade. Labor shared in productivity 
gains in the 1990s, but its share of the gains since 2001 has been 
extraordinarily low. Squeezed by a falling labor share of income and 
rising health benefit costs, wages have grown slowly in recent years. 
The continued disappointment in wage growth despite strong productivity 
gains was a major factor accounting for the trustees' decision to 
advance the projected dates for the trust fund cash flow to turn 
negative and for the trust fund to be exhausted. On the other hand, if 
productivity gains of the last decade are sustained and labor's share 
of those gains reverts to historical norms, then the trustees' 
projections for taxable wages are too pessimistic.
    The share of taxable wage and salary income below the cap 
represents another key variable. As noted earlier, people making income 
above the cap have enjoyed faster than average wage and salary gains 
since 1983. That trend abated somewhat with the downturn in financial 
markets and technology companies. This year's data on tax revenues and 
anecdotal information about a revival of bonuses and stock options 
suggest that the share of income above the cap is rising again.
    Unlike other economic variables, the share of wages over the cap 
can readily be fixed by legislation. The cap does not have to move at 
the rate of average wages when high income wages are growing faster. 
The cap could be raised to maintain a fixed share of income above the 
cap or to restore the 90% coverage of 1983. If the cap is removed 
altogether, the trust fund would no longer be hurt by greater wage 
inequality.

Conclusion
    Most middle-income Americans have come to rely on Social Security 
to protect their families in retirement, disability, or early death. In 
a world of topsy-turvy labor and financial markets, the Social Security 
system provides a port in the storm.
    Pre-funding the retirement costs of future retirees requires 
sacrificing current consumption in favor of future consumption. Policy 
decisions in recent years have turned in the opposite direction. 
Between 2001 and 2004, policy decisions reduced the federal budget 
balance by 3.7%, more than five times the annual average shortfall that 
SSA actuaries project for Social Security. Both the prescription drug 
legislation and the tax cuts of 2001-2003 have 75-year fiscal effects 
that are multiple times as large as the Social Security shortfall. As a 
nation, we are rapidly selling off our assets to persons abroad
    The rhetorical argument that private accounts can materially offset 
the cuts proposed by the President does not bear close scrutiny. 
Indeed, if Congress enacts the President's plan for private accounts, 
the private accounts may have few takers because the odds are stacked 
against the typical investor coming out ahead of the ``clawback'' 
interest charge.
    Economic variables important to the trust fund include immigration, 
productivity, the share of the population employed, the share of output 
received by labor, the share of labor compensation paid as wages, and 
the share of wages paid below the cap. The trustees were probably too 
pessimistic on the first two variables, but recent trends on the other 
variables are worrisome.
    Of all the variables with a significant effect on the trust fund, 
the one most under the control of Congress is the amount of wage income 
above the cap. Congress should revise the formula for the cap to 
prevent future erosion. Eliminating the cap altogether would prevent 
increased wage inequality from eroding trust fund revenue. Otherwise, a 
return to a normal pattern of gains in both employment and wages would 
do wonders both for Social Security beneficiaries and for the trust 
fund.

                                 

    Chairman MCCRERY. Thank you, Mr. Price. Now, Dr. Samwick.

STATEMENT OF ANDREW W. SAMWICK, PH.D., PROFESSOR OF ECONOMICS, 
   AND DIRECTOR, THE NELSON A. ROCKEFELLER CENTER, DARTMOUTH 
                COLLEGE, HANOVER, NEW HAMPSHIRE

    Mr. SAMWICK. Mr. Chairman and Members of the Subcommittee, 
thank you for the opportunity to testify on the economic 
factors affecting Social Security's financing and the role of 
personal accounts in strengthening retirement security. I 
commend you for holding this series of hearings. I can imagine 
you must all be exhausted on your seventh out of eight. There 
is no better place for a bipartisan and comprehensive reform to 
start than in this Subcommittee. I would like to emphasize the 
following four points as an overview of my full written 
testimony.
    The first point is that, while it is true that many 
demographic and economic factors affect Social Security's long-
term finances, the most important drivers of the looming 
shortfalls are demographic--continued improvements in life 
expectancy and retirement, and fertility rates that remain 
around two children per woman. I see very little in the economy 
and society more generally to suggest that this demographic 
pressure is overstated. The reality of this demographic shift 
should guide our discussions about how to reform the system, 
and in particular, I think this demographic pressure should 
strongly motivate us to consider higher target ages of 
retirement for non-disabled workers.
    Second, among the factors that are both important for 
Social Security's finances and subject to considerable 
uncertainty in their projections, the real wage differential is 
the most critical. While it is true that the ultimate 
assumption for the real wage differential of about 1.1 percent 
seems low, particularly relative to the productivity boom that 
we have experienced over the last decade, when this number 
averaged 1.6 percent, any reasonable increase in the assumed 
rate of real wage growth would still leave a large hole in the 
system's finances. There really is no alternative to financing 
the projected retirement income of future beneficiaries other 
than preparing them to save more as a Nation and work more 
prior to retirement.
    Third, the issue of whether to bring new moneys into the 
system, and whether to do so in the form of tax increases in 
the current system or contributions to a new system of personal 
accounts, is perhaps the most polarizing in the current debate. 
I can only offer my own perspective. The default outcome if we 
do nothing today is to wait until the fiscal consequences of 
running the current system with a retired population of Baby 
Boomers has become unmanageable. That could happen anytime 
between 2017, when the current system is first projected to pay 
out more in benefits than revenues are collected in taxes, and 
2041, when the current system is projected to lose its 
authorization to pay benefits as scheduled without new 
legislation.
    When that day of reckoning occurs, it will likely involve a 
combination of benefit cuts, tax increases, and delays in the 
retirement age, as in the 1983 amendments. However, compared to 
1983, these changes will have to happen in greater measure and 
with more immediacy. We will have squandered the opportunity to 
envision a more modern retirement system that relies less 
heavily on pay-as-you-go financing. We will have done nothing 
to prepare a new generation of retirees for their lower 
retirement incomes. Worst of all, we will impose a tax burden 
on our children's generation that, with full knowledge of its 
likely appearance, we will have refused to address today. I 
wouldn't blame them if they refused to pay, or, in the face of 
higher taxes, they simply decided to work less.
    Fourth, if we do not intend for retirement incomes to fall, 
and if we are unwilling to move Social Security's target 
retirement ages higher in the face of these demographic shifts, 
then the only option left is to increase saving today. There 
are two reasons why I believe that this additional saving 
should happen through personal accounts, whether inside or 
outside the Social Security system, rather than in the trust 
fund. The first is that in the last two decades the budget 
policies show quite clearly that the Social Security surpluses 
do not, as a rule, serve their intended purpose of lessening 
the burden on future generations. The availability of the 
Social Security surplus in the unified budget has encouraged 
the government to run larger deficits in the on-budget account. 
If new moneys are to be brought into the system, they have to 
be matched by an outflow to something like personal accounts to 
avoid this problem. If there is a so-called lock box, it seems 
that it has 536 keys; but more importantly, it has no lid. The 
second reason to favor personal accounts is that, if we are 
serious about restoring solvency to Social Security over the 
long term, not just postponing the date that the trust fund is 
exhausted outside the 75-year projection period, then the scale 
of investments required is simply too large to be managed in 
anything but a decentralized manner. Some rough calculations 
suggest that restoring solvency on a permanent basis would 
require the accumulation of an aggregate portfolio that would 
be equivalent to about two-thirds of all mutual funds in 
existence today.
    Mr. Chairman and Members of the Subcommittee, this 
concludes the overview of my written testimony, and I would be 
happy to answer any questions that you might have.
    [The prepared statement of Dr. Samwick follows:]

   Statement of Andrew W. Samwick, Ph.D., Professor of Economics and 
Director, The Nelson A. Rockefeller Center, Dartmouth College, Hanover, 
                             New Hampshire

The Impact of Economic Trends on Social Security's Financing and 
        Retirement Security
    Mr. Chairman and Members of the Subcommittee:
    Thank you for the opportunity to testify on the economic factors 
affecting Social Security's financing and the role of personal accounts 
in strengthening retirement security. I commend you for holding this 
series of hearings. There is no better place for bipartisan and 
comprehensive reform to originate than in this committee.
    As you have requested, my testimony today will focus on three 
topics: the economic factors that are used to project the future 
condition of the Social Security system; the consequences of raising 
taxes to meet Social Security's obligations, and the advantages of pre-
funding future benefits through personal accounts.
    I would like to emphasize the following four points:

    1)  While it is true that many demographic and economic factors 
affect Social Security's long-term finances, the most important drivers 
of the looming shortfalls are demographic--continued improvements in 
life expectancy in retirement (about 4 more years at age 65 over the 
next 75 years) and fertility rates that are about 2 children per woman. 
I see very little in the economy and society more generally to suggest 
that this demographic pressure is overstated in the current 
projections. The reality of this demographic shift should guide our 
discussions about how to reform the system. In particular, the shift 
strongly suggests the need to target higher retirement ages.
    2)  Among the economic factors that are both important for Social 
Security's finances and subject to uncertainty in their projection, the 
real wage differential is the most critical. While it is true that the 
ultimate assumption for the real wage differential of 1.1 percent seems 
low, particularly relative to the productivity boom of the last decade 
when it averaged 1.6 percent, any reasonable increase in that assumed 
rate of real wage growth would still leave a large hole in the system's 
finances. There really is no alternative to financing the projected 
retirement income of future beneficiaries than preparing them to save 
more as a nation and work more before entering retirement.
    3)  The issue of whether to bring new monies into the system, and 
whether to do so in the form of tax increases in the current system or 
contributions to a new system of personal accounts, is perhaps the most 
polarizing in the current debate. I can only offer my own perspective. 
The default outcome if we do nothing today is to wait until the fiscal 
consequences of running the current system with a retired population of 
Baby Boomers become unmanageable. That could happen anytime between 
2017, when the current system is first projected to pay out more in 
benefits than the revenues that are collected in taxes, and 2041, when 
the current system is projected to lose its authorization to pay 
benefits as scheduled without new legislation to authorize this. When 
that day of reckoning occurs, it will likely involve a combination of 
benefit cuts, tax increases, and delays in the retirement age, as in 
the 1983 amendments. However, unlike 1983, these changes will have to 
happen in greater measure and with more immediacy. We will have 
squandered the opportunity to envision a more modern system that relies 
less heavily on pay-as-you-go financing. We will have done nothing to 
prepare new retirees for their lower retirement incomes. And, worst of 
all, we will impose a tax burden on our children's generation that, 
with full knowledge of its likely appearance, we will have refused to 
address ourselves today. I wouldn't blame them if they refused to pay, 
or, if in the face of these higher taxes, they simply decided to work 
less.
    4)  If we do not intend for retirement incomes to fall, and if we 
are unwilling to move Social Security's target retirement ages higher 
in the face of the demographic shifts, then the only option left is to 
increase saving today. There are two reasons why I believe that this 
additional saving should happen through personal accounts, whether 
inside or outside the Social Security system, rather than the Trust 
Fund. The first is that the last two decades of budget policy show 
quite clearly that the Social Security surpluses do not as a rule serve 
their intended purpose of lessening the burden on future generations of 
taxpayers for financing the current generations' retirement benefits. 
The availability of the Social Security surplus in the unified budget 
has encouraged the government to run larger deficits in the on-budget 
account. If new monies are to be brought into the system, they have to 
be matched by an outflow (to something like personal accounts) to avoid 
this problem. If there is a ``lockbox,'' it seems that there are 536 
keys, but more importantly, no lid. The second reason to favor personal 
accounts is that, if we are serious about restoring solvency to Social 
Security over the long term--not just postponing the date of Trust Fund 
exhaustion outside the 75-year projection period--then the scale of 
investments required is simply too large to be managed in anything but 
a decentralized manner. Restoring solvency on a permanent basis would 
require the accumulation of an aggregate portfolio that would be 
equivalent to about two thirds of all mutual funds if it existed today.

    I would now like to discuss each of these points in more detail. In 
all of my calculations, I will rely on the projections based on the 
Intermediate assumptions of the 2005 Social Security Trustees' Report.
The Centrality of Demographic Factors
    As the committee has heard in previous hearings, the driving force 
behind the projected deterioration in Social Security's finances is an 
increase in the number of beneficiaries relative to the number of 
workers. Between 2005 and 2080, the number of beneficiaries per hundred 
workers is projected to rise from 30 to 54, an increase of 80 percent. 
Over that same period, Social Security's cost rate--the amount of 
benefits relative to the payroll tax base--is projected to increase 
from 11.1 percent to 19.1 percent, an increase of about 72 percent.
    Given the other assumptions underlying these projections, the 
demographic shift more than explains the worsening of Social Security's 
financial picture. Over this 75-year projection period, life expectancy 
after age 65 is projected to increase by about 4 years. (Note as well 
that this represents a slowing of the rate of improvement in life 
expectancy relative to the historical period, suggesting that the 
actual improvements could be larger.) The fertility rate is projected 
to be 1.95 children per woman, a rate that would not increase the size 
of the working age population in the absence of immigration. Even if 
this assumption turns out to be too low, it would be several decades 
before a higher fertility rate could meaningfully affect Social 
Security's annual financial balance.
    Regardless of our individual political views or our preferred 
approaches to Social Security reform, I believe that we can all agree 
that this unprecedented aging of the population will require a 
substantial adjustment in the way we conceive of our systems of old-age 
support.

The Relevance of Economic Factors
    There are several assumptions about economic factors that affect 
the projections of Social Security's long-term solvency. The economic 
effects come from either of two main channels. First, they can alter 
the time-value of money, and thus the relative importance of the near-
term annual surpluses compared to the longer-term annual deficits. 
Second, they can alter the size of the payroll tax base relative to the 
amount of benefits to be paid in a given year. For the purposes of the 
discussion in this section, I will focus on the projected long-term 
actuarial deficit as calculated over the 75-year projection period, 
which was 1.92 percentage points of payroll in the 2005 Trustees 
Report. Obviously, this is an incomplete measure of solvency, but it is 
sufficient to illustrate the key points about the role of economic 
factors. I will focus on longer-term measures of solvency in the next 
sections.
    The intermediate assumptions put the real interest rate at 3 
percent. Because the system runs near-term surpluses and longer-term 
deficits, a higher interest rate would improve the long-term financial 
outlook for Social Security. However, the effects are fairly small. The 
sensitivity tests in the Appendix of the Trustees Report show that for 
each percentage point increase in the real interest rate, the long-term 
actuarial deficit falls by about 0.7 percent of taxable payroll. Thus, 
the real interest rate would have to nearly double to close the gap 
completely. Since the current assumption of 3 percent is only a bit 
below recent history, we would not expect substantially higher real 
interest rates than in this baseline. In addition, it would be hard to 
maintain the ``other things equal'' assumption in such a scenario, 
since an exogenous increase of a few percentage points in the real 
interest rate would dampen economic growth and thus Social Security's 
finances.
    It might seem like the inflation rate would have a large impact on 
Social Security's long-term finances, particularly given the annual 
attention given to the size of the cost-of-living adjustments for 
current beneficiaries (and all of the recent discussion about the 
possibility of switching from wage--to price-indexing in the current 
benefit formula). However, higher inflation has only a mildly positive 
effect on Social Security's projected finances, because the higher 
COLAs are preceded by higher nominal wages. The effect is not large--
the Trustees Report estimates that a 1 percentage point increase in the 
CPI inflation rate improves the long-term actuarial balance by only 
0.21 percent of taxable payroll.
    The key economic assumption is the growth in the average annual 
wage in covered employment relative to the CPI, commonly referred to as 
the real wage differential. The current projections are based on an 
ultimate real wage differential of 1.1 percent per year. While this 
number is consistent with actual experience over the last 45 years, it 
is about 0.5 percentage point below the average for the past decade. 
The sensitivity analysis in the Trustees Report shows that raising the 
real wage differential by this difference would lower the long-term 
actuarial deficit by about 0.53 percent of taxable payroll. In order 
for higher real wage growth to close the gap, it would have to average 
about 2.9 percent per year. To get an idea of how infeasible this is 
over the long term, the real wage differential averaged 2.9 percent per 
year over the period from 1996--2000, a period that we now regard to 
have been a bubble. Nonetheless, an economic policy that focused on 
capital accumulation--whether privately through enhanced retirement 
savings vehicles or publicly through a more responsible budget policy--
could raise real wages and have the salutary benefit of improving 
Social Security's financial outlook.
    The final economic assumption of interest is the growth of the 
labor force. As we all know, the growth of the labor force is projected 
to slow over the coming decades as the large Baby Boom cohort makes its 
transition from working careers to retirement. There appears to be 
nothing unreasonable in the way this has been projected in the Trustees 
Report, but promoting greater labor force participation is one of the 
few policy levers that we could utilize to help shore up the system's 
finances. The natural way for this to happen would be lower the overall 
tax burden on working families (consistent with a responsible budget 
policy) and to encourage older workers in particular to remain in the 
labor force. As the committee has already devoted considerable 
attention to this issue, I can only underscore my agreement with 
panelists at prior hearings that it makes sense to begin a national 
conversation about how the target retirement age for most workers 
should increase in the face of improvements in life expectancy and the 
impact of demographics on the system's finances.

Consequences of Raising Taxes to Finance Future Benefits
    I believe that the question of whether taxes should be raised to 
finance future benefits is primarily a matter of equity and only 
secondarily a matter of efficiency. We may feel that larger tax burdens 
are bad, but we should also feel that larger deficits are surely worse, 
because they are your children's taxes. If revenues coming into the 
Social Security system will ultimately have to increase, then the 
responsible course of action is to increase them now, so that the 
burden can be spread more equitably across generations.
    Consider what happens if we wait to act. In 2005, the Trustees 
Report tells us that we have unfunded obligations (over the infinite 
horizon, not just the next 75 years) that are equal to about 90 percent 
of GDP. Those unfunded obligations could be eliminated by raising the 
payroll tax by 3.5 percentage points, immediately and forever (and 
ignoring the likely declines in economic activity associated with this 
tax increase). If we were to wait until the Trust Fund is projected to 
be exhausted in 2041, then we would find ourselves (according to my own 
rough calculations) with unfunded obligations that are about 140 
percent of (a much larger) GDP. Tax increases and benefit cuts would 
have to be commensurately higher, and all of those who retire in the 
next 35 years would evade any responsibility for sharing in the burden 
of those tax increases.
    As a matter of efficiency, it is worth reiterating points made 
recently to the Committee in the testimony of Tom Steinmeier and Gene 
Steuerle that, despite the fact that individuals both pay taxes and 
earn benefit entitlements as a result of working in covered employment, 
the link between benefits and taxes is often very weak. There is quite 
a bit of redistribution in the current system, but surprisingly little 
of it serves to make the system more progressive, largely due to the 
spousal benefit rules. In the usual way they are proposed, personal 
accounts do not redistribute resources as in the current system, and 
thus contributions to personal accounts should be viewed as less 
distortionary and less likely to reduce economic activity compared to 
raising taxes.

The Role of Personal Accounts in Pre-Funding Future Benefits
    Once we have decided to make greater saving an element of Social 
Security reform, there are institutional reasons for channeling that 
saving to personal accounts rather than the pay-as-you-go system. The 
first pertains to the way the Federal Government handles the revenues 
embodied in Social Security surpluses. The second pertains to the scale 
of investments required if reform is to actually restore solvency to 
the system on a permanent basis.
    The budget process in the Federal Government makes pre-funding 
through the Trust Fund completely unreliable. Over the past two 
decades, the government's targeting of the unified budget deficit in 
its policy making has meant that the presence of the Social Security 
surplus has facilitated larger deficits in the on-budget account. This 
practice extends back to the Gramm-Rudman legislation in the 1980s and 
continues to this day as the Administration sets a budget target of 
``cutting the deficit in half in 5 years.'' The ``deficit'' in question 
included not just the level of the Social Security surplus but its 
growth over that period. Absent a budget policy that is truly 
disciplined--like a balanced budget excluding Social Security over the 
business cycle--running larger Social Security surpluses will not have 
the desired effect of alleviating the financial burden on future 
taxpayers of paying for the current generation's retirement benefits. 
Requiring the new revenue to immediately flow out to personal accounts 
would prevent the government from spending it on current projects.
    Even if the budgetary institutions could be reformed, a recognition 
of the scale of new saving that is required argues strongly for 
investments in personal accounts rather than a Trust Fund. By 2080, the 
annual deficit in Social Security is projected to grow to 5.75 percent 
of taxable payroll. Suppose that we wanted to save enough money to 
accumulate a portfolio so that the investment income from that 
portfolio would cover this deficit. If we could get a return of 5 
percent, after inflation and net of administrative costs, that would 
require a portfolio equal to 5.75/5 = 1.15 times taxable payroll. If 
that portfolio existed today, when taxable payroll is $4.73 trillion, 
it would be about $5.4 trillion. To put that in perspective, it is 
about two thirds of all mutual funds in the United States today. There 
is simply no feasible way for that money to be managed in anything but 
a decentralized manner. Personal accounts provide a mechanism to 
accommodate the need for widespread ownership and decentralized money 
management.
    Thank you again for the opportunity to testify today. Much of what 
I have written can be found in further detail on my weblog, http://
voxbaby.blogspot.com.

                                 

    Chairman MCCRERY. Thank you, Dr. Samwick. Dr. Furman?

  STATEMENT OF JASON FURMAN, PH.D., SENIOR FELLOW, CENTER ON 
 BUDGET AND POLICY PRIORITIES, AND VISITING SCHOLAR, NEW YORK 
                 UNIVERSITY, NEW YORK, NEW YORK

    Mr. FURMAN. Mr. Chairman, Mr. Levin, other Members of the 
Subcommittee, thank you for the invitation to address you 
today. There are many important issues in the reform of Social 
Security, some of which I had the opportunity to address at the 
Full Committee hearing, including the impact on benefits, debt, 
and the overall economy. Today I want to focus in particular on 
the issue of prefunding.
    In an analogy to help illustrate the choices Congress faces 
as it crafts reforms to the Social Security system, consider a 
family with a substantial mortgage on its home and daughter who 
is going to go to college in 10 years. If the parents want to 
help pay for the child's education, they have three choices. 
First, they could prefund their daughter's tuition by reducing 
their spending, saving more, and paying down their mortgage 
more quickly. Alternatively, they could save more and use the 
extra money to invest in an account. Finally, the parents can 
decide not to prefund and instead plan on reducing their future 
spending to pay for college when the bills come due. These are 
three reasonable ways to finance the daughter's education. Now 
consider more reckless parents. They take out a second mortgage 
on their home so they can invest the money they borrowed. That 
would not be prefunding. This family would not be any better 
prepared to pay their daughter's tuition. They might have more 
money set aside, but they would also have much larger mortgage 
payments. This metaphor is, I hope, instructive as we consider 
various ways Congress might reform Social Security. I would 
like to make four specific points that build on the simple 
insights about Social Security that can be gleaned from this 
metaphor.
    First, partially prefunding Social Security is a sensible 
goal. If benefits for people at or near retirement are 
protected, prefunding can only be accomplished by raising 
Social Security contributions. Prefunding Social Security means 
making benefit reductions or contribution increases today that 
would raise net Federal savings. Raising savings should be a 
fundamental goal of any proposal to reform Social Security. For 
this reason and others, partially prefunding Social Security as 
part of an overall strategy to restore solvency is a good idea. 
President Bush and congressional leaders from both parties have 
ruled out benefit reductions for people at or near retirement. 
The Chairman and other Members of this panel have called for 
more prefunding. The only way you can possibly do that is to 
increase the contributions people are making to Social Security 
beyond the 12.4 percent they are making today. I interpreted 
Dr. Samwick as meaning that when he talked about bringing new 
moneys into the system. The Committee is interested in 
prefunding Social Security; this is the only way to do it.
    Second, none of the major Social Security reforms under 
discussion have any significant prefunding. I have reviewed 
every reform proposal that the Social Security actuaries have 
scored based on the 2003 and 2004 Social Security trustees' 
assumptions, and other than two proposals--one by economists 
Peter Diamond and Peter Orszag and one by former Commissioner 
Bob Ball, both of which have a modest, relatively small amount 
of prefunding--none of the other proposals has any real 
prefunding at all. They do not do anything to benefits before 
2012. Even then, the benefit reductions begin gradually and 
there are no contribution increases. If you look at Figure One 
and Figure Two in my prepared testimony, they show the benefit 
changes under two proposals. One of them is the President's 
sliding scale benefit reductions, and the other is a 
combination of raising the retirement age and longevity 
indexing. Both of those do relatively little for solvency in 
the first decades that they are in effect, and only grow 
substantially larger much later on. That is not prefunding.
    Third, individual accounts by themselves do nothing to 
prefund Social Security. As I mentioned, increasing Social 
Security contributions--for instance, raising the total 
contribution to 15.4 percent and dedicating 3 percentage points 
of that to individual accounts--would partially prefund Social 
Security. It is not the accounts that are leading to the 
prefunding, it is the larger contributions. None of the major 
recent individual accounts plans that have been scored by the 
actuaries propose increasing total account contributions. As a 
result, any assets in the accounts are matched by increases in 
the government's debt. Like the family that mortgages its house 
to put money in a college savings account, this process does 
nothing to prefund Social Security or increase Federal savings.
    One of the leading public finance textbooks, written by 
Harvey Rosen, the former Chairman of President Bush's Council 
of Economic Advisors, explains that, ``There is no reason to 
believe that privatization``--and that is the only time I will 
use that word in this hearing, is in quotes--``by itself would 
raise Federal savings. At the end of the day, all that takes 
place is a swap of public and private securities between the 
trust fund and private markets. No new savings is created.''
    In short, the primary effect of borrowing to finance 
individual accounts is no change in national savings. 
Furthermore, accounts could reduce savings if individuals treat 
them as net wealth and consequently decrease their savings in 
401(k) s and IRAs. This would leave people even less prepared 
for retirement. Some have argued that accounts could increase 
savings if the higher deficits associated with them lead to 
lower government spending and/or higher taxes outside of Social 
Security. Note that, even in this case the prefunding is a 
result of other budgetary policies, not the accounts. There is 
little reason to believe that even this development would 
occur. The Bush Administration has not claimed that if accounts 
were passed it would propose additional reductions in Federal 
programs or higher taxes to offset the increased deficit. In 
fact, Administration officials emphasize that they do not 
believe there is any need for such steps because, they contend, 
the accounts are fiscally neutral over the infinite future.
    Finally, and very briefly because I have more than 
exhausted my time, Social Security is a relatively small part 
of the long-run deficit, and I urge this Committee to focus on 
our overall fiscal challenges, which include health care and 
the level of taxes in light of the tax cuts in the last 5 
years. Thank you.
    [The prepared statement of Dr. Furman follows:]

Statement of Jason Furman Ph.D.,\1\ Non-Resident Senior Fellow, Center 
on Budget and Policy Priorities & Visiting Scholar, New York University 
      Wagner Graduate School of Public Service, New York, New York
---------------------------------------------------------------------------
    \1\ The views expressed in this testimony are mine alone.
---------------------------------------------------------------------------
    Mr. Chairman and other members of the Committee, thank you for the 
invitation to address you today regarding an important facet of the 
Social Security reform debate--prefunding. Social Security is currently 
running a substantial surplus but in the coming decades the number of 
workers supporting each retiree will fall and the challenges facing 
Social Security will grow. Prefunding entails making larger initial 
reductions in benefits or increases in contributions in order to reduce 
the magnitude of the changes required in the future. At the same time, 
prefunding increases national savings, reducing consumption today but 
expanding the economy and thus consumption possibilities in the future.
    An analogy can help illustrate the choices Congress faces as it 
crafts reforms to the Social Security system. Consider a family with a 
substantial mortgage on its home and a daughter who will go off to 
college in a decade. If the parents wants to help support their 
daughter's education, they have three choices:

      The parents could ``prefund'' their daughter's education 
by reducing their spending, saving more, and using the money to pay 
down their mortgage more quickly.
      Alternatively, the parents could use the additional 
savings to prefund their daughter's education by investing their new 
savings in an educational savings account.
      Finally, the parents could decide not to prefund their 
daughter's education and instead plan on reducing their future spending 
to pay for college when the bills come due.

    All three of these are reasonable ways to finance the daughter's 
education. But one method is not: the family could take out a larger 
mortgage on their home and invest the borrowed money in an educational 
savings account. This would not represent prefunding. The family is no 
more prepared for their daughter to go to college--they have more money 
set aside for college but they also have larger mortgage payments. And 
the family might suffer from the dangerous delusion that they have 
prefunded their daughter's education. They will thus be unprepared for 
the combined burden of repaying the mortgage and sending their daughter 
to college.
    In my remarks today, I will make five points that build on the 
simple insights about Social Security that can be gleaned from this 
metaphor:

      First, fully prefunding Social Security is neither 
warranted on policy grounds nor feasible.
      Second, partially prefunding Social Security is a 
sensible goal. But, if benefits for people at or near retirement are 
protected, prefunding can only be accomplished by raising Social 
Security contributions.
      Third, none of the major Social Security reform plans 
under discussion have any significant prefunding. All of the plans 
protect benefits for people at or near retirement and none contain 
contribution increases.
      Fourth, individual accounts--by themselves--do not do 
anything to prefund Social Security.
      Finally, I recommend--as a starting point--prefunding our 
future fiscal challenges by partially undoing some of the major fiscal 
errors of the last four and a half years, including the tax cuts and 
the prescription drug bill.

First, fully prefunding Social Security is neither warranted on policy 
grounds nor feasible.

    Our law requires that private pension plans are fully funded. They 
must maintain sufficient assets to cover all accrued benefits--even if 
plan closes down and receives no future contributions. This rule was 
designed to ensure that companies retain the resources to pay retirees, 
even if they go bankrupt.
    In contrast, Social Security is largely a pay-as-you-go system. The 
majority of benefit payments in any given year are paid for by revenues 
collected in that year. If payroll tax contributions ceased today, the 
Social Security trust fund would only be sufficient to pay benefits for 
the next three and a half years.
    Social Security's pay-as-you-go structure originated in the 1930s. 
President Franklin Delano Roosevelt and the Congress that created 
Social Security decided that the elderly, who fought in World War I and 
bore the brunt the Great Depression, should immediately start receiving 
benefits. If Social Security had been fully advance funded, no one 
would have gotten full benefits until the late 1970s--after a lifetime 
of contributions to the system.
    The policy logic that applies to a private company does not apply 
to Social Security. Unlike a private company, the United States will 
not cease to exist and the Federal Government can count on continued 
payroll tax collections into the indefinite future. With adjustments in 
Social Security benefits and taxes, Social Security can be made 
sustainably solvent.
    Even if one believes that the wrong decision was made in the 1930s 
and wishes Social Security were fully advance funded, shifting from our 
current system to an advance funded system is not feasible. Doing so 
would require either eliminating an entire generation's benefits or 
doubling an entire generation's payroll taxes. Every significant Social 
Security reform proposal, whether with or without accounts, largely 
maintains Social Security's pay-as-you-go structure.

Second, partially prefunding Social Security is a sensible goal. But, 
if benefits for people at or near retirement are protected, prefunding 
can only be accomplished by raising Social Security contributions.

    Partially prefunding Social Security, as part of an overall reform 
to restore solvency, is a good idea. America currently enjoys a more 
fiscally-favorable demographic structure than our country is likely to 
face ever again in the future. As a result, the Social Security 
Trustees project that the system will run a surplus through 2017 (on a 
cash basis) or 2027 (including interest on the trust fund). As the 
number of workers per retiree diminishes, Social Security will shift 
into deficit.
    Instead of waiting for deficits to emerge, acting sooner to reduce 
benefits or raise contributions to Social Security would allow for 
smaller future adjustments. But on the other hand, future generations 
are likely to be richer and more able to afford adjustments. 
Policymakers should weigh these competing considerations. I recommend 
erring on the side of caution by including at least some prefunding.
    Prefunding Social Security means making benefit reductions or 
contribution increases today that, at a more fundamental level, would 
raise net national savings. Raising savings should be a fundamental 
goal of any proposal to reform Social Security. This goal was 
unanimously accepted by the 1994-96 Advisory Council and endorsed by 
the President's Commission to Strengthen Social Security.
    This goal is particularly important today because in the last three 
years, net national savings has averaged 1.6 percent of GDP--the lowest 
level in seventy years. At the same time, investment was financed by an 
average 4.8 percent of GDP in capital inflows from abroad--the highest 
level on record. Borrowing at this level is unsustainable; eventually 
this debt will need to be repaid. Social Security and pension reform 
can help increase private savings and reduce government dissaving 
(i.e., by reducing budget deficits).
    Higher national savings leads to increased investment and/or 
reduced foreign borrowing. Either way, higher savings is the only way 
to increase consumption by future generations of the elderly without 
reducing consumption by future generations of the young.
    President George W. Bush and Congressional leaders from both 
parties have ruled out reducing benefits for people at or near 
retirement. This is a sound choice because people at or near retirement 
have already factored their expected benefits into their financial 
plans and it would be too late for them to make up for reductions by 
saving more. But, because policymakers have ruled out reducing benefits 
for people at or near retirement, the only way to meaningfully prefund 
Social Security is to increase contributions to Social Security.
    Policymakers can choose from several ways to raise contributions, 
including: raising Social Security tax revenues (i.e., raising the 
ceiling on taxable earnings, applying a smaller ``legacy charge'' above 
the ceiling, or raising payroll tax rates); raising other revenues 
(i.e., dedicating revenues from a reformed estate tax to Social 
Security); or raising the total contribution to Social Security above 
the current 12.4 percent FICA rate and dedicating the additional 
contributions to individual accounts.\2\ While all of these steps would 
partially prefund Social Security, the choice of which provision or 
combination of provisions to adopt should be guided by several goals: 
ensuring the source of revenue is progressive, respecting Social 
Security's role as the core tier of retirement security, maintaining 
administrative efficiency, and being mindful of the interaction of 
prefunding with other aspects of the federal budget.
---------------------------------------------------------------------------
    \2\ Another variant of this is to establish quasi-mandatory add-on 
accounts by subsidizing the additional account contributions by those 
who choose to make the added contributions with even larger benefit 
reductions than would be necessary to restore solvency for those who 
choose not to establish accounts. This is the approach taken by Martin 
Feldstein and Andrew Samwick and proposed by the President's Commission 
Model 3. Unless the subsidies for the additional account contributions 
are so large that most people would participate, this approach will not 
result in significant prefunding.

Third, none of the major Social Security reform plans under discussion 
have any significant prefunding. All of the plans protect benefits for 
people at or near retirement and do not have any contribution 
---------------------------------------------------------------------------
increases.

    Few of the major Social Security proposals from recent years have 
any real prefunding. The proposal by economists Peter Diamond and Peter 
Orszag and the proposal by former Social Security Commissioner Bob Ball 
are the only plans scored by the Social Security actuaries that entail 
even modest prefunding. None of the other proposals increase the total 
contribution to Social Security. None of the proposals reduce Social 
Security benefits before about 2012 and even then the reductions in 
Social Security begin very gradually.
    For example, consider the benefit reductions in two leading 
approaches: the sliding scale benefit reductions (also known as 
``progressive price indexing'') supported by the President and benefit 
reductions from raising the retirement age and longevity indexing (as 
proposed by Senator Chuck Hagel). As shown in Figure 1, it takes more 
than 20 years before either plan reduces Social Security spending by 
0.5 percent of payroll, a relatively modest contribution to overall 
solvency. In contrast, the Diamond-Orszag plan would reduce the Social 
Security deficit by this amount almost immediately and would continue 
to grow over time.

       Figure 1. Reduction in Social Security Cash Flow Deficit*

[GRAPHIC] [TIFF OMITTED] T3926A.022

     *Increase in the Social Security cash flow surplus before 2017

   Note: ``Sliding scale redns'' indicates the President's proposal. 
  ``Longevity indexing'' indicates Senator Hagel's plan to raise the 
  retirement age to 68, index benefits for longevity, and modify the 
                   early/delayed retirement factors.

    Figure 2 shows the percentage of the Social Security cash flow 
deficit closed by each of the three plans, excluding the individual 
accounts portions of the plans. Both the President's plan and the 
longevity indexing plan close only a small fraction of the deficit in 
the early years, growing to nearly 70 percent of the deficit by 2080. 
In contrast, the Diamond-Orszag plan closes more than 100 percent of 
the deficit (or modestly increases the surplus) prior to 2020 (not 
shown in the Figure) and thus smoothes the process of restoring 
sustainable solvency.

          Figure 2. Percentage of Cash Flow Deficit Eliminated

[GRAPHIC] [TIFF OMITTED] T3926A.023

    *Increase in the Social Security cash flow surplus before 2017.

   Note: ``Sliding scale redns'' indicates the President's proposal. 
  ``Longevity indexing'' indicates Senator Hagel's plan to raise the 
  retirement age to 68, index benefits for longevity, and modify the 
                   early/delayed retirement factors.

    Fourth, individual accounts_by themselves_do not do anything to 
prefund Social Security.

    Individual accounts, by themselves, do nothing to prefund Social 
Security. Increasing Social Security contributions--for example raising 
the total contribution to 15.4 percent and dedicating 3 percentage 
points of this to an individual account--would partially prefund Social 
Security. But it is not the accounts but the larger contributions that 
are leading to the prefunding.
    No major recent individual account proposal, however, is proposing 
to increase total account contributions. In the last few years, every 
major individual accounts proposal is funded by diverting existing 
payroll taxes or by borrowing from the general fund. In either case, 
any assets in the accounts are matched by increases in the government's 
debt. Like the family that mortgages its house to put money in a 
college-savings account, this process does nothing to prefund Social 
Security or increase national savings.
    One of the leading public finance textbooks, written by the former 
Chairman of President Bush's Council of Economic Advisers Harvey Rosen, 
explains that ``privatization'' by itself does not raise national 
savings:
    Hence, privatization can help finance future retirees' consumption 
only to the extent that it allows future output to increase. And the 
only way it can do this is by increasing saving.
    However, there is no reason to believe that privatization by itself 
would raise national savings--At the end of the day, all that takes 
place is a swap of public and private securities between the Trust Fund 
and private markets--no new savings is created.\3\ (emphasis added)
---------------------------------------------------------------------------
    \3\ Harvey S. Rosen, Public Finance, Seventh Edition, 2005, p. 208. 
Rosen goes on to explain that ``sophisticated schemes'' that include 
additional out-of-pocket contributions could increase savings. Recent 
carveout account proposals, including the President's proposal, do not 
have any of the features Rosen identified as potentially leading to 
higher savings.
---------------------------------------------------------------------------
    In short, the primary effect of borrowing to finance individual 
accounts is no change in national savings. Furthermore, two secondary 
effects could be important.
    First, the accounts would reduce savings if individuals treat them 
as net wealth and consequently decrease their savings in 401(k)s and 
IRAs. The completely rational actor who inhabits economics textbooks 
should not change his or her savings as a result of the accounts 
because, in the absence of additional revenue, every dollar contributed 
to accounts is generally matched by a dollar reduction in present value 
terms in future Social Security benefits.\4\ The accounts do not 
represent net wealth but are instead are akin to a loan. Workers will 
still need to save as much of their own money to enjoy a dignified 
retirement. But, the design of the President's accounts (and the way in 
which they are often described) could lead many people to overlook the 
benefit offset associated with the account and to incorrectly assume 
that the accounts represent new wealth. Such people could feel less 
need to save in the form of 401(k)s and IRAs.\5\ This would not just 
reduce national savings, it would also leave these people even less 
prepared for retirement.
---------------------------------------------------------------------------
    \4\ This either occurs directly as a result of the benefit offset 
(as proposed by President Bush) or indirectly as a result of other 
benefit reductions necessary to make up for the cost of subsidies for 
individual accounts.
    \5\ Douglas Elmendorf and Jeffrey Liebman provide evidence 
suggesting that individuals reduce savings by about 40 percent of the 
value of individual accounts but only increase savings by 25 percent 
for future reductions in Social Security benefits (like the benefit 
offset). As a result, they conclude that ``individual accounts are 
likely to crowd out some other household saving.'' Douglas W. Elmendorf 
and Jeffrey B. Liebman, ``Social Security Reform and National Saving in 
an Era of Budget Surpluses,'' Brookings Papers on Economic Activity, 
2:2000.
---------------------------------------------------------------------------
    Second, in theory the accounts could increase savings if the higher 
deficits associated with them lead to lower government spending and/or 
higher taxes outside of Social Security. In this case, the government 
would not be completely financing the accounts with borrowing and 
national savings would increase. Note, even in this case, the same 
level of prefunding could be achieved without the account as long as 
the President and Congress have the political will to reduce the non-
Social Security deficit.
    But there is little reason to believe that such developments would 
occur. The Bush administration has not claimed that if accounts were 
passed it would propose additional reductions in federal programs or 
higher taxes to offset the increased deficit. In fact, administration 
officials emphasize that they do not believe there is any need for such 
steps because, they contend, the accounts are fiscally neutral over the 
infinite future. In addition, the Bush administration has not included 
the short-run deficit impact of the accounts in its budget submissions. 
It would be imprudent to base a major policy on the hope that future 
government spending and/or taxes would change as a result.
    As a result, debt-financed accounts--including the President's 
proposal--are likely to reduce national savings permanently. Even with 
the potentially offsetting effect of phased-in benefit reductions, 
national savings would likely be lower and America as a whole would be 
poorer for several decades.

Finally, I recommend_as a starting point_prefunding our future fiscal 
challenges by partially undoing some of the major fiscal errors of the 
last four and a half years, including the tax cuts and the prescription 
drug bill.

    Social Security is only one part, and a relatively small part, of 
the long-run deficit. Policymakers should focus on prefunding our 
overall fiscal challenges by reducing the deficit and thus increasing 
net national savings.
    In the 1990s, policymakers put America in better fiscal shape to 
meet the future challenges of Social Security, Medicare, and Medicaid. 
In 2000, President Bill Clinton proposed devoting the entire Social 
Security surplus to debt reduction and devoting additional portions of 
the non-Social Security surplus to further debt reduction and Social 
Security solvency. The Social Security actuaries estimated that paying 
down the debt and dedicating the savings to Social Security would have 
extended the life of Social Security by 20 years.\6\ It is important to 
note that these contributions constituted prefunding by increasing the 
unified budget surplus, reducing the debt held by the public, and 
raising net national savings. Prefunding does not require equity 
investment or individual accounts.\7\
---------------------------------------------------------------------------
    \6\ Stephen C. Goss, ``Long-range OASDI Financial Effects of the 
President's Proposal for Strengthening Social Security--INFORMATION,'' 
June 26, 2000.
    \7\ In addition, the Clinton proposal included another provision to 
invest part of the trust fund in equities. Even using returns that are 
not adjusted for risk, the equity investment contributed only 6 years 
to solvency, much less than the genuine prefunding entailed by the 
additional debt reduction.
---------------------------------------------------------------------------
    In the last five years the surplus has disappeared as a result of 
several rounds of large tax cuts and spending increases, and, to a 
lesser degree, adverse shocks. As a result, it is no longer feasible to 
use debt reduction to substantially prefund Social Security. 
Nevertheless, there is still substantial scope to close the overall 
fiscal gap. This is worth doing whether or not the steps are officially 
scored as extending the solvency of Social Security or not. Ultimately, 
what matters most is overall fiscal sustainability and, in this regard, 
the tax cuts passed from 2001 through 2004, if made permanent without 
causing a large increase in the Alternative Minimum Tax (AMT), would 
cost more than three times as much as the 75-year Social Security 
deficit and the prescription drug benefit will cost more than twice as 
much as the 75-year Social Security deficit.
    As a starting point, I recommend repealing a portion of the tax 
cuts passed from 2001 to 2004 or, at the very least, allowing them to 
expire in 2010 or offsetting the cost of extending them by broadening 
the tax base. In addition, I recommend exploring ways to reduce the 
cost of the prescription drug benefit passed in 2003. This would lay a 
foundation for more significant deficit reduction, including policies 
to restore Social Security solvency.
    Thank you, I look forward to the Committee's questions.

                                 

    Chairman MCCRERY. Thank you, Dr. Furman. Mr. Shipman?

    STATEMENT OF WILLIAM G. SHIPMAN, CHAIRMAN, CARRIAGEOAKS 
    PARTNERS, LLC, MANCHESTER-BY-THE-SEA, MASSACHUSETTS; CO-
   CHAIRMAN, THE CATO INSTITUTE'S PROJECT ON SOCIAL SECURITY 
                             CHOICE

    Mr. SHIPMAN. Chairman McCrery, Ranking Member Levin, and 
other Members of the Subcommittee, I thank you very much for 
giving me the opportunity to be here this morning to express my 
views on Social Security reform. To start off, if I may, I 
would like to share with you a personal story that I think is 
central to the debate. It was many years ago when our young 
teenage son came home very proud. He had his first paycheck. 
This was a real paycheck, where somebody actually wrote him a 
check, as opposed to mowing lawns and being paid by neighbors. 
He opened it up and he said, ``Dad, what's ``ficka``?'' And I 
said, ``I have no idea. I have never heard that term before. 
Where did you get it?'' And he showed me the paycheck and I 
looked at it and I said, ``Oh, that's the Federal Insurance 
Contributions Act (FICA).''
    And ``ficka''--FICA--doesn't mean that much to a young 
teenage boy. He said, ``Well, what's that?'' And I said, 
``Well, that's the Federal Insurance Contributions Act.'' That 
went directly over his head, and I thought I lost him. He said, 
``Well, well, what's that?'' I said, ``Well, that's Social 
Security.'' He said, ``You know something about that. What does 
it really mean?'' And I said, ``Well, do you see what was taken 
out of your check?'' He said yes. I said, ``Double that, 
because you're employer takes the same amount out of your wages 
and that is sent to the government as long as you work. Then 
when you get old and retire, the government will send you some 
money.'' He pondered that. He said, ``Oh, is it a good deal?'' 
And I said, ``Frankly, no, it's not.'' And then the real 
question: ``Do you think I should do it?``
    [Laughter.]
    And I said to him, ``You have no choice.'' What this lack 
of choice means is that for about 10 percent of our wage income 
Americans are not free to be able to spend that on other common 
and available retirement options. Not having this choice is bad 
enough. Its costs are compounded by the fact that the 10 
percent doesn't really buy very much. An average wage worker 
today at 45 years of age, retiring in 20 years under scheduled 
benefits, will receive a benefit roughly equal to about 36 
percent of that worker's last year's wage. If that individual 
were to save half of the amount of the Social Security tax, and 
just the retirement portion of the Social Security tax, that 
individual would receive a benefit, based on historical market 
returns, a benefit roughly double what you would receive from 
Social Security. Roughly double the benefit at roughly half the 
price. This may be one reason why Social Security is mandatory. 
Few people likely would participate if it were voluntary. This 
should give us some pause. Should our government force its 
citizens to buy a product they may not want? Or, to put it 
differently, shouldn't our government encourage competition 
amongst product providers so that citizens can choose best what 
meets their needs?
    These questions will weigh more heavily as Social Security 
ages further, because pay-as-you-go systems become less 
attractive with time. In 1950 in the United States, when there 
were 16 workers per retiree, the highest Social Security tax 
any American paid was $90 a year. Today, just for the 
retirement portion of Social Security, the highest tax is 
$9,540 a year. Even adjusted for inflation, the tax has gone up 
by about 2000 percent. You may not have noticed this. Even if 
you did notice it, you may not have cared so much because it 
edges up so very slowly that it is unyielding. I kind of think 
of it as comparable to getting kicked to death by a rabbit. You 
don't feel it. The last strike is terminal.
    As much as this tax has gone up, our friends in Europe 
would consider us lucky. As you may know Social Security 
started in Europe, specifically in Germany, in 1889. So, we 
have something to learn from them. Their payroll is not capped 
at $90,000, such as ours. Their Social Security tax is on all 
of their wage income. The payroll tax rate in France today is 
51 percent of payroll. In Germany, Italy, and Spain, it is 
about 38 to 42 percent of payroll. These prohibitive taxes have 
led to almost zero economic growth in Western Europe, high 
unemployment--10 percent in France, over 12 percent now in 
Germany. There is civil unrest, and they are talking now, as we 
are, about raising taxes further.
    The alternative is a market based system where individuals 
are free to save and invest in markets highly diversified 
across asset classes, across national borders, and across time. 
Much of this from other testimonies that have been given. These 
systems--and by the way, they are common in the private sector, 
defined benefit plans, defined contribution plans and the 
like--these are quite common and they could work extremely well 
as a national system. In my view, it is almost certain that we 
will adopt a market based system. In my view, it is almost 
uncertain as to when we will do it--now, when we have time to 
prepare, or later, when we don't.
    You as Members of Congress hold a hope for America because 
you have a unique opportunity to provide workers the freedom to 
choose, to accumulate wealth, to pass it along to their kids if 
they so choose, and for Americans to no longer be tethered to 
the government for their retirement. You should grasp this 
opportunity. Should you do that, all Americans will be forever 
thankful. Thank you very much.
    [The prepared statement of Mr. Shipman follows:]

Statement of William G. Shipman, Chairman, CarriageOaks Partners, LLC, 
    Manchester-by-the-Sea, Massachusetts, and Co-Chairman, The Cato 
             Institute's Project on Social Security Choice

    Chairman McCrery, Ranking Member Levin and members of the 
subcommittee, I thank you for giving me the opportunity to express my 
views on the reform of our Social Security system. Eleven years ago, on 
October 4, 1994, I had the opportunity to speak before this same 
Committee and in my written testimony I offered:
    As both a son and a father, I am interested that the elderly are 
well cared for, and that the young have the opportunity to build 
sufficient assets so that they, too, can retire in dignity. Social 
Security, as presently structured, ultimately will achieve neither 
objective. Although compassionate in its original intent, it is flawed 
in design.
    The system's financial structure is fundamentally unsound. 
Legislation of 1977 and 1983 attempted to address this by raising taxes 
and cutting benefits; Social Security was to be on sound financial 
footing well in to the 21st century. And now, just a few years later, 
The 1994 Board of Trustees' report suggests that the system will run 
out of money seven years earlier than it projected just one year ago. 
Legislative initiatives to reduce benefits further and raise taxes are 
again on the drawing board. This did not work in 1977 or 1983; it will 
not work now. Social Security's financial integrity requires an 
entirely different approach. I offer this testimony in the spirit of 
the starting point for an alternative: a concept of privatization 
wherein Americans benefit from the engine of a free economy and free 
choice. With privatization properly structured, today's elderly will be 
protected, the young will retire with higher incomes, and our political 
leaders will have offered, once and for all, a lasting solution for 
which all voters will be thankful.
    Since that testimony our nation has had a vigorous and open 
discussion. Many new ideas have been offered, ideas not developed prior 
to 1994. The climate of opinion has changed; more Americans are now 
aware of the issue, more Americans want the option to save and invest 
for their own future. We are getting closer to the point where the 
``rubber meets the road,'' when you, as Members of Congress, will have 
to vote. Your decision is more important than perhaps you know.
    It has been eleven years since my first testimony on this issue and 
in many ways, but certainly not all, little has changed politically; 
we're still talking about raising taxes and reducing benefits. We have 
wasted precious time.

A Collision Course
    Like other nations we face an unprecedented challenge of how to 
deal with a reality that mankind has never confronted before and one 
that most people are unaware of. How we and other governments respond 
will affect each American citizen, our families, businesses across the 
land, indeed our very way of life. The reality is not only 
unprecedented, it is unyielding.
    Dr. Karl Otto Pohl, former president of the German central bank, 
the Bundesbank, stated it this way: ``In a relatively short period, we 
must adapt our domestic institutions, international relationships, and 
even our individual life plans to a new, and powerful reality.''
    What he was speaking of, and what confronts each of us here, is the 
fact that there are two powerful forces on a collision course. The 
first is the aging of society, the reality that the elderly population 
is increasing more rapidly then the population as a whole. In America, 
but even more so in other countries, the elderly rely on Social 
Security to survive financially. Should Social Security falter, many 
elderly will be destitute.
    The second force is that most Social Security systems, including 
ours, are, in fact, failing. They are financially unstable, and not 
sustainable as they are presently structured.
    The challenge is to avoid the collision of these two forces. In my 
view, the risks are high that we will not. But should we prevail by 
structuring a lasting solution, the rewards will be as unprecedented as 
the challenge itself.

The Early Years: Social Security's Roots
    Social Security was enacted in 1935 during the Great Depression. 
During the first half of the 1930s real GDP fell by about 25 percent, 
unemployment jumped to 22 percent and the stock market virtually 
imploded and fell about 70 percent. Our nation was on her economic 
knees. President Roosevelt had to do something, something big, but 
large government programs were anathema to the frontier spirit of our 
young nation. In order to achieve his goals he needed unprecedented 
authority. To grasp that authority he went before the nation on March 
4, 1933 in his first Inaugural Address and asked for authority ``. . . 
as great as the power that would be given me if we were in fact invaded 
by a foreign foe.'' He achieved his goal and ushered in Social 
Security, the flagship program of the New Deal.
    Much like other Social Security programs that preceded ours, the 
first being Germany's in 1889, benefits paid to the elderly were 
financed by payroll taxes. In our case, during the Great Depression, 
people who had jobs were considered the wealthy. It wasn't like today 
wherein Americans have portfolios of stock and bonds, real estate, 
defined benefit and contribution plans and the like; you were 
considered wealthy if you had a job. And needs were so urgent that the 
``payroll wealth'' was taxed. A saving and investment structure would 
not have worked at that time because it takes time to compound 
investment returns to accumulate wealth, and time was short.

Today: A Fundamentally Flawed Program
    Over the decades, however, this sort of urgent safety net has 
turned into the rough equivalent of a defined benefit plan. Yet its 
financial structure has not advanced. The Old-Age and Survivors 
Insurance part of Social Security, as its finances are presently 
structured, is inefficient, financially unsound and fundamentally 
flawed.
    Because benefits are paid by taxing payroll, benefits can increase 
by no more than payroll increases, assuming that the tax rate on 
payroll is held constant. Over the last four decades or so, payroll has 
increased by about 1.5 percent per annum in real terms. That is roughly 
equivalent to saving and investing and receiving a rate of return of 
1.5 percent. To put this into perspective, if one were to save $1,000 
each year for a 45-year working career and earn 1.5 percent, the saving 
would accumulate to about $64,000. During the last 79 years a mixed 
portfolio of 90/10 percent large/small company stocks earned an 
inflation-adjusted average annual return of 9.7 percent. One thousand 
dollars invested annually for 45 years earning that return would 
accumulate to about $650,000. And a conservative portfolio of 60/40 
percent stocks and bonds, respectively, would accumulate to about 
$288,000. These different values give a glimpse of the lost opportunity 
that our citizens incur by being required to finance their retirement 
through payroll taxes.
    But it is worse. For any particular age group it matters how many 
workers pay taxes relative to the number of retirees who receive 
benefits. The change in this ratio is largely determined by the change 
in national wealth, or GDP per capita. As national wealth rises, life 
spans also rise. We observe this not only here but across all parts of 
the globe. When Social Security was enacted life expectancy at birth 
was 61 years of age; it is now about 78. In the post-war period global 
life expectancy has increased from 45 to 65 years of age, a greater 
increase in the last 50 years or so than in the previous 5,000 years. 
This is all new. We didn't expect it. But now we think it will 
continue.
    Also, as nations become more wealthy birth rates fall. In many 
countries they have fallen below the population replacement rate of 
2.1. The combination of rising life expectancy and falling birth rates 
causes havoc with pay-as-you-go financed Social Security systems. In 
the United States there were 16 workers per beneficiary in 1950; today 
there are about 3.3. It is expected that there will be only two in just 
35 years. Therein lies an interesting paradox: as countries become more 
wealthy their Social Security systems become more poor. The oddity is 
driven by the causal relationship between increasing wealth--and 
increasing life expectancy as well as decreasing birth rates--all 
wrapped around pay-as-you-go financing.
    Birth rates have fallen to such low levels in Europe--France-1.9, 
Germany-1.4, Italy-1.3, Spain-1.3--that ``there is now no longer a 
single country in Europe where people are having enough children to 
replace themselves when they die.''

The Global Political Response: Raise Taxes
    The political responses to the changing demographics that squeeze 
Social Security's finances are frequently the same across the world. 
Governments and politicians tend to see the problem in the narrowest of 
lights: merely a solvency issue--too many benefits paid, too few taxes 
received. This near-sighted analysis is further compounded by the focus 
on just today's solvency and not tomorrow's.
    But from this myopic perspective the options are clear; raise 
taxes, cut benefits. Of the two, governments tend toward raising taxes 
first. This makes sense for at least a couple of reasons. There are 
more workers to tax than there are retirees from whom to cut benefits. 
Therefore, if the choice were only one or the other, raising taxes 
inflicts a lesser per capita burden. The second reason is that workers 
are younger than retirees, therefore, they have more time to adjust to 
a tax increase than retirees have to adjust to a benefit cut.
    The short-sighted strategy of raising taxes has been employed 
world-wide. In the United States, for example, in 1950 when there were 
16 workers per beneficiary, the maximum Social Security tax any 
American worker paid was $90 a year. At that time the tax rate was 3 
percent on only $3,000 of wage income. As the glacial force of 
demographics slowly and unrelentingly squeezed the system, the $90 tax 
rose and squeezed the worker. Now, the tax, just for the retirement 
portion of Social Security, is 10.6 percent of $90,000, or $9,540. 
After adjusting for inflation over the last 55 years, that tax has 
increased almost 2,000 percent. In all likelihood, the reason that we 
stood for this is that the tax rose slowly; the increase was never 
really noticeable in any one year, but over time it has become more of 
a burden than the income tax for about three quarters of American 
workers.
    Our friends in Europe, however, would consider us lucky. The 
payroll tax in France is about 50 percent and in Germany, Italy and 
Spain it ranges roughly between 38 and 42 percent. It is true that 
these countries' systems provide more services than ours, but this is 
not a plus. Europeans are dependent on more of their needs from 
government programs that are not sustainable.
    As many European nations have raised their payroll taxes to 
prohibitive levels they have choked individual economic freedom and 
incentive. Economic growth is stagnant, and unemployment rates hover 
around 10 percent, even 12 percent in Germany. Civil unrest is now more 
common in Germany and France as governments tell their people that 
benefits are no longer affordable and will have to be cut, while at the 
same time they extol the virtues of the welfare state. We are on the 
same path, but for the moment we trail far behind.

Then, Cut Benefits
    At some point, the strategy of raising taxes approaches a political 
wall. People sense that maybe, just maybe, they could achieve more with 
their hard-earned wages than they get from Social Security. Politicians 
sense this and move to the lesser desirable option of cutting benefits. 
Such blunt language, however, is not commonly uttered. Code is 
employed: progressive price indexing, longevity indexing, adding a 
third bend point, reducing bend point factors, increasing the NRA, 
decreasing the PIA, and it goes on and on. It's all code for cutting 
benefits.

Fundamental Reform: Retarded by the Claim of Insurance
    Eventually, after cutting benefits hits its political wall, the 
thinking shifts to fundamental reform, saving and investing in wealth-
producing assets for all workers. This idea of market-based financing 
for retirement income is not new, in fact it is old and well 
established in the private sector, but it is viewed with some disdain 
from advocates of the status quo. They object to the notion that Social 
Security should be an investment structure and defend their objection 
by claiming that it is insurance. This claim had some merit decades 
ago. Not now. In fact, Social Security's finances are in trouble 
largely because they are inappropriately based on the insurance model.
    Insurance works well when many people are subject to an event that 
has little chance of happening to any single individual. A good example 
is homeowners' fire insurance. Many people buy fire insurance to 
protect their homes and yet few homes burn. Because the number of homes 
insured is many times the number of homes that burn, the annual 
insurance premium is very low relative to the replacement cost of one's 
house. Insurance companies are simply the medium through which 
individual uncertainty of loss is transferred to, and financed by, the 
group.
    The insurance model does not work well when the group is subject to 
an event that the entire group experiences. For example, if it were 
certain that everybody's house would burn down, say, when the owner 
reached age 65, then insurance companies would have to charge annual 
premiums the future value of which would be the cost of rebuilding all 
the houses. This premium would be a large multiple of the premium 
charged for the uncertain case. Central to the insurance model is that 
the ratio of the annual premium to the dollar value of what it protects 
is negatively correlated to the uncertainty of individual loss.
    Social Security is frequently heralded as insurance, more precisely 
social insurance. The `social' part of the term merely means that the 
government plays the role of the insurance company. Other than that, it 
remains the insurance model. When Social Security was enacted in 1935, 
life expectancy was 61 but benefits weren't payable until age 65. Now 
benefits are payable at age 62 and life expectancy is 78. The element 
of uncertainty has kind of flipped upside down. Because of this, the 
retirement component of Social Security isn't insurance; once born, 
reaching age 62 and needing retirement income is almost certain. As a 
result, there is very little risk, or uncertainty, to transfer to the 
group, resulting in the fact that annual premiums must be enough to 
accumulate to a sum, including interest, that will finance retirement 
income.
    Under these conditions, social insurance cannot provide such income 
at a lower cost than saving and investing for retirement. 
Unfortunately, however, it can and does provide it at a higher cost 
because it is financed through the payroll tax and is subject to 
unyielding demographic forces. In a perverse way Social Security's 
finances and its adherence to the insurance model are caught in a kind 
of time warp; in the age of the iPod Social Security is a 78 RPM, wind-
up phonograph. Unless protected by the power of the state, it can 
neither compete nor survive.

The State Monopoly Faces Competition
    Being protected by the power of the state really means that for 
10.6 percent of their wage income American workers are not free to 
choose among alternatives for their retirement. Bad as that is, the 
10.6 percent doesn't buy much relative to reasonable and available 
alternatives. This is why Social Security is mandatory; few would 
participate if they had the freedom not to. Competition, as always, is 
a threat to the status quo. For workers, however, competition is their 
hope.
    Competition would allow all workers to invest part of their payroll 
tax in capital markets around the world, in professionally managed 
portfolios that are highly diversified across asset classes, national 
borders and time. Such an opportunity would allow one to accumulate 
enough wealth to replace the pay-as-you-go benefit entirely.
    For an average wage worker retiring this year at age 65, Social 
Security's scheduled benefits are projected to replace about 42 percent 
of his last year's wage. But for workers retiring in the future full 
benefits won't be paid until age 67. For those future retirees, should 
they choose to retire at age 65, benefits will replace only 36 percent 
of their last wage. The worker's cost for these scheduled benefits, 
which are in excess of what is affordable based on present law, is the 
10.6 percent payroll tax.

The Market-Based Alternative
    The market-based alternative is significantly more attractive. Over 
the last 79 years a conservative portfolio of 60/40 percent stocks and 
bonds, respectively, earned a real return of just a little over 7 
percent. Investing just half of the retirement payroll tax, 5.3 
percent, each year for 45 years would provide a retirement benefit 
equal to 97 percent of one's last year's wage. This assumes that there 
is no interruption in saving each year, that the market return is as 
stated and falls by 2 percent during the distribution phase, and that 
life expectancy upon retirement is 20 years. Each of these assumptions 
can be changed. Work may be interrupted. Markets may do worse or 
better. Life expectancy may be more or less than 20 years once retired.
    To take a conservative path, if the market return were only 5.5 
percent and if life expectancy were 30 years at the onset of 
retirement--about 10 years more than assumed by Social Security--then 
under these conditions the replacement rate would 39 percent, higher 
than Social Security's scheduled benefits at age 65 and significantly 
higher than payable benefits.

Americans Understand the Tradeoffs
    Our citizens sense these tradeoffs, risks, uncertainties, and the 
fundamental differences in providing retirement income from a tax 
system versus a saving and investment system. This is why, but only 
part of why, they want the option, the freedom to choose.
    If they could acquire this freedom they also would have personal 
property rights over their accumulated wealth. They have no such rights 
to Social Security benefits. They also could bequeath some or all of 
their retirement assets. They cannot under Social Security. They would 
benefit from the direct relationship between effort, their saving, and 
reward, their accumulating wealth. They would have the dignity that 
comes with being personally responsible for their future. They would no 
longer be tethered to the government. They would no longer be subject 
to politicians' preferences over when they can retire, how much they 
can get, how their spouses are treated, how much they're going to pay, 
and all of the rules and regulations that have evolved to the point of 
being incomprehensible. They would be free.
    It's been eleven years since I had the opportunity to speak before 
this Committee. Although much of what I am saying today is what I said 
then, I hope that we are closer to fundamental reform. If we are not, 
and the two powerful forces that I mentioned above in fact collide, we 
will edge closer to the wrenching difficulties that Europe is now 
facing.

You, Congress, are the Hope
    But should we grasp the extraordinary opportunity that this 
challenge offers, we will forever strengthen our nation, our economy, 
our freedoms, and our ability to finance the many needs that the future 
will undoubtedly require. It is a matter of will and political 
leadership in seeing the benefits of greater personal freedom and 
acting to ensure them. You, as Members of Congress, have the unique 
opportunity to offer, once and for all, a lasting solution for which 
all Americans will be forever thankful.
            Thank you,
                                                 William G. Shipman

                                 

    Chairman MCCRERY. Thank you, Mr. Shipman. Thank all of you 
for your excellent testimony this morning. I want to emphasize 
again something Dr. O'Neill said when she said that in 2042, or 
in 2052, depending on whose assumptions are correct, 
beneficiaries would experience an initial decline in benefits. 
Which implies that after that initial decline, there would be a 
further decline. Is that correct, Dr. O'Neill?
    Ms. O'NEILL. That is correct, according to what we believe 
is going to happen with the economy.
    Chairman MCCRERY. So, whether it is a 22-percent decline or 
a 27 percent initial decline, the benefits are going to get 
worse after that. Is that right?
    Ms. O'NEILL. Yes, because the gap between revenues and 
benefits grows.
    Chairman MCCRERY. Thank you. Obviously, we have some 
disagreements about the definition of prefunding and the merits 
of prefunding. Dr. Furman, I was interested in your comment 
that the only way to prefund Social Security is to increase 
Social Security taxes. I assume if we were to increase Social 
Security taxes and then put those into personal accounts or 
make a direct government investment in the markets, that that 
would satisfy your definition of prefunding. Is that right?
    Mr. FURMAN. I was giving, I think, a generally accepted 
definition in the economics profession. You could immediately 
cut benefits. That has been ruled out, and I think wisely so. 
Alternatively, I used the word ``contributions'' because that 
could come from payroll taxes, raising the cap, a mandatory 
individual account on top of the 12.4. I am not saying that I 
recommend any of those, just giving you that if you want to 
satisfy the definition----
    Chairman MCCRERY. No, I am not calling you an advocate for 
prefunding. I am trying to get our definitions straight here. 
Why wouldn't it satisfy your definition of prefunding if we 
raised, say, personal income taxes and dedicated that to 
personal accounts in Social Security?
    Mr. FURMAN. Oh, no, that would satisfy it. I used the word 
``contributions'' to mean anything that----
    Chairman MCCRERY. Broadly speaking. Not contributions----
    Mr. FURMAN. At the fundamental economic level, the most 
important thing is that we are raising savings, which is 
equivalent to reducing consumption.
    Chairman MCCRERY. Right. We could do that either by raising 
taxes within the Social Security system, you know, raise the 
cap on income subject to taxes or raise the tax rate itself, or 
we could satisfy that by raising general taxes and applying 
them to the Social Security system.
    Mr. FURMAN. But again, that wouldn't make the policy good 
or bad, but that would make it prefunding.
    Chairman MCCRERY. Okay, well, that is good. At least we, I 
think, can agree on that definition of prefunding with respect 
to funding personal accounts. I don't think it is at issue 
that--or perhaps some of my colleagues would disagree, maybe 
some on the panel would disagree--but is it at issue that 
absent some new source of revenue or some reduction in spending 
elsewhere to come up with the cash to fund personal accounts, 
there is no increase in Federal savings? Is that correct? 
Anybody disagree with that?
    Mr. ENTIN. In a static sense, yes, unless the changes you 
made triggered some additional behavior changes by the public. 
If you trimmed benefit growth and trimmed the tax rate equally 
and you, in static terms, got no change in the net budget 
situation, but if the reduced payroll tax encouraged some 
additional employment and the people would earn more and save 
more, you would have a change in Federal saving. So, the 
mechanisms you choose can have an effect on these static 
estimates.
    Chairman MCCRERY. Sure. I don't want to get into this right 
now, maybe others will, but Mr. Price's comment that we are not 
managing the economy very well now. We can certainly agree or 
disagree on that, but Mr. Shipman--I think it was Mr. Shipman 
that pointed out that other economies are not doing nearly as 
well as ours.
    Mrs. TUBBS JONES. Mr. Chairman, I am having a hard time 
hearing you. I don't know if I am the only one, but could you 
raise your level just a little bit?
    Chairman MCCRERY. I will certainly try to do that. Other 
Nations' economies don't seem to be doing quite as well as 
ours, so evidently we are doing something right in comparison 
to those nations that are most similar to us from an economic 
standpoint in Western Europe and Eastern Europe. So, I think 
that certainly is something that people could disagree on. That 
is an example of what Mr. Entin is talking about, making 
changes in policy that affect other things in our economy which 
make the economy better. Many of my colleagues in the Minority 
are disparaging of the tax cuts that have been made. Most of 
us, I guess all of us on our side believe that those tax cuts 
are responsible for, in some part, the difference in economic 
growth in the United States and those countries in Western 
Europe, and the difference in the unemployment rate here, which 
is much better than the unemployment rate in Western Europe.
    So, those are things we can discuss. That is a good point 
Mr. Entin made. I certainly wouldn't discount increases in 
national saving that are kind of a spinoff of other policies. I 
am talking about static, direct, what we can identify through 
the establishment of personal accounts in Social Security. 
Clearly, if we funded those with some new revenue or by an 
identified cut in other spending dedicated to the personal 
accounts, then you would automatically have an increase in 
national savings.
    Dr. Furman.
    Mr. FURMAN. Thank you. I am only aware of one study that 
examines the impact of carve-out accounts on national savings. 
It was performed by Doug Elmendorf, who is an economist at the 
Fed, and Jeffrey Liebman, who is an economist at the Kennedy 
School of government. They found that carve-out accounts 
financed by debt would, over the long term, reduce national 
savings and reduce economic output. They found that people 
would look at the assets in their individual accounts and treat 
some of that as net wealth, say, oh, I have $100,000 in my 
account, I don't need to put as much into my IRAs, 401(k), and 
not realize that that $100,000 they had in the account was 
matched by $100,000 worth of benefit reductions that were 
coming 20, 30 years in the future. If people overlook the 
benefit offset, that is what will happen. That is, as I said, 
the only study I am aware of, and it finds that the 
interactions are negative.
    Chairman MCCRERY. Yes, Mr. Price?
    Mr. PRICE. If I could clarify. I don't want to get into--
this is not the place to debate the wisdom of fiscal policy, 
but simply to point out that as to prefunding, whether we are 
contributing to more saving today on behalf of future 
generations, we have gone in the other direction. The policy 
decisions that we have made have done the opposite of what you 
had said was the definition of prefunding; we have done the 
opposite. As a statistical matter, I don't think there can be 
any question that that is what we have done.
    Chairman MCCRERY. I agree.
    Mr. PRICE. It may have been the right thing to do to manage 
the economy. I don't think so; other people think so. The fact 
is, it was the opposite direction of prefunding.
    Chairman MCCRERY. Oh, absolutely. No question about that. 
Which brings up another question, and that is the 1983 reforms. 
Some--maybe it was my good friend Sandy Levin, who said in his 
opening remarks that that was a form of prefunding, when we 
increased the payroll tax and increased the surplus coming in 
and we dedicated that surplus to future generations of 
beneficiaries, that was a way to prefund. I suppose technically 
it is a way to prefund, and maybe in the macro picture it is a 
way to prefund, but with respect to the Social Security program 
itself, as Dr. O'Neill said, it was merely putting promises to 
pay in the Social Security box. Would any of you like to 
comment on whether the 1983 reforms, the increase in the 
surplus, is prefunding? Is that the kind of prefunding we 
should do? Dr. Samwick?
    Mr. SAMWICK. I would like to draw a distinction between 
prefunding future benefits and pre-authorizing them. All that 
the 1983 amendments have done, based on the conduct of our 
other budget policy, is to pre-authorize those payments. If we, 
instead, had a fiscal policy which was, say, over the course of 
a business cycle to balance the on-budget account, then that 
would be prefunding because it would have engendered no 
additional government spending outside of Social Security. I 
think Mr. Price described another scenario, which would be 
there is no drift in debt-to-GDP ratio, presumably, exclusive 
of the Social Security Trust Fund. That would make that pre-
authorizing of those benefit payments actual prefunding. I 
don't believe----
    Chairman MCCRERY. Had we done that, had we followed a 
fiscal policy that balanced the operating budget and left aside 
the surplus--that is what you are suggesting--well, what would 
we have done with that surplus?
    Mr. SAMWICK. Well, you would have bought back existing debt 
held by the public.
    Chairman MCCRERY. Bought back debt. How long would it have 
taken us if we had started in 1984, when this big surplus began 
to accumulate, to extinguish all the debt if we had immediately 
gone to a balanced budget in the operating side of the budget?
    Mr. SAMWICK. I don't have the direct answer.
    Chairman MCCRERY. It wouldn't have taken very long.
    Mr. SAMWICK. Right. In my----
    Chairman MCCRERY. In my recollection, it would have taken 
only a few years to totally extinguish the debt of the United 
States, the external debt of the United States. So, then what 
do we do with it?
    Mr. SAMWICK. I believe, and my written testimony makes this 
clear, that if you are to run--if you are to increase 
contributions to the system, you would like to do so in a 
decentralized manner of personal accounts for a variety of 
reasons, not just the availability of suitable credit market 
instruments for the government to be able to hold.
    Chairman MCCRERY. Thank you very much.
    Mr. FURMAN. Mr. Chairman, if----
    Chairman MCCRERY. I am going to let Mr. Levin have his 
turn, but maybe he will let you say something. Mr. Levin?
    Mr. LEVIN. Thank you for giving me a chance. I will save a 
minute to do that. I am glad, Mr. Shipman, you are here, 
because I think your presentation is the most frank discussion 
of what is behind private accounts. I think everybody should 
take note of it. That is really what the President's private 
proposals do. They move toward elimination of what you call 
tethering of people to a Social Security system, or government 
system. That is exactly what the President's proposals would do 
over time, with the clawback and with the change in indexing--
and adding annuitization, by the way, which doesn't allow 
people to pass it on to their heirs. But anyway, your 
presentation here, Cato has been very direct, and essentially 
it means the end of our Social Security system over time. That 
is what you are after. That is what the President is after.
    Let me just say--and then we will come back to you if there 
is time. No one is saying do nothing. That is number one. No 
one is saying that. Second, I think it is a mistake to read 
Social Security as an anti-poverty program. It has helped to 
bring seniors out of poverty, it has reduced the poverty rate 
from 30 percent at the time of Social Security down to less 
than 10. It is not only or basically an anti-poverty program. 
It was structured, originally, and certainly after that to 
provide a level of retirement benefits so people, as my mother 
would have put it, could continue to live independently. She 
wasn't in poverty, she wasn't wealthy, she was allowed to 
continue to live her own life. So, when we say, we talk about 
poverty, Social Security and the replacement rate of 39 percent 
or 40 was an effort to allow people to live in dignity, to live 
with independence, and not fall back into poverty in many, many 
cases.
    Dr. Furman, let me give you a chance to answer the 
question, because it raises--and Dr. Samwick. In the Clinton 
years we projected a deficit that was a form of prefunding, it 
seems to me. The Chairman asked the question what you do after 
you pay off the debt. We are a long ways from that today. I 
think the policies of recent years have shown that fiscal 
irresponsibility is the opposite of prefunding. Dr. Furman, go 
ahead. You were going to answer.
    Mr. FURMAN. I remember in 2001 one of the problems people 
in Washington were preoccupied with was paying off the debt too 
quickly. I think we can all agree that President Bush has 
decisively solved that economic problem.
    [Laughter.]
    Mr. FURMAN. But the debate over the 1983 and whether it 
constituted prefunding or not, in this context, I view as 
somewhat academic. Which is to say interesting to me, but not 
very relevant. None of the major Social Security proposals I am 
aware of--and the Chairman may have one that I am not yet aware 
of--involve any significant degree of prefunding. So, to debate 
whether you should prefund through the trust fund or prefund 
through accounts, when the plan isn't doing any prefunding at 
all, strikes me as not the most relevant debate to be having. 
That being said, first of all, the debt is high enough now that 
we do have substantial scope to prefund the system--but not 
proposal does that--through debt reduction.
    Second of all, the question 1983 and whether it prefunded 
or not is not, did we raid the Social Security surplus, which 
we did do and we didn't do in the nineties when President 
Clinton was President; the question is would the deficit have 
been even higher if we hadn't had the Social Security reforms 
in 1983. In that case, the debt would be lower than it 
otherwise would have been in the absence of those reforms, and 
we would genuinely have prefunded. That is my reading of the 
evidence.
    Mr. LEVIN. Actually, my time is going to be up, Mr. 
Chairman. Again, I want to thank you for painting what I think 
is the basic issue. I think the American public basically 
disagrees with you. I don't think they think they are tethered 
to Social Security. It provides, in addition to retirement, 
disability protection and also survivor benefits, which are 
hard to purchase in the private market. I think more and more 
people think they are tethered to their private plan. If you 
ask people who are employed and who are covered by private 
pension plans, whether they work for United or whatever, I 
think they feel Social Security is something they worked for, 
they earned, and is guaranteed. They want it to continue. The 
problem that President Bush is having is that people understand 
that inside of his proposals is essentially the essence of what 
you are proposing, and that is the replacement of Social 
Security with private accounts. They don't want that.
    Mr. SHIPMAN. May I respond?
    Mr. LEVIN. You may--you think 50 years from now the 
decision will be different, but it is not today. Go ahead.
    Mr. SHIPMAN. First of all, I believe that you mentioned 
that my preference is to end this over time. I am speaking only 
about the retirement portion of Social Security, not disability 
insurance. Of course disability insurance is part of Social 
Security, so that----
    Mr. LEVIN. And survivors?
    Mr. SHIPMAN. Well, that is really--85 percent of survivors 
are aged widows and widowers, which really come under the 
retirement portion. Fifteen percent are the tragic cases of 
children whose parents have died early. Even in a market based 
system, if those parents die early, from my point of view those 
children should not be disadvantaged whatsoever because of 
moving to a market based system. I believe that the amount that 
is paid is roughly between $3 billion and $5 billion a year to 
these children, and that should not be interrupted whatsoever 
even if you were to move to a market based system.
    As to whether Americans are tethered or not, as to whether 
Americans want to continue with Social Security as it is 
structured now or a market based alternative which we could 
structure, we will only know the answer to that question if 
they are given the choice. You may think that they will stay 
with Social Security. Somebody else may think that they would 
go to the market based alternative. If you are correct, giving 
them the option to have a market based alternative will not 
alter whatsoever the fact that they think that Social Security 
is a better deal. They will stay with it.
    Mr. LEVIN. No, because what it means is massive debt and 
major benefit cuts for everybody on Social Security. That is 
what the President----
    Mr. SHIPMAN. If they think it is a better deal, they won't 
move from it.
    Mr. LEVIN. I know, but for those who move, it means massive 
debt for the Nation and major benefit cuts for everybody else. 
Essentially, what the American people are saying to the 
President of the United States and to this Congress is that 
they want to maintain the guaranteed benefit of Social 
Security. That is what they are saying. Thirty, 40 years from 
now, you may be right. At this point, I think the American 
people are saying that you are wrong. Thank you.
    Chairman MCCRERY. Mr. Johnson?
    Mr. JOHNSON OF TEXAS. Thank you, Mr. Chairman. Mr. Levin, 
you and I don't agree at all. I mean, you got a couple of 
people out there that are saying no to everything, and Dr. 
Furman, his no-net savings would reduce the input, and the only 
answer is tax increase. I don't believe that.
    Mr. FURMAN. Well, I was thinking if you want to prefund and 
you don't want to cut benefits for people now, you have to----
    Mr. JOHNSON OF TEXAS. I will ask you a question when I get 
ready to. I believe that Mr. Shipman made a statement some 
years ago, actually the Board of trustees Report in 1994 
suggested the system is going to run out of money, and it 
didn't work in 1977, it didn't work in 1983, it will not work 
now. I appreciate that statement because I think that is 
correct. I think Mr. Shipman is absolutely correct that people 
need the choice. The choice doesn't include benefits for 
disability, widows, and orphans. Nobody wants to mess with 
that. I think those funds are going to be there under any plan 
that is proposed today. So, I wonder if you would discuss 
personal accounts with a different vision, maybe, Mr. Shipman.
    Mr. SHIPMAN. Yes, thank you, sir. From my perspective, 
speaking only for myself, all Americans should be free to stay 
in Social Security as it is structured or move to an 
alternative, a market based alternative. The efficacy of market 
based alternatives have been spoken of in extent in this 
hearing, as well as at others. The way that I would design it 
would be if you choose to go into the market based alternative, 
then some portion of your existing FICA tax, the OASI tax, 
which is 10.6 percent of $90,000 of wage income this year, some 
portion of that would go into a private account, sent by the 
employer to Treasury just as it presently is in the FICA tax. 
Treasury receives the wire transfer and immediately sends it 
over to a private custodian bank, held in trust for each 
American that made that choice.
    Now, when that amount is reconciled to the individual's 
name, which takes about a year or so under existing Social 
Security structure, then each individual would be allowed to 
put that amount into one of three highly diversified balanced 
funds--U.S. stocks, U.S. bonds; foreign stocks, foreign bonds; 
and cash. Very common as structures in defined benefit plans as 
well as defined contribution plans. One of three funds. One of 
three funds. After a period of roughly three to 5 years, after 
the system reaches a steady state, each individual could go 
down to another level and, through other providers such as 
mutual funds, registered investment advisors, certified 
financial planners, and the like, all constrained by the 
trustees of this system as to what the portfolio would be, they 
could move down into that level. I refer to this as a retail 
level. This would be more expensive than the first three 
balanced funds. I move down to that retail level, let's say go 
to Fidelity; I could move from Fidelity, to T. Rowe Price, to 
Vanguard to various other providers, and they would charge me 
whatever they wished. I don't have to be there because I could 
move back up into this institutional platform, which would be 
the three balanced funds.
    I testified to the House Budget Committee Social Security 
Task force, I believe it was called, in 1999 on this structure 
and shared with the Committee that this had been costed out, 
including asset management, recordkeeping, custody, an annual 
statement, 175 to 350 million phone calls per year to a 
customer service center, 85 percent of which are answered by a 
computer, 15 percent answered by a customer service 
representative--very much like a 401(k) structure. Including 
all of those costs, assuming just a 2 percentage point savings 
rate, steady state costs 19 to 34 basis points of assets. That 
is less than the 401(k) model, that is less than the mutual 
fund model, and it is very, very cost effective. To Mr. Levin's 
point, nobody has to do it. It would all be by freedom of 
choice. Thank you, sir.
    Mr. JOHNSON OF TEXAS. Thank you. I might add, Mr. Levin, 
that all--100 percent--of the young people in our district want 
that type of voluntary way to put their money into an account.
    Mr. LEVIN. Would you yield?
    Mr. JOHNSON OF TEXAS. Sure.
    Mr. LEVIN. The surveys show the more young people hear 
about the President's plan, the less they like it. That is what 
the surveys show. You need to, Mr. Shipman, talk about the 
impact of diverting those kinds of moneys from Social Security 
into private accounts on the benefits structure and on the debt 
of this country. It doesn't come, the diversion isn't cost-
free, sir.
    Mr. JOHNSON OF TEXAS. No, but it does----
    Mr. LEVIN. It is trillions of dollars.
    Mr. JOHNSON OF TEXAS. Solvency occurs downstream and you 
don't have to worry.
    Mr. LEVIN. It doesn't touch solvency. It doesn't touch 
solvency.
    Mr. JOHNSON OF TEXAS. Thank you, Mr. Chairman.
    Chairman MCCRERY. Actually, it does touch solvency under 
Mr. Johnson's plan as scored by the Social Security actuaries. 
Mr. Neal?
    Mr. NEAL. Thank you very much, Mr. Chairman. Chairman 
McCrery mentioned the debate that we have had here over tax 
cuts, which is in some measure, I think, a reflection of the 
major differences that we hold about the condition of the 
Social Security Trust Fund today. Dr. Holtz-Eakin, is it fair 
to say that in some measure the Social Security Trust Fund 
surpluses have been used to fund the tax cuts?
    Mr. HOLTZ-EAKIN. It is fair to say that the dollars 
entirely intermingle in the Federal budget and that we have run 
deficits in recent years, despite the fact that there are 
Social Security surpluses.
    Mr. NEAL. But that is fair to say that the surplus has been 
used to fund the tax cuts?
    Mr. HOLTZ-EAKIN. Not in any dollar-for-dollar matching 
sense, but on net.
    Mr. NEAL. No, no. The general statement, it is accurate, 
and the other aspects of the budget as well. Given your 
previous position here, Dr. O'Neill, would you agree with that 
statement?
    Ms. O'NEILL. Well, you can't identify which----
    Mr. NEAL. No, you can't identify which dollar, but is it a 
fair statement to offer?
    Ms. O'NEILL. The entire--all of the expenditures----
    Mr. NEAL. We have great regard for the role that you have 
played here, Doctor. One of the things about the positions that 
you have held here is that you tend to be above the fray. Is 
that an accurate statement or not, that the tax cuts have been 
in some measure funded by the Social Security surplus?
    Ms. O'NEILL. Well, I--of course it is----
    Mr. NEAL. Thank you very much. That is why we have such 
regard for you folks that hold those positions here, because we 
do respect you in an academic sense.
    Ms. O'NEILL. But I pause----
    Mr. NEAL. Let me go to you, Dr. Furman, for a moment here. 
If we were to establish private accounts, how would we 
guarantee that they were actually prefunded? Wouldn't we have 
to fully offset the cost of those accounts by either raising 
taxes or cutting benefits? I think a moment ago you were headed 
there?
    Mr. FURMAN. Right. My comments today, contrary to Mr. 
Johnson, I actually didn't view as negative or positive about 
accounts. I was trying to stick to the topic of prefunding, and 
not some of the broader issues I have addressed previously. 
Accounts by themselves don't constitute prefunding. You need to 
pay for the money that goes into the accounts for prefunding, 
and you need to pay for that by raising contributions in one 
way or another.
    Mr. NEAL. Is that sustainable?
    Mr. FURMAN. It depends on the way in which it is done. I 
think one would have concerns that some of the prefunding that 
you think you are getting on paper that way unravels, because 
people end up saving less in their 401(k)'s and IRAs.
    Mr. NEAL. What kind of policy changes would occur, or would 
lead, if we were to go in the direction of private accounts 
being retained without prefunding?
    Mr. FURMAN. You would need dramatic reductions in future 
defined Social Security benefits to pay off the debt associated 
with those accounts. You would not have any up-front increases 
in national savings to help smooth that transition.
    Mr. NEAL. Mr. Price, would you agree with that?
    Mr. PRICE. Yes.
    Mr. NEAL. You would? Dr. Eakin?
    Mr. HOLTZ-EAKIN. I think it is important to recognize that 
you cannot evaluate the long-run consequences of any of these 
without a fully specified plan. Just saying ``accounts'' in 
isolation really doesn't give you enough information.
    Mr. NEAL. What would happen--I mean, the dot-com phenomenon 
is fresh in all of our minds here for those who would say we 
would only put these trust fund accounts in certain-to-grow 
private initiatives. I am certain that if we were sitting here, 
though, five, six, 7 years ago, the same forces that will be 
saying these will all be safe investments would have been 
pressuring this Congress to open up those opportunities for the 
dot-com industry. What happens to the families that would come 
here asking their elected officials for ability to access the 
accounts for purposes other than retirement? Mr. Price, would 
you like to----
    Mr. PRICE. I am sorry, could you repeat the question?
    Mr. NEAL. If there were requests from the general public 
asking for access to those accounts for purposes other than 
retirement. We have talked about using the IRAs, which I agree 
with, by the way, for first-time home purchases and things of 
that magnitude. What do you think would happen?
    Mr. PRICE. Well, surely people face big crises in their 
lives. We have created--you guys have passed laws that allow 
people to get access to various tax-favored assets for other 
purposes than retirement. I think that those same kinds of 
political pressures would apply to these new accounts. Whether 
you would relent and allow people to do with those, you would 
know better than I. I think there would be a lot of pressure 
from people who face medical crises or education finance 
crises, that they would get access to their--they have been 
told it is their account, and they think they know better than 
anybody else when they are 45 or 50 that it should be spent now 
rather than later.
    Mr. NEAL. As we pursue this discussion, it has really 
healthy, and Mr. McCrery has done a very good job with the 
panels that have been assembled. Many of us have a fresh memory 
of the S&L issue and how that played out here, when we allowed 
people to get into the S&L industry and to do things that they 
had not been properly chartered, or the issue had not been 
vetted for. The bill was enormous to the American taxpayer. Do 
you want to offer your comments on that, Mr. Price?
    Mr. PRICE. I would like to comment on that because I think 
a lot of people have a tendency to exaggerate their ability to 
make decisions. Some of the most interesting research is that 
even if you have broad measures, a bond account versus a stock 
account, that people buy--they read the newspapers that stocks 
are going up and so they go buy the stocks. Or that stocks are 
going down and they sell the stocks and buy the bonds. When you 
look at actual research, when people had access to confidential 
private accounts, what people were buying and selling, they 
were doing it--they were buying high and selling low. You look 
at inflows into mutual funds. They go in at the wrong time. 
Actual, real people know that they make bad decisions. That 
these measures, like Robert Schiller shows, the average return 
using indexes is a median return using historical performance 
of actual stock markets, and you apply those to--and take what 
a recent Wall Street Journal Survey projects are going to be 
the returns, with a median return of 2.6 percent. The President 
has a clawback charge of 3 percent. That means that 71 percent 
of the time, people will lose money. That is using an index. 
That is using steady performance. That is not taking real 
people, who in real time, evidence clearly shows, make the 
wrong decisions. They buy high and sell low. They tend to do 
worse than the averages, because they have confidence.
    The evidence is that men are much more active traders than 
women, they have more confidence. Higher-income people have 
more confidence than--they do more trading, and they don't do 
it better. People are not patient to just let things stand. 
They move into stocks when they have read that they have been 
going up. They buy high.
    Mr. NEAL. Thank you.
    Thank you, Mr. Chairman.
    Chairman MCCRERY. Thank you, Mr. Neal.
    Mr. PRICE. We did the same thing in the S&L situation. We 
thought that if we just turned the market loose and let people 
invest, they would make good decisions in housing and whatever 
else we let them do, and they made a lot of bad decisions.
    Chairman MCCRERY. Mr. Shaw?
    Mr. SHAW. Mr. Shipman, do you agree with what Mr. Price 
just said?
    Mr. SHIPMAN. No, I don't. And----
    Mr. SHAW. Thank you. Dr. O'Neill, I saw you were frustrated 
at being cut off by Mr. Neal with regard to the answer to his 
question as to whether the tax cuts that this Congress put in 
place, or has put in place over the last several years, what 
effect they have had on the shortfall, the coming shortfall on 
Social Security. Would you like to expand on that answer?
    Ms. O'NEILL. The overall budget deficit--are you referring 
about the budget deficit that we now face?
    Mr. SHAW. Well, he was trying to blame that on the problem 
with the Social Security. Let me ask you another question. If 
we had----
    Mr. NEAL. Would the gentleman yield?
    Mr. SHAW. No, I will not. You didn't yield to her when she 
was trying to answer your question fully. The question is, 
would we have put real money, put actual money into the Social 
Security Trust Fund, or would it have been converted into 
Treasury bills----
    Ms. O'NEILL. But we don't have any way of putting money 
into the Social Security----
    Mr. SHAW. Right.
    Ms. O'NEILL. To take money from now and put it into the 
future in Social Security is the whole problem of a pay-as-you-
go system. Various speakers have sort of endorsed the lock-box 
idea, that if you can, having budget savings, that that will 
reduce the publicly held debt below what it would have been, 
and therefore, in the future we will have more money for Social 
Security. But, that arguement has two problems with it. One is 
during the days when we did have a large surplus, I think the 
proof was really shown that it is impossible to have a surplus 
dangling there and not be touched. The surplus, in part, 
evaporated because it was there. It meant that after all those 
years of restraint during much of the nineties, suddenly there 
was money. It is Members of Congress; it wasn't just the Bush 
Administration who decided to increase spending of all kinds 
during that period. It was everybody. It is just difficult to 
run a surplus. That plus the recession, plus 9/11, contributed 
to the deficit.
    Okay. Suppose we hadn't done that and the surplus--suppose 
somehow there had been restraint and much of the surplus had 
been saved. What then? There is no guarantee that if we lowered 
the debt now that in the future that money would go to Social 
Security. There is nothing to tie it to Social Security.
    Mr. SHAW. That is right.
    Ms. O'NEILL. There could be another thing that we would 
rather spend the money on at the time.
    Mr. SHAW. There is no mechanism----
    Ms. O'NEILL. There is no direct link.
    Mr. SHAW. That is right. There is no mechanism in order to 
hold money in the Social Security Trust Fund.
    Ms. O'NEILL. There is not any lock box.
    Mr. SHAW. Now, the years when we had surplus, we paid down 
the national debt. We did not pay down any of the Treasury 
bills that were being held by Social Security Trust Fund, did 
we?
    Ms. O'NEILL. Well, on paper there was increasing so-called 
balances, the promises.
    Mr. SHAW. So the Treasury bills actually inside the trust 
fund continue to grow.
    Ms. O'NEILL. They continue to grow, but in terms of----
    Mr. SHAW. And they are backed by the full faith and credit 
of the U.S. government.
    Ms. O'NEILL. Yes, but that----
    Mr. SHAW. They are not a real economic asset at this 
particular point if it is a Treasury bill that is owned by the 
government and held by the government, payable to the 
government by the government.
    Ms. O'NEILL. That is all true, but when the time comes when 
the funds would actually be needed, there is no guarantee that 
the economy would be in a position to actually honor those 
promises, and the law can be changed. It has in the past, and--
we do not know what future Congresses and future Presidents are 
going to do.
    Mr. SHAW. This Congress has been very active, and we have 
seen it in some of the disasters that we have had in the 
private pension system. United Airlines would be one I know of 
very well because my brother is a retired United Airlines 
captain. This was not a fully funded system, and it is going 
down. This Congress is working on requiring the private sector 
to fully fund or at least fund up to 80 percent, or some 
percentage, of the liabilities. That is different--and those 
funds may have been backed up by the full faith and credit of 
United Airlines, but certainly they were not funded properly, 
and we are trying to apply the same standards to the SSA, or at 
least go in that direction by creating real economic assets. 
Now, these same bonds, if they were in the name of the people 
that are in the system of the workers, then those would be real 
economic assets, wouldn't they?
    Ms. O'NEILL. That is their private property, right.
    Mr. SHAW. It would really be a very, very strong--make a 
strong statement as to the full faith and credit of the 
government payable to the worker. That would be a substantial 
asset.
    Ms. O'NEILL. Which is why I mentioned that the private 
sector has taken care of this problem by converting to defined 
contribution plans, which essentially are pre-funded plans. I 
belong to such a plan, TIAA-CREF. That plan has been highly 
successful, and I think that most of the participants are very 
happy with it. It has weathered the storm of the bubble 
collapse. Enough had already been accumulated. Depending on the 
share that you had in the stock portion versus the bond 
portion, everybody experienced some degree of decline. But by 
now, with the expansion, the rebound for many has more than 
made up for it.
    Mr. SHAW. And in your testimony, you quite correctly 
testified that some time between 2015 and 2020, there would not 
be enough cash coming in to honor the benefits in the benefit 
structure that we have today. Is that not correct?
    Ms. O'NEILL. That is correct.
    Mr. SHAW. Thank you. Thank you, Mr. Chairman.
    Chairman MCCRERY. Mr. Becerra?
    Mr. BECERRA. Thank you, Mr. Chairman. Thank you to the 
panelists for their testimony. Again, an engaging discussion, 
and we thank you, Mr. Chairman, for the numerous hearings that 
we have had. Let me ask Dr. Furman a question. This hearing is 
supposed to focus on the issue of pre-funding, coming up with a 
system where we prefund the benefits that will be available 
into the future for those who retire. Yet, if I heard you 
correctly, what you were saying is that the Bush tax cuts which 
have benefited mostly America's wealthiest people have amounted 
to the opposite of prefunding, in fact, a defunding of a system 
that could be available to help in retirement. Is that an 
accurate statement?
    Mr. FURMAN. That is an accurate statement. They have 
defunded our overall fiscal situation at a cost that is more 
than 3 times as much as the 75-year Social Security deficit 
that so much of the policy discussion has been focused on.
    Mr. BECERRA. So, if there is a desire to try to prefund a 
future retirement system, what we have done through the Bush 
tax cuts is actually not only made it more difficult to pre-
fund, but by a factor of perhaps three or so?
    Mr. FURMAN. That is correct.
    Mr. BECERRA. Now, did I hear you correctly as well that 
private accounts, at least those that we know proposed by 
President Bush, that those themselves, as they have been 
proposed by President Bush, do not lead to any prefunding as 
well?
    Mr. FURMAN. That is correct. There has been a lot of 
discussion, and I think it is an important discussion, whether 
to prefund through accounts or not through accounts. To get to 
that second stage of the discussion, you need a plan to prefund 
in the first place, and I have not seen any plans that would do 
that.
    Mr. BECERRA. Mr. Price, I think you are the one that had 
mentioned that you cannot do prefunding by having the Federal 
Government borrow money. Is that accurate?
    Mr. PRICE. That is accurate.
    Mr. BECERRA. As well, okay. Go ahead.
    Mr. PRICE. I think the Chairman and everybody on the panel 
would agree with that.
    Mr. BECERRA. Mr. Shipman, I listened with interest to your 
testimony when you mentioned that the Social Security benefit 
does not amount to very much for most Americans. I think to 
myself today there are about 10 percent of America's seniors 
who are living in poverty. Without Social Security, that number 
would be about 50 percent. So, I think a lot of seniors, at 
least that 40 percent that does not live in poverty, probably 
looks at Social Security and says it does amount to quite a 
bit.
    You mentioned that your alternative to Social Security 
would be a market based system, if I am quoting correctly, ``a 
market based system where we are free to invest where we 
want.'' You also indicated that no one has to do it, no one has 
to participate, and that there is freedom of choice. Again, 
that makes me think of what we had prior to the Depression, in 
the twenties leading up to the Depression. That is what we 
had--freedom of choice. You could invest wherever you wanted. 
There was nothing that guaranteed you a set retirement benefit, 
and we saw what happened as a result of the Depression. In 
fact, the result was President Roosevelt coming forward with 
the Social Security program.
    Then I thought to myself, I remember when I was in the 
State legislature, there was a very similar argument that was 
made that we should have freedom of choice, you can participate 
if you wish, and it had nothing to do with retirement. It had 
to do with motorcyclists on our freeways and whether or not 
they should wear helmets. Most of the motorcyclists that we had 
testify before us in Committee would say, ``We want the freedom 
of choice. We want to be able to decide whether we need to wear 
a helmet or not.'' The difficulty was we had all the evidence 
before us, the data that pointed out the number of hospital 
stays, the amount of costs that were incurred by the traumatic 
injury to heads and otherwise to motorcyclists, as a result of 
freeway accidents. The fact that almost none of these 
individuals had the moneys or the insurance to pay for the 
costs of their health care, in some cases long-term health 
care, needed as a result of permanent brain damage, and so 
forth.
    So, the State legislature in California, as I think in most 
States, had moved forward, has since moved forward with 
legislation requiring motorcyclist to wear helmets. Under your 
framework of freedom of choice and you do it if you wish, you 
are not required to, we probably would still have a lot of 
motorcyclists in this country riding around on their 
motorcycles, many of them very good motorcyclists, without 
helmets. I guess my question would be: While it is great to 
have freedom of choice, say we were living under your system 
framework of no Social Security, what would your response be to 
an Enron employee who yesterday had a 401(k) but today does 
not?
    Mr. SHIPMAN. Enron is a classic case, and----
    Mr. BECERRA. What would you say if you had an Enron 
employee here today sitting before you? How would you respond 
to them in terms of their retirement benefits under the 401(k) 
that they had before?
    Mr. SHIPMAN. As far as their 401(k) plan, or as far as a 
market based system for Social Security?
    Mr. BECERRA. Well, a 401(k) is a market based plan that is 
available to those. You are free to choose to participate if 
you wish, as you have proposed. What would you say to an Enron 
employee who had a 401(k) plan principally invested in the 
Enron company itself?
    Mr. SHIPMAN. I guess I would say--and I would say to you as 
well as the rest of the panel--that from my point of view, the 
freedom of choice is to whether you can go into the market 
based system or not. Then it ends. Once you are in it, as I 
mentioned to Mr. Johnson, once you are in it, the trustees 
stipulate the portfolios, highly diversified across asset 
classes, borders, and time and so on. In each of these 
portfolios, there would be literally thousands of securities. 
One of them will be tomorrow's Enron. There are thousands of 
them, and the impact upon the portfolio will be to the right of 
the decimal point.
    In a 401(k) plan, it is significantly different because not 
only are the individuals free to go into the 401(k) plan, in 
most cases beyond that they are free to invest any way that 
they want. That is not what I have argued for in the reform of 
Social Security. Free to go into the market based system, but 
not free to invest any way you want after you have made the 
election to go into the market based system. They are 
fundamentally different structures.
    Mr. BECERRA. I know my time has expired, so I thank you for 
the response. Mr. Chairman, thank you.
    Chairman MCCRERY. Mr. Ryan?
    Mr. RYAN. Thank you, Mr. Chairman. I think I followed Mr. 
Becerra last week, and I have sort of a deja-vu sense. In 
Wisconsin you do not have to wear a motorcycle helmet, and we 
are going to defend that right. We make Harley Davidsons there.
    [Laughter.]
    Mr. RYAN. And bows and arrows. This whole hearing about 
prefunding, I just want to ask the panel kind of a general 
question. The younger you are under the current system, the 
worse you do as a percentage of your payroll, correct? Meaning 
if you are 70 today, the payroll taxes you experienced are 
giving you about a 4.5 to 5-percent rate of return based upon 
those payroll taxes. If you are 40 today, you are getting about 
a 1-percent rate of return. If you are one today, you are 
scheduled to get about a negative 1 percent rate of return. 
Correct? I think everybody----
    Mr. FURMAN. Average rate of return in the system going 
forward is still positive, not negative.
    Mr. RYAN. I am not going to take it individually. The 
average age cohort. So----
    Mr. PRICE. Let's just keep in mind that there is no market 
for many of the products that Social Security provides. You are 
trying to focus in on the retirement product.
    Mr. RYAN. The question was directed specifically as a 
component of what you pay in and what you get out in the 
benefit.
    Mr. PRICE. Right, and what I am saying is that there is no 
product that provides people inflation-adjusted benefits until 
retirement.
    Mr. RYAN. Sure, well----
    Mr. PRICE. There is no product that----
    Mr. RYAN. You could buy a Treasury Inflation-Protected 
Securities (TIPS) bond that would provide you an inflation-
protected instrument against inflation for retirement.
    Mr. PRICE. But, the plan so far----
    Mr. RYAN. Absolutely.
    Mr. PRICE. You talk about--I mean, the problem with----
    Mr. RYAN. I do not mean to cut you off, but we only have 5 
minutes. So, my next question is--please. My next question is: 
Since we are talking about prefunding, what is more reliable 
for a younger worker, say aged 40 and below? The concern I have 
is, when you talk to anybody in their twenties and their 
thirties, and half the people in their forties, they almost 
always tell you, ``I don't believe it is going to be there when 
I retire. I am not counting on Social Security. My investment 
adviser told me not to count on Social Security for my 
retirement planning.'' That is wrong. We do not want that kind 
of a system. Whether you are Democrat or Republican here, we 
want to make sure this is a program you can count on when you 
retire.
    So, my question is: What is more reliable for a person to 
get this certain level of benefits, prefunding by giving an 
ability for an individual to put money in their own account, to 
grow at a market rate of return, to help finance their 
benefits, or hoping that Congress will come up with a solution 
on this pay-as-you-go system given the current problems that we 
have today? I will just start with you, Mr. Shipman, and go 
down the row, whoever wants to comment.
    Mr. SHIPMAN. I accept the question as being rhetorical. It 
is clearly safer to save and invest in capital markets and 
receive the market rate-of-return than it is to pay taxes to 
the government in a pay-as-you-go system wherein the number of 
workers relative to retirees has, is, and will be, shrinking.
    Mr. RYAN. Mr. Furman, I've got to think you have an answer 
to that.
    Mr. FURMAN. I will try to think of one. First of all, I 
would not have used the word ``prefunding.'' Prefunding to me, 
and I think to most of----
    Mr. RYAN. Yes, we went through that.
    Mr. FURMAN. So I will not repeat that. In terms of the 
answer to your particular question, if you look at--let's just 
take the President's proposal as an example.
    Mr. RYAN. Okay.
    Mr. FURMAN. Under that, you have either a Social Security 
benefit on the one hand, or a combination of a Social Security 
benefit and an account on the other hand. In terms of market 
risk, the one with the account has more market risk than the 
one without the account, in terms of pure market risk. In terms 
of political risk, those two retirement systems are, from my 
perspective, exactly identical. You can still reduce the 
residual defined benefit under the President's plan or increase 
it, if you want to. There is also this critical factor of the 
offset rate, which as he sets it, 3 percent, an arbitrary 
number, could change it to 2.5, could change it to 3.5. That 
would dramatically change the value of your account. Finally, 
you could change the tax treatment of accounts. You could tax 
them as they accumulate them, tax them upon withdrawal. Any of 
those----
    Mr. RYAN. So, the political----
    Mr. FURMAN. The political risk of these two benefits are 
identical. One of them has more market risk. That means one of 
them has more overall risk.
    Mr. RYAN. Look, I want to get to these other folks, but 
basically what you are saying is it is impossible for us to tie 
the future hands of Congress, and they could do anything in the 
future. Given the fact that we have a $4 trillion 75-year 
shortfall, $11.1 trillion infinitely rising shortfall, clearly 
Congress is going to have to do something about this. So, these 
benefits are right now at risk.
    Mr. FURMAN. I feel like we have had this discussion before. 
They are at the same level of risk. I view that risk as very, 
very low. Historically, Congress has never made changes in 
benefits from year to year of the magnitude that Enron stock 
has fluctuated from year to year.
    Mr. RYAN. Anybody else?
    Mr. SAMWICK. If you are going to prefund, there are two 
reasons why you have to do it through personal accounts: one, 
you want to be able to invest in risky securities, not just 
riskless bonds; second, there really is no mechanism to make 
sure that prefunding actually serves to reduce the tax burden 
on future generations. That is why it has to be personal 
accounts.
    Mr. PRICE. Personal accounts create tremendous risk for the 
government. One of the things that is misunderstood about the 
United plan, most defined benefit plans were in great shape in 
2000. The change in the stock market has a big effect. If you 
had an individual who had all his money in stocks in 2000 and 
wanted to retire then, and could get the higher interest rate, 
they could get a great annuity. Three years later, their stock 
portfolio would have been down. Their interest rate that they 
can convert to annuity would have been down. They would have 
had more than--the monthly annuity they could get in 2003 would 
be cut in half when compared to what they got in 2000. What 
would be the political response to that if that happened? It is 
a huge political risk----
    Mr. RYAN. Okay, because there are four more hands up, I 
want to let them go. Mr. Beach?
    Mr. BEACH. Well, I would just briefly say, Congressman 
Ryan, that the creation of the fiscal deficit which we have in 
Social Security right now--and it is growing--is evidence of 
the political risk that surrounds the current system. The 
Congress has not been able to contain its willingness to 
increase those benefits, and as a consequence, there is now the 
problem which is before this Committee. I think I would join 
Mr. Shipman in saying that one of the ways to reduce that risk 
is embrace a highly diversified personal retirement account 
system.
    Mr. ENTIN. Highly diversified stocks beat bonds over a 
lifetime of work. Bonds beat the pay-as-you-go potential from 
the demographic situation. You are going to be better off in 
that. They have to be diversified. Of course, if you put money 
into your own account, you have funded it. If the national 
situation is not funded, that is Congress's fault. You do have 
to get the government to wean itself from the Social Security 
revenue if you are going to do that, and it should. As for the 
annuitization, it is like the savings and loan crisis. Congress 
passed a bad provision, and people took advantage of it. That 
was the Congress's fault. If you mandate that people annuitize 
their account the moment they retire, regardless of the state 
of the market, somebody could get injured relative to somebody 
else who did it a year earlier or 2 years later. Let people 
wait a couple of years and annuitize it in stages. For goodness 
sakes don't make people annuitize everything, beyond what is 
necessary for a basic retirement level. Give them the freedom 
to leave some of the account to their children later.
    Ms. O'NEILL. The political risk of private accounts I think 
would be as close to zero as possible. We do believe in private 
property in this country and would not abscond the private 
accounts of individuals. So, the political risk, I think is 
minimal. On the other hand, the political risk of Social 
Security can be great because there are too many factors that 
can affect it that we have no control over now. Given that, the 
monetary return is obviously better from a market account, even 
by the most conservative strategy; and, as the other speakers 
have mentioned, there would likely be control--one could not 
become a day trader, for example, with your Social Security 
account. Any prudent plan--I have not really seen any suggested 
seriously that would allow anybody to invest in anything. 
Prudent plans would follow the general rule of don't put all 
your eggs in one basket.
    Mr. PRICE. You don't think United diversified its assets?
    Mr. RYAN. Dr. Holtz-Eakin?
    Ms. O'NEILL. That is not the only----
    Mr. RYAN. Please. Typically it is Member to witness instead 
of witness to witness. Dr. Holtz-Eakin?
    Mr. HOLTZ-EAKIN. The systems have different risk and return 
characteristics. Prefunded plans offer higher rates of return 
than can any pay-as-you-go system going forward. Risks around 
those kinds of returns, in a pay-as-you-go system you have got 
all the risks we talked about in our testimony--productivity, 
inflation, unemployment, the kinds of things that affect that 
system. Then you have market risk in individual accounts, and 
how people manage that is an important issue, the tools that 
are available for risk management. Finally, both face 
legislative risk. The system is currently out of balance and 
will have to be brought into balance at some point, somehow, 
and to get to a prefunded system we have to somehow get from 
here to there, and that involves sacrifice by somebody to put 
the resources away. How that would be done is also unknown. So, 
there is a competitive set of risks on both sides.
    Mr. RYAN. Thank you.
    Chairman MCCRERY. Just to follow up real quickly, if we 
were to make an effort to take as much risk out of personal 
accounts as possible, Mr. Entin, would it make sense--and be 
careful how you answer this because this is a suggestion that 
Dr. Holtz-Eakin gave me some time ago. Would it make sense to 
require when a person's personal account achieved a level 
sufficient to an annuity effective on the date of his 
retirement, which would guarantee him income equal to the 
poverty rate or poverty plus 10 percent or whatever we want to 
make it, and then allow him to continue to accumulate in his 
account without annuitization required at that point?
    Mr. ENTIN. I think, in fact, some foreign countries do that 
to get that added degree of security, but also to get an added 
degree of freedom, because once you have achieved the basic 
social objective of preventing yourself from going onto the 
public dole later in life, you should be free to either add to 
the account or not add to the account. In Chile, for example, 
once you have been able to do that and purchase that annuity--
and it might take a different form, not necessarily an annuity 
but some guaranteed set-aside--you can stop contributing. You 
can take the money out of the system and put it in some other 
investment, or spend it.
    Chairman MCCRERY. So, you would not have any objection to 
our building in some safeguard like that.
    Mr. ENTIN. I would have no objection to building in some 
sort of safeguard. Why are you going to make people--as some 
plans do--contribute all the way up until the time they retire, 
even if their saving has gone way beyond that annuity? You 
might as well let them out of the system, and let them put 
their money in some other sort of program at that point. 
Remember, you have this moral hazard you are trying to guard 
against, and indeed you may make the protection level more than 
the poverty level so that independence can be achieved. Beyond 
some reasonable amount, you don't need to go any further. If 
you look at the table as to where benefits are going over time 
in the Trustees' Report or in my testimony, you might ask 
yourself: Why do we need to go up to $109,000 a year for an 
upper-income couple? Let them be free after some reasonable 
point.
    Chairman MCCRERY. I understand. Thank you. Mr. Pomeroy?
    Mr. POMEROY. Thank you, Mr. Chairman. You know, there is 
the story about Strom Thurmond who set all kinds of records for 
lengthy service in the Senate, and there were some chuckles 
when he voted for the term limits bill in the Senate. It is 
like, ``Stop me before I run again.'' I kind of have the same 
reaction to Members of the majority who presided over the 
largest swing in our Nation's fiscal standing in the history of 
the country, largely driven by the 2001 and 2003 tax cuts. Now 
they are talking about prefunding. It is kind of like, ``Stop 
me before we take some more.'' I really think that the lock box 
agreement between the parties represented that brief hour when 
there was this virtuous competition in terms of who would not 
spend those dollars the best. Really, it was a wonderful but 
brief period of time. The notion that we ought to borrow more 
money to somehow prefund to me defies rationale.
    Now, in a visit that the Chairman and I were having with 
another Member, it helped me understand some of the drive 
toward this concept, basically saying, look, an unfunded 
liability is the same as a debt owed by the country. So, if we 
borrow $2 trillion the first decade, $4 trillion the second 
decade, and add it to the balance sheet, it is just the same as 
the unfunded liability for Social Security. Now, I am wondering 
if the fiscal markets--or is there any recognized treatment in 
fiscal policy for actually reducing the hard borrowed 
obligation of the U.S. Government versus an unfunded liability, 
if those stand an equal treatment at all. Dr. Furman?
    Mr. FURMAN. Yes, that is a very good question, and I know 
of no Nation that has undergone a crisis because its implicit 
debt was too large. A lot of Nations have undergone crises 
because their explicit debt was too large, because they had to 
service that and pay that on an annual basis. There is not a 
one-for-one economic substitution between explicit debt and 
implicit debt. Explicit debt is more immediate, more tangible, 
and implicit debt is less certain and more subject to change 
and does not carry the same full faith and credit.
    Mr. PRICE. There have been researchers looking at the 
Argentinean experience that claim that added debt for their 
privatization, and borrowing to do that contributed to their 
fiscal crisis and their economic problems.
    Mr. POMEROY. Dr. Holtz-Eakin, you said a statement that did 
not surprise me, and I would not think you would have it in one 
of your scoring models. You indicated that, basically, 
offsetting risks of the private account theory, markets go up, 
markets go down, some risk there. On the Social Security side 
of the equation, you always have political risk. Dr. O'Neill, 
you have alluded to the political risk of making this system 
insecure. Basically, the benefits are established in the 
national code. It is a matter of national law. So, the 
political risk you are talking about involves Congress 
strolling over to the House and Senate floor and voting to 
slash benefits to retirees and having that law signed by the 
President. That is the essence of the political risk that 
Social Security benefits face. Is that correct from an 
individual recipient's perspective?
    Mr. HOLTZ-EAKIN. From an individual recipient's 
perspective, the question is, will the benefits be changed by 
law, or will the taxes be changed by law. There are two sides 
of the equation, and both are up in the air because the current 
system is unsustainable----
    Mr. POMEROY. In seven decades, you have not had that march 
to the House floor to slash benefits, and I would say that if 
there is one thing the aging demographic of our country 
probably makes likely, it is that that it is not a risk that 
needs to keep people awake in the years ahead. You know, there 
is something--Mr. Entin, you said a statement that I really 
like. Government should wean itself off of Social Security 
revenue. Instead, this fiscal turn that we have had has made us 
completely dependent upon Social Security revenue. I am 
wondering if your institute, the----
    Mr. ENTIN. The Institute for Research on the Economics of 
Taxation.
    Mr. POMEROY. The Institute for Research on the Economics of 
Taxation. Did you take a position on the 2001 tax cut?
    Mr. ENTIN. Yes.
    Mr. POMEROY. Were you for it?
    Mr. ENTIN. I was critical of some elements of it. I came 
down for it. I would have preferred that it be restructured.
    Mr. POMEROY. How about the 2003 tax cut?
    Mr. ENTIN. Yes.
    Mr. POMEROY. I have seen an analysis that while there are 
many features that may have driven this deficit, the tax cuts 
were the single biggest component of us being in the fiscal 
straits that we are, certainly recognizing the economic 
slowdown, recognizing 9/11, and the costs of the war as all the 
other contributors, but the tax cut, number one of those 
causes.Mr. ENTIN. I think the recession was number one, and I 
think that you are looking at static revenue estimates and 
taking it out of the economic context. If you let the economy 
go downhill, you are in trouble. Remember the perfect golden 
years of harmony in the Congress and the real push for fiscal 
discipline that occurred between 1930 and 1933? Everyone said, 
``we have got to balance this budget, we are in a recession,'' 
and it turned into a depression. That really threw us in a 
financial hole. You have to make sure the economy is strong for 
any of this to work, and if the economy goes south, then the 
returns in the private accounts will not be so high. Capital 
formation will be in the tank, wages will not be growing, and 
payroll tax receipts will slow to a crawl.
    Mr. POMEROY. The reference to the pre-Roosevelt period and 
our Federal Government reminds me of the budget----
    Mr. ENTIN. Mr. Roosevelt also raised taxes.
    Mr. POMEROY. Committee testimony that blamed the depression 
on the economic activism of Herbert Hoover. I think that that 
is an extreme and highly contentious----
    Mr. ENTIN. Mr. Hoover recommended balancing the budget in 
the recession, and Mr. Roosevelt tried by raising taxes to 
balance the budget in the recession, until he changed later, 
quite wisely. He started down the wrong road, too. Remember----
    Mr. POMEROY. The essence of the question--look, this is 
interesting----
    Mr. ENTIN. In 1983----
    Mr. POMEROY. The essence of my question was for someone 
that just said the government should wean itself off of Social 
Security revenue, you are with an institute that has supported 
two tax cuts that have substantially driven the deficit deeper 
and thereby made our reliance upon Social Security revenue for 
funding government programs----
    Mr. ENTIN. We have also urged a great deal more spending 
restraint.
    Mr. POMEROY. I yield back, Mr. Chairman.
    Chairman MCCRERY. Thank you, Mr. Pomeroy. Mr. Brady is 
next, but just before he begins, I just want to pose a question 
for you to think about and answer when all of my colleagues 
have questioned the panel; that is, I think Mr. Pomeroy and Dr. 
Furman really posed the wrong question when they were talking 
about debt and the impact of that increased debt, that is, if 
you use debt to finance personal accounts, there is no market 
that would accept the proposition that over 75 years it will 
all even out and actually be better. While that may be true, I 
don't know that it is exactly relevant. What I think probably 
is relevant, however, is what level of additional debt would 
actually impose an economic burden on our society. I think that 
is the question on which, I suspect, we have different 
opinions. The weight of the evidence, I believe, is that with 
what the President has proposed, it would not affect the 
economy one whit. Mr. Brady?
    Mr. FURMAN. Could I briefly respond to that?
    Chairman MCCRERY. No. Be thinking about it so that you can 
respond more than briefly at the appropriate time.
    Mr. FURMAN. Thank you.
    Chairman MCCRERY. Mr. Brady?
    Mr. BRADY. Thanks, Mr. Chairman. Obviously, Members of the 
panel see different sources for our defecits. I think the 
economy--the triple hit of the attacks of 9/11, the recession, 
and the dotcom bust all contributed to the economy in a big 
way. I think all those press releases we sent out about 
projects we have delivered back home have contributed greatly 
to our deficit. Yes, I think the tax cuts have, but to the 
extent that they have been an economic stimulus have been a 
price I have been willing to pay. I also think as we look at 
pre-funding we can look at, rather than raise this ``scare our 
seniors'' type approach, we can look at models like the Thrift 
Savings Plan (TSP), decades old, tens of billions of dollars, 
averaging 7.5 percent return, Galveston Plan, 24-years-old, 
interest-bearing accounts only averaging 6.5 percent, Texas 
Teachers half a century old, averaging now about 10 percent 
return a year. All models where those participants would not 
ever choose Social Security and go back to that lower income 
alternative.
    Let me ask this question. Dr. Holtz-Eakin made an 
inescapable point that preserving Social Security for every 
generation is going to cost a ton of money, both in the 
permanent deficit that we face in the future, as well as when 
we begin to pay back the Social Security Trust Fund, the first 
year about $16 billion. That is the size of the NASA budget. 
The second year it doubles, $35 billion. That is the size of 
the U.S. Department of Homeland Security. As he testified, it 
moves very quickly to $100, $200, $300 billion.
    It raises the point that to preserve Social Security for 
every generation, we are going to spend a lot of money. The 
question I have for you, from an economic impact as we weigh 
how we are going to do this, whether we fund the pay-as-you-go 
system or prefund retirement accounts that, like these other 
models, grow slowly and steadily over the years. Starting, 
Douglas, with you, if I could, from an economic impact, 
comparing raising taxes to borrowing money, to reducing 
spending, from a number one choice as good for the economic 
impact of those three options, which would you prefer? How 
would you rank them? I guess that is the question.
    Mr. HOLTZ-EAKIN. The core economic question is will we 
accumulate sufficient assets in the form of capital and 
technologies and education to have a larger economy in the 
future. So, you have to give up something now, save for the 
future. That means you consume less. The next question is the 
mechanism by which that happens. Do you consume less because 
you borrow a whole bunch? Do you consume less because of your 
tax consumption? Those are all secondary features of the core 
issue, which is how will we grow the U.S. economy so that it 
will be large enough to pay for these programs in the public 
sector and the private sector lifestyle that we have come to 
enjoy.
    Mr. BRADY. Doctor?
    Ms. O'NEILL. We can't predict very well, and we don't know 
the exact recipe for stimulating productivity. We know what can 
have adverse effects on productivity--policies that have 
disincentives, and Social Security I think is among the 
programs that have disincentives attached to them, 
disincentives to save and disincentives to work at certain 
ages. It is hard to answer the question without introducing 
your personal beliefs. I don't think it is an exact science 
that can tell you what strategy is more economically 
advantageous, by some precise amount, than another. You can 
point out the elements that you perceive will contribute. To 
some extent, it is a matter of the way you read the economy. In 
my view, I think that reducing expenditures would be more 
stimulating to growth, as would reducing taxes, but certain 
kinds of taxes, taxes that blunt incentives. Reducing marginal 
tax rates obviously gives an incentive boost. Raising them 
gives you disincentives.
    The payroll tax can have harmful effects, particularly for 
low-income workers. I think most economists agree that the 
payroll tax is paid for--the employer's share is really paid 
for by the employee in the form of lower earnings. For a low 
earner, that bumps into the minimum wage for one thing, so that 
there is nothing to roll it back against, and it leads to 
unemployment.
    Mr. BRADY. Great. Thank you. Mr. Entin?
    Mr. ENTIN. We have so many taxes to choose from, and so 
many spending programs and regulations to choose from. You have 
to put it in the context of the broader national system. We do 
know certain things promote investment by lowering the cost of 
capital, the hurdle rate you have to earn in order to make the 
investment pay off. You can get that in any corporate finance 
book. We also know that certain types of taxes certainly affect 
the asset values of securities, so that would affect the future 
growth of personal accounts. You can arrange a change in the 
fiscal budget, and in the level of Federal spending that would 
let you make tax changes that would help employment and work 
incentives, saving incentives, and would cause corporations to 
want to put more capital in place in the U.S. rather than 
overseas. You can get a lot of good growth out of doing the 
right policies. I think economists know what those are. I think 
the urge to spend a lot right now is blocking such policies, 
and I think the growth of spending over the last few years has 
hurt us in our ability to reform the tax system and reform 
Social Security in a way that will benefit everybody for the 
next hundred years.
    Mr. BEACH. Let me just continue that answer, and add one or 
two things to it, and also what June and Doug have said. I 
think the Congress really needs to get a grip on spending. I 
mean, this is part of the problem. We have not talked about it 
today. The deficit was either the economy, 9/11, or the tax 
cuts. It is also enormous spending growth over the last three 
or 4 years, which in some respects is unprecedented when you 
have got singularity of party control. The other thing, 
Congressman, that I know you are concerned about, and I am 
concerned about, too, is that history may not be a good guide. 
Implicit debt may become now a major discount against external 
debt values. We see this happening in Europe where implicit 
debt for elderly programs is growing rapidly, and I would 
become concerned with that, despite the relative absence, as 
Dr. Furman said, of scientific evidence, I think the anecdotal 
financial evidence is becoming a real factor in the way people 
see the invest ability in certain economies.
    Mr. PRICE. I am very concerned that as a nation we are 
borrowing, spending 6.5 percent more than we are producing and 
making. We should not be borrowing that much. We are not going 
to be able to borrow that much in the indefinite future, and we 
need to change our fiscal posture, so that when the turn in 
that comes, we don't squeeze investment too much. So, we should 
be dealing with the fiscal gap that we have got. That means 
cutting spending and raising revenues. We all have candidates 
for cutting spending. I am not going to defend every spending 
program that is out there, but I think it is also the case that 
we do not have such an ideal tax system that we could not raise 
more revenue and still have as good economic performance. We 
have got to be able to find ways to raise more revenue that 
does not hurt our economic performance. We have a lousy tax 
system right now, and we can raise more revenue and do it in a 
way that does not hurt growth that much. I think we have got to 
watch spending, but we also have to be realistic that that is 
not going to be enough politically if we are going to allow 
enough financing in the private market to support the 
investment we need.
    Mr. BRADY. I am going as long as the Chairman will let me 
go.
    Mr. SAMWICK. I would simply say that a larger program 
involves more distortion to the economy via the revenue that is 
raised and the spending decisions that are made. Some of that 
distortion is absolutely essential if you believe that the 
cornerstone purpose of this program is to reduce elderly 
poverty. The demographic shift means there is not enough money 
to achieve all of the objectives that Social Security may have 
achieved in the past without reducing somebody's consumption of 
something at some time. Since consumption is going to have to 
go down, we ought to start that process sooner rather than 
later to smooth those reductions.
    Mr. FURMAN. I just wanted to clear up one misunderstanding. 
I am not saying that implicit debt does not matter. It does 
matter, and it would be better to have less of it than more of 
it, all things equal. As a pure hypothetical, let's say right 
now we have 20 units of explicit debt, 80 of implicit debt, so 
we have a total of 100. Don't worry about what the units are. 
What carve out accounts do is they take some of that implicit 
debt and turn it into explicit debt. Let's say it makes it 50/
50. What I was saying is that composition, having the same 
amount of debt, more of it in explicit form, leads to more of a 
danger of a financial crisis. At the very best, it is neutral 
and we are fine, it does not hurt us, it does not help us. At 
worst, it hurts us really badly. You average those two 
together, and it is not such a good idea.
    Mr. SHIPMAN. In the ranking--reducing spending, raising 
taxes, cutting benefits--number one in my view is reducing 
spending, absolutely. As far as raising taxes or cutting 
benefits--I am speaking about payroll taxes and cutting payroll 
benefits--we have gone over the last 55 years, we have 
increased the payroll tax by 2000 percent, roughly, inflation-
adjusted. We are sitting here again talking about how we keep 
this system going. Raising taxes will not solve the problem. 
Reducing benefits, by the way----
    Mr. BRADY. Thank you. Mr. Chairman, Ms. Tubbs Jones has 
said that my extra time could come out of hers, so there is no 
problem.
    [Laughter.]
    Chairman MCCRERY. I am sure. Mrs. Tubbs Jones, feel free to 
take your time and all the rest of Mr. Brady's.
    Ms. TUBBS JONES. In your dreams.
    [Laughter.]
    Good afternoon, panel. Thank you, Mr. Chairman. We will 
work out a relationship here. What I think it ought to be is 
that I get as much time as you got in order to make my inquiry 
in a bipartisan conduct of this wonderful hearing we are having 
here. Let me start with Mr. Beach. Mr. Beach, I think I heard 
you say something to the effect that we need to reduce our 
spending.
    Mr. BEACH. Yes, ma'am.
    Ms. TUBBS JONES. From my perspective, the only time this 
Administration really talks about reduction of spending is when 
we are outside the expenditures of dollars for Iraq and 
Afghanistan, and we are talking about domestic spending that is 
a particular concern to people who are the have-nots, like on 
Social Security, on Medicare prescription drug benefits, on a 
health care benefit for America, even on No Child Left Behind. 
Would you agree with me on that, sir?
    Mr. BEACH. The Administration is full of spending ideas and 
has given you lots of opportunities to spend additional money, 
and you have taken those and you have added to them as well.
    Ms. TUBBS JONES. Wait a minute. Go back to my question. 
There is no talk about a limit on spending when we talk about 
the war in Afghanistan or the war in Iraq.
    Mr. BEACH. I am not an expert on the war. I understand you 
have to spend money to win them.
    Ms. TUBBS JONES. You do understand deficit spending and 
restraint on spending, and you never heard a discussion about 
restraint on spending with regard to Iraq or Afghanistan, have 
you, Mr. Beach. Come on, be nice and say yes or no. That is the 
truth.
    Mr. BEACH. Well, yes, I----
    Ms. TUBBS JONES. You may not be an expert on war, but you 
are supposed to be an expert on spending money.
    Mr. BEACH. Congresswoman, I do believe I heard a debate on 
the spending in Iraq, yes.
    Ms. TUBBS JONES. Okay. Thanks, Mr. Beach.
    Mr. BEACH. You are welcome.
    Ms. TUBBS JONES. At least you got close to a yes or no 
answer. Mr. Price, let me ask you this: When there is a 
discussion about how young people want to have a private 
account in this ``ownership society,'' do you ever hear them 
talk about the fact that Social Security is the best deal for 
young people if they should become disabled or die?
    Mr. PRICE. Very rarely. The fact is that a 20-year-old has 
a 3 in 10 chance in their lifetime of claiming some disability 
insurance. It is a big program. One in 10 of those or 1 of 
those 3 will die and have survivor benefits, and another, 2 in 
10, 1 of whom was disabled, 2 in 10 are going to get survivor 
benefits for their families. The insurance piece of this 
program is vitally important.
    Ms. TUBBS JONES. Have you ever heard a dollar figure for 
the cost of a young person being able to purchase a policy that 
is as clear and broad as either the disability or survivor 
benefit policy?
    Mr. PRICE. I have not. I would love to see a measure, if 
you were to buy in the private market, of what it would cost 
for somebody to get the disability insurance, get the survivor 
insurance, get the inflation insurance, and the retirement 
part. I think it would come out to a good buy.
    Ms. TUBBS JONES. I have heard in the private market in some 
of the reports that I have read that it ranges between $323,000 
to $400,000 for a young person to to go out into the market and 
purchase the coverage that the disability or survivor benefits 
provide.
    Mr. PRICE. No. That is the sort of face value of the 
insurance policy.
    Ms. TUBBS JONES. Right.
    Mr. PRICE. When I buy $300,000 worth of life insurance, I 
pay $1,500 a year. I am not paying $300,000.
    Ms. TUBBS JONES. Face value, you are correct.
    Mr. PRICE. Right, but the face value of the life insurance 
and the face value of the disability insurance are on the order 
of $300,000 to $400,000.
    Ms. TUBBS JONES. In some of the prior questions, Mr. Price, 
there was a whole discussion--I have lost that thought. How did 
I do that?--about private accounts and other benefits--no, it 
was about prefunding, and you got cut off in your response 
about prefunding. I wonder do you want to continue any response 
that you had given previously. If not, it is okay. I am going 
to go to Dr. Furman and see if he.
    Mr. PRICE. I apologize. I was cut off, but I have 
forgotten.
    Ms. TUBBS JONES. Okay. Dr. Furman, you can use up the rest 
of my time.
    Mr. FURMAN. I will even give some back to make up.
    Ms. TUBBS JONES. No, they owe us time. I got cut off. Go 
ahead.
    Mr. FURMAN. I guess I would summarize what I have said. A 
lot of it is if you are interested in prefunding, I would be 
more than happy to work with you, but----
    Ms. TUBBS JONES. Oh, I know what the question was, Dr. 
Furman----
    Mr. FURMAN. Have to figure out ways to get additional 
contributions.
    Ms. TUBBS JONES. Excuse me. My father--and I say this in 
every hearing. My father, my sister, my brother-in-law, and my 
niece are all United Airlines employees. The question was with 
regard to United Airlines and the problems that they are 
facing, and I want to get a response. Actually, Dr. Price, I 
think that is where we were. Either of you can.
    Mr. FURMAN. I think it is an important reminder that we 
have a three-legged stool for retirement. One is Social 
Security, which has no market risk associated with it; one is 
private pensions; and one is your personal savings. We need to 
be focused on strengthening all three of those legs, not 
chopping one off and using it to replace another leg.
    Ms. TUBBS JONES. Do you remember what you wanted to say 
about United Airlines, Mr. Price? If you do not, it is okay. I 
will get you on another occasion. Ladies and gentlemen, Mr. 
Chairman, I am returning the time I did not get on these 
questions back to you, and I thank you for the opportunity.
    Chairman MCCRERY. Yes, ma'am, thank you very much. Mr. 
Hulshof?
    Mr. HULSHOF. Mr. Chairman, thank you. Let me start by 
saying how much I appreciate the evenhanded manner that you 
have conducted this hearing, especially as we have heard some 
interesting questions, some speeches, and other things, and 
just how much I appreciate that you do not get ruffled, because 
when you come on the tail end of this and you have heard the 
questions, the advantage is you have heard all of the testimony 
that you provided. One of the disadvantages is that I feel 
compelled to respond to some of those things that have been 
raised. Mr. Pomeroy talked about the use of excess payroll 
taxes in our national budget, as if that were a recent 
phenomenon. I think, Dr. Holtz-Eakin, correct me if I am wrong, 
but I think even going back perhaps to the late sixties through 
1998, excess payroll taxes were, in fact, used to help finance 
the national budget. Mr. Levin, you had made a comment that no 
one says to do nothing. I think I wrote that quote down. Yet, I 
respectfully disagree because other than your colleague, Mr. 
Wexler, Mr. Boyd, I hear little in the way of constructive 
dialog as far as what to do.
    Dr. Furman, I agree with you that your presence here as the 
subject matter of this hearing was on prefunding, and yet you 
seemed eager to offer gratuitous criticism of fiscal policy, 
and specifically that President Bush is primarily responsible 
for our current fiscal situation. So, let me probe that bias of 
yours. I was tempted to let it slide, but do you acknowledge 
that our country experienced a recession?
    Mr. FURMAN. The recession has almost nothing to do with the 
deficit.
    Mr. HULSHOF. That is not my question. Dr. Furman, here is 
how this works. Let me ask you a question.
    Mr. FURMAN. Yes.
    Mr. HULSHOF. If I do not--if you do not understand my 
question, I will rephrase it. Do you acknowledge that our 
country experienced a recession?
    Mr. FURMAN. Yes.
    Mr. HULSHOF. Now, I take it from your expanded answer that 
you disagree with Mr. Entin that the recession is the number 
one cause for our fiscal situation.
    Mr. FURMAN. In fiscal year 2004 and fiscal year 2005, it is 
not a major cause of our fiscal situation.
    Mr. HULSHOF. Let me ask, do you agree with many mainstream 
or most--I hate to characterize it as ``most,'' but many 
mainstream economists that the economic slowdown began in the 
last quarter of the year 2000?
    Mr. FURMAN. The official recession began in March 2001.
    Mr. HULSHOF. That the economic slowdown began, commenced in 
the last quarter of the year 2000. Agree or disagree?
    Mr. FURMAN. There are a variety of measures of the economy 
on a month-to-month basis. I have not studied them all. I am 
sure some of them show that and some of them show other----
    Mr. HULSHOF. So, you agree or disagree?
    Mr. FURMAN. Recession began March 2001.
    Mr. HULSHOF. Agree or disagree?
    Mr. FURMAN. I agree that the recession began in March 2001.
    Mr. HULSHOF. I think as--you know, this is somewhat 
rhetorical, because you have to admit that the direct attacks 
on September the 11th had some direct and indirect economic 
consequences, did they not?
    Mr. FURMAN. They certainly did.
    Mr. HULSHOF. And as Ms. Tubbs Jones pointed out, Federal 
expenditures for conflicts in Iraq and Afghanistan, those are 
real dollars, whether we agree or disagree with the policy, the 
fact is Federal expenditures have gone into those military 
conflicts, have they not?
    Mr. FURMAN. That is correct.
    Mr. HULSHOF. Now, I do want to, on a lighter note--because 
it is interesting, Mr. Chairman, in the remaining time I have, 
we each try to come up with an analogy of what prefunding is, 
and I like, Dr. Furman, your analogy of a family with a 
substantial mortgage on its home and a daughter who is going 
off to college in a decade, because that is basically my 
family's situation, and then the choices that we have. We have 
also heard--and for those newcomers to the room, we have also 
heard about being kicked to death by a rabbit. I invite you to 
watch the replay of this, if you are wondering about this 
rabbit possessing murderous intent. Mr. Shipman, you say that 
regarding prefunding--and this is from your testimony--that in 
the age of the iPod, Social Security is a 78 RPM wind-up 
phonograph. Would you like to elaborate just a bit, briefly?
    Mr. SHIPMAN. Yes, the purpose of that was to say that 
things have changed from when Social Security started, really 
as a reaction to the Great Depression. The OASI part has really 
morphed into a defined benefit plan, essentially. Its finances 
have not advanced. It is still a pay-as-you-go system. It is 
archaic in trying to pay for relatively certain future 
liabilities through a tax transfer system as opposed to saving 
and investing for those relatively certain future liabilities.
    Mr. HULSHOF. To conclude, again, a crude analogy. If I own, 
Mr. Chairman, a 1935 antique car that can do the speed limit, I 
would like to pass it to my kids. It sprang an oil leak, and I 
have noticed that I have had to add a quart of oil almost 
from--it used to be every month and then every week, now it is 
almost daily. It seems that I now have a choice of whether to 
continue to just pour oil into this car, or to actually drop 
the engine and overhaul it. Of course, I know that that is 
going to entail some cost to do that. Again, that is my crude 
analogy of this issue, but I certainly applaud you for having 
yet again another stellar hearing. Thanks.
    Chairman MCCRERY. Thank you, Mr. Hulshof. Mr. Thompson, 
welcome to our Subcommittee. We are glad to have you, and if 
you would like to pose any questions to the panel, you may do 
so.
    Mr. THOMPSON. Well, Mr. Chairman, thank you very much for 
having the hearing and for allowing me to sit in. Mr. Levin, 
thank you very much for inviting me. I, too, came at the tail 
end and have found interesting some of the analogies and some 
of the comments that were made. I am particularly concerned 
from a fiscal perspective, and I suspect that all of you share 
all or part of that concern. A lot of the discussion prompted, 
I think, by Mr. Brady when he asked his question--that is where 
I came in--about cutting programs, cutting spending versus 
increasing taxes, it just seems to me that at some point--and I 
do not want to suggest that this has not been an honest 
hearing, but we have to have an honest debate on what the 
American people want in regard to those services and how it is 
we are going to pay for those services. The idea that we can 
just somehow cut, I think people need to know what that means. 
You know, just the $427 billion deficit this year, you could 
cut the Environmental Protection Agency, Health Services, 
Housing and Urban Development, Commerce, Education, and a whole 
bunch of other programs, and not even get to the deficit number 
of $426 billion. That does not even include the $160 billion 
that was borrowed from Social Security.
    So, I think that discussion has to take place, but I think 
it has to be a transparent, honest discussion. I think the 
whole issue of borrowing money and the debt has to be part of 
it. You could go a long way to prefund this program just by 
diverting the billion dollars a day that we spend in paying the 
interest on our National debt. We could use that to front-load 
this prefunding. I guess that brings me to my first question. 
When David Walker was before our full Committee, he had an 
interesting chart that he put up on the board that showed that 
by the year 2040, the Federal Government would be taking in 
just a small amount of revenue more than what we would paying 
out in the interest only on our National debt. Now, if we 
borrow to prefund Social Security or we borrow to privatize 
Social Security, it seems to me that we are going to grow that 
national debt. We could actually trigger a scenario that, by 
2040, our interest is actually as much of, or more than what we 
are taking in just to pay that interest. I would be interested 
to know what this panel thinks the impact of that would be on 
our overall economy. Just briefly, if you could just--whoever 
would like to take it.
    Mr. HOLTZ-EAKIN. Well, I think, Mr. Thompson, that the debt 
profile that you have characterized is the outcome of current 
law mandatory programs which will----
    Mr. THOMPSON. I understand. My question is if the Walker 
scenario comes to fruition or, even worse, if we continue to 
borrow and it becomes worse, as was explained, what impact is 
that going to have on our National economy.
    Mr. HOLTZ-EAKIN. It will have, initially a corrosive, and 
ultimately a contractionary effect if left unattended.
    Mr. THOMPSON. Does everybody--when we are talking about 
debt-financed accounts, this is obviously in today's situation 
going to lead to more foreign borrowing. When you have Japan 
and China and the Organization of Petroleum Exporting Countries 
Nation's leading the way in regard to foreign lending to us, I 
think we are at $2 trillion now in the amount of money that we 
owe other countries.
    Mr. PRICE. Three.
    Mr. THOMPSON. Pardon me?
    Mr. PRICE. We will find out next week it is three.
    Mr. THOMPSON. Three trillion?
    Mr. PRICE. Yes.
    Mr. THOMPSON. I am going to lose even more sleep than I was 
planning on. Just since January of last year, about $500 
billion in foreign debt, and as this continues to grow. I think 
that puts our priorities in conflict--I don't care what side of 
the aisle you are on--what we want to see this government doing 
and what we want to see happen for our country. I would like to 
know--Dr. Price, we will start with you--what do you see as the 
pitfalls of us continuing to grow not only our National debt 
but our national foreign debt?
    Mr. PRICE. Well, this is a big open question. We had a 
foreign exchange crisis and went off the gold standard in 1971 
when we were going from a trade surplus to a trade deficit. 
Then, you know, in the mid-eighties when the dollar turned and 
people were worried about the dollar being too high, we had a 
current account deficit of 2.5 percent of GDP. The 
international financial markets have become more generous, 
particularly the central banks of Asia. So, we now have a 6.5 
percent of GDP borrowing, and we have yet to see a real turn 
that I think we need to have.
    So, the big open question is how long, how generous are the 
central banks of Asia going to be? Otherwise, what is going to 
happen to private markets? Because at some point, if private 
markets turn against--and it can be Americans. I mean, the big 
decline of the Mexican peso, or the British pound, or the U.S. 
dollar in the past has been as much by people inside moving 
their currency out, as people outside. We could have a run on 
the dollar by Americans that the Asian central banks cannot 
keep up with, and that would cause serious problems for our 
interest-sensitive industries, like housing, autos, and others.
    Mr. THOMPSON. Can we differentiate between a Social 
Security strong dollar and a national strong dollar? Can you 
have one and not the other?
    Mr. PRICE. No.
    Mr. THOMPSON. Thank you.
    Thanks, Mr. Chairman.
    Chairman MCCRERY. Mr. Thompson, thank you for coming, and I 
agree with you that we ought to have an honest debate about any 
number of decisions we must make as policymakers here in the 
Congress. In the pursuit of that, I would like to clarify some 
of the numbers you used in your question. First of all, the 
$426 billion figure, was that last year's deficit, Dr. Holtz-
Eakin?
    Mr. HOLTZ-EAKIN. You are talking about 2004? The current 
year, 2005, our current estimate is a ball park $350 billion.
    Mr. THOMPSON. $350 billion.
    Mr. HOLTZ-EAKIN. For the fiscal year ending September 30th.
    Chairman MCCRERY. Okay. Mr. Thompson also said--that does 
not count the $160 billion we borrowed last year, maybe this 
year, from Social Security. In fact, have we borrowed from 
Social Security and spent $160 billion either last year or this 
year?
    Mr. HOLTZ-EAKIN. The primary surplus in Social Security is 
much smaller. I have failed to remember this number twice in 
front of you, and I will never show up again without knowing 
it.
    Chairman MCCRERY. Sixty-nine billion.
    Mr. HOLTZ-EAKIN. Thank you.
    [Laughter.]
    Chairman MCCRERY. That is the correct, honest number that 
we used from the Social Security Trust Fund. That was the cash 
surplus. The interest that was credited to the trust fund, of 
course, we could not spend that. It is on paper. It is 
interest. So, I would like for us to be honest in this debate 
and use good numbers when we are trying to paint the picture 
that we would like everyone to see and operate from.
    Mr. THOMPSON. Mr. Chairman, could you yield for a moment?
    Chairman MCCRERY. Sure.
    Mr. THOMPSON. If the number $427 billion or the numbers 
that you just gave us, $419 billion, the issue is those are 
real dollars. I think.
    Chairman MCCRERY. Those are real dollars, Mr. Thompson, but 
to exaggerate those in the pursuit of your ends I don't think 
serves the public or the debate well, and I was just trying to 
make it clear that the correct numbers are much different from 
those you cited. Now, I agree with the point you were trying to 
make very much, and that is the point of these hearings, and 
that is the point of those of us, including the President, who 
want to reform Social Security. Then we would like--some of us 
would like to move on to Medicare, and yes, Mr. Price, health 
care, because you are right, that is the biggest looming 
problem from a fiscal standpoint, and perhaps from a quality-
of-life standpoint. And, fortunately or unfortunately, the 
government plays a huge role in health care through Medicare 
and Medicaid, and other policies, including tax policy. So, 
yes, I would like very much for us to move on from Social 
Security, which is much easier to fix, and to generate some 
savings from current policy in the out-years, and then address 
these more difficult and eventually bigger problems like 
Medicare, Medicaid, and health care. With that, thank you all 
very much for your testimony. It was all excellent, and we look 
forward to continuing to consult you as we move through this 
discussion. The hearing is adjourned.
    [Whereupon, at 12:50 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]

             Statement of Dolores Guinn, Horshoe Bay, Texas

    In reference to the Social Security reform hearings, I feel 
strongly that the committee should consider all aspects of this issue. 
The cornerstone of the proposed reform is to let the future generations 
set aside their own savings and/or pension funds. This is a disturbing 
proposal and I ask that each of you be honest. I, for one, can remember 
what was happening in my life during the age of twenty to forty. I 
spent many hours wondering if I could survive to the next payday, being 
a single Mom with three daughters. Do you think, for one moment, that I 
even considered a savings account.
    Surely, intelligent people that you are, you have studied the 
living conditions of those at the lower end of the spectrum who cannot 
even afford a car for transportation or medical treatment at the 
hospital. Have you given any consideration to them? Have you looked 
ahead to see what will be the results if we leave every American in 
charge of their own pension? Perhaps if you did, you would see that 
there will be a lot of elderly people out on the street. You know, and 
I know, that they will not be able to survive with the reduced Social 
Security payment that will be in place at that time.
    More importantly, what plans do you have if some catastrophic 
decline in the stock market should occur? What alternative plan do you 
have if over half of the American population is ready to retire and 
their account is empty? I believe that the easiest way to reform Social 
Security is set it aside, untouchable and unmolested by the 
government,as it was originally planned. The other thing is to take the 
cap for Social Security off of the wealthy. There is nothing wrong with 
having all Americans pay on all that they earn.
    We can surely see that fairness in the system has been at the heart 
of all of Americans discontent. Remember the beginning of the American 
Revolution? Americans were unhappy over taxation. Taxation without 
representation. Unfairness in the system!
    The Social Security plan, drawn up by Franklin.D. Roosevelt, was 
good and has helped so many people, probably some of your own 
relatives. It needs to be returned to its roots and tweaked with the 
earnings cap issue, but please do not destroy this program. I remind 
you, that you are making decisions that will affect future generations 
and the shame and blame for its failure will be upon your head.
    Thank you for allowing me to be heard on this issue.

                                 

          Statement of Thomas S. Marino, La Habra, California

    I wish to provide my personal support of HR 147, ``Social Security 
Fairness Act''. When I retire in 2008, at the age of 65, I will be 
affected by the present Government Pension Offset (GPO) and the 
Windfall Elimination Provision (WEP).
    I am employed by the County of Orange in California, with many 
years of government service behind me. I did, however, manage to earn 
my forty Social Security credits during the years before government 
service. This included fours years of military service to my country 
during my Marine Corps enlistment.
    I earned my right to collect the full benefits of Social Security, 
irregardless of the fact that I chose a career in government service. I 
feel that government service workers, as well as teachers have a right 
to receive full earned benefits from their government pension plans and 
Social Security if they contributed to the systems.
    I work for a County agency that provides aid to needy persons. I am 
personally aware of individuals who also receive Federal Social 
Security benefits who have never paid into this system. I don't 
understand how it can be considered fair or ethical for these persons 
to receive benefits when our government will deny me from receiving the 
full measure of the benefits I earned because I contributed to a 
government pension plan.
    I personally urge the members of Congress to support passage of HR 
147.

                                 

                Statement of Bob Moore, Lawton, Oklahoma

Reform Social Security and Personal Income Tax
    First item is federal income tax on interest earned on bank 
accounts. Why have income tax laws for 300 million people when the 
Federal Government should have the financial institutions (appr. 
10,000) pay a monthly tax being a percentage of the total dollars paid 
as interest to clients. No tax due from the citizens, the bank pays the 
tax, SIMPLE.
    Same is true with stock dividends, have the corporations pay the 
government a percentage of the dollar amount paid to the stockholders. 
No tax due from the citizens, the corporations pay the tax, SIMPLE. 10% 
is a good rate.

    a.  Second item is a 40-40 Tax on Gasoline:
    b.  eliminate the.9 cent;
     c.  this tax shall not be amended for forty (40) years;
    d.  a total tax of forty (40) cents a gallon tax according to the 
following:
     e.  twenty (20) cents shall go to the Federal Government and
     f.  twenty (20) cents shall go to the originating State government
    g.  gasoline tax to ONLY go toward roads and bridges.
    h.  Third item is Truthful Tax Reform--Federal Tax Payroll Program.

    ``TOTALLY'' Eliminate the Personal Income Tax ``TOTALLY''.

    1.  Fact: FICA tax is over 15% of the employees' paycheck. Federal 
Courts have ruled the FICA is a tax not a retirement fund. The Federal 
Government needs to be honest and declare that FICA tax goes to the 
general fund to pay for government spending programs. Re-name FICA tax 
to Federal Tax Payroll Program.
    2.  Government taxes should be on commission, just like all private 
businesses and private business' employees. The government spending can 
only grow if more people make more money.
    3.  Payroll deduction is the most efficient way to collect taxes. 
The Federal Tax Payroll Program will be the only federal tax that wage-
earning Americans will pay. Never a personal income tax form to file 
with the IRS.
    4.  Keep the system simple, one rate for all taxpayers. Ten (10%) 
Percent is good enough for GOD, then Ten (10%) Percent should be good 
enough for the government. However the Federal Government is not as 
efficient as GOD so lets put the maximum rate at twenty (20%) percent.
    5.  The Federal Tax Payroll Program shall be 20% ``Maximum'' of 
which Ten (10%) Percent to be withheld from the wage-earners' pay to be 
matched by Ten (10%) Percent from the Employer. Rate shall not be 
raised ever.
    6.  Earmark how the money shall be allocated, such as:

          1% to DOD for National Defense;
          4% to Citizens Retirement Fund, a 401K type program--
        private social security fund for each person;
          15% to Social Security and other spending programs.
          A total of 20% of the wage-earners' salary to go to 
        the Federal Government.

    This type of system would result in no forms, no worry and a much 
smaller I.R.S. No tax forms to file each year. No tax credits to be 
given or taken away by the Federal Government. No increase or decrease 
in the tax rate.
    This would get the Federal Government out of micro-managing the 
daily life of the taxpayers. It is called FREEDOM!
    Social Security; at this point, the government should just pay 
everyone the same amount each month once the person has reached age 62 
or 65. We are a rich Country and we do not want our Senior Citizens 
living below the poverty level so just increase the monthly check for 
all senior citizens. If Congress was really serious about eliminate the 
national debt, Congress would cut the spending program.
    An advantage given by the government to one person means an unfair 
dis-advantage to all other Americans. Our Founding Fathers believed 
that small government and less taxes means more freedom.
    The Oklahoma Taxpayer, Editorial by Bob Moore

                                 
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