SPEAKING THE TRUTH ABOUT

SOCIAL SECURITY REFORM

by Milton Friedman

No. 46 April 12, 1999

As support grows for transforming Social be mandatory. The fraction of a person’s income
Security from a pay-as-you-go defined benefit pro- that it is reasonable for him or her to set aside for
gram to a system of individually owned, privately retirement depends on that person’s circum-
invested accounts, critics of privatization have stances and values. It makes no more sense to
warned that making the transition to such a new specify a minimum fraction for all people than to
system would impose substantial new costs on mandate a minimum fraction of income that
today’s young workers. However, given a proper must be spent on housing or transportation. Our
understanding of Social Security’s current un- general presumption is that individuals can best
funded liabilities—variously estimated at from$4 judge for themselves how to use their resources.
trillion to $11 trillion—there are no real transition The ongoing discussion about privatizing
costs to privatizing Social Security, merely the Social Security would benefit from paying more
explicit recognition of current implicit debt. attention to fundamentals, rather than dwelling
A privatized Social Security system should not simply on nuts and bolts of privatization.

Milton Friedman, winner of the 1976 Nobel Prize in Economics, is a senior research fellow at the Hoover Institution. Originally published in
the New York Times, January 11, 1999. Reprinted by pemission.
The link between retirement benefit by making regular pay-
the payroll Introduction ments into a joint fund.”
Balderdash. Taxes paid by today’s workers
tax and benefit The journalist Michael Barone recently are used to pay today’s retirees. If money is left
payments is part summed up the conventional wisdom about over, it finances other government spending—
reforming Social Security. “The content of the though, to maintain the insurance fiction,
of a confidence reform is fairly clear—individual investment paper entries are created in a “trust fund” that
game. accounts to replace part of the government is simultaneously an asset and a liability of the
benefits financed by the payroll tax, later government. When the benefits that are due
retirement ages, adjusted cost of living increas- exceed the proceeds from payroll taxes, as they
es,” he wrote in the American Enterprise. And, he will in the not very distant future, the differ-
added, “suddenly the money to pay for the costs ence will have to be financed by raising taxes,
of transition is at hand, in the form of a budget borrowing, creating money, or reducing other
surplus.” government spending. And that is true no
I have italicized “part” and “costs of transi- matter how large the “trust fund.”
tion” because they epitomize key defects in The assurance that workers will receive
conventional wisdom. benefits when they retire does not depend on
Social Security has become less and less the particular tax used to finance the benefits
attractive as the number of current recipients or on any “trust fund.” It depends solely on the
has grown relative to the number of workers expectation that future Congresses will honor
paying taxes, an imbalance that will only get promise made by earlier Congresses—what
bigger. That explains the widespread support supporters call “a compact between the gener-
for individual investment accounts. Younger ations” and opponents call a Ponzi scheme.
workers, in particular, are skeptical that they The present discounted value of the
will get anything like their money’s worth for promises embedded in the Social Security law
the Social Security taxes that they and their greatly exceeds the present discounted value of
employers pay. They believe they would do the expected proceeds from the payroll tax.
much better if they could invest the money in The difference is an unfunded liability vari-
their own 401(k)s or the equivalent. ously estimated at from $4 trillion to $11 tril-
But if that is so, why replace only part and lion—or from slightly larger than the funded
not all of government benefits? The standard federal debt that is in the hands of the public
explanation is that this is not feasible because to three times as large. For perspective, the
payroll taxes—or part of them—are needed to market value of all domestic corporations in
pay benefits already committed to present and the United States at the end of 1997 was
future retirees. That is how they are now being roughly $13 trillion.
used, but there is nothing in the nature of To see the phoniness of “transition costs”
things that requires a particular tax to be (the supposed net cost of privatizing the cur-
linked to a particular expenditure. rent Social Security system), consider the fol-
lowing thought experiment: As of January 1,
2000, the current Social Security system is
The Myth of Transition Cost repealed. To meet current commitments, every
participant in the system will receive a govern-
The link between the payroll tax and bene- mental obligation equal to his or her actuarial
fit payments is part of a confidence game to share of the unfunded liability.
convince the public that what the Social Secur- For those already retired, that would be an
ity Administration calls a social insurance pro- obligation—a treasury bill or bond—with a
gram is equivalent to private insurance; that, market value equal to the present actuarial val-
in the administration’s words, “the workers ue of expected future benefits minus expected
themselves contribute to their own future future payroll taxes, if any. For everyone else, it

2
would be an obligation due when the individ- that they would receive the means-tested
ual would have been eligible to receive benefits amount.”
under the current system. And the maturity The paternalism of the first reason and the
value would equal the present value of the ben- reliance on the extreme cases of the second are
efits the person would have been entitled to, equally unattractive. More important, Prof-
less the present value of the person’s future tax essor Feldstein does not even refer to the clear
liability, both adjusted for mortality. injustice of a mandatory plan.
The result would be a complete transition The most obvious example is a person with
to a strictly private system, with every partici- AIDS who has a short life expectancy and lim-
pant receiving what current law promises. Yet, ited financial means, yet would be required to
aside from the cost of distributing the new use a significant fraction of his or her earnings
obligations, the total funded and unfunded to accumulate what is almost certain to prove
debt of the United States would not change by a worthless asset.
a dollar. There are no “costs of transition.” The More generally, the fraction of a person’s
unfunded liability would simply have become income that it is reasonable for him or her to
funded. The compact between the generations set aside for retirement depends on that per-
would have left as a legacy the newly funded son’s circumstances and values. It makes no
debt. more sense to specify a minimum fraction for
There are no
How would that funded debt be paid when all people than to mandate a minimum frac- “costs of transi-
it came due? By taxing, borrowing, creating tion of income that must be spent on housing tion.” The
money, or reducing other government spend- or transportation. Our general presumption is
ing. There are no other ways. There is no more that individuals can best judge for themselves unfunded liability
reason to finance the repayment of this part of how to use their resources. Mr. Feldstein sim- would simply have
the funded debt by a payroll tax than any other ply asserts that in this particular case the gov-
part. Yet that is the implicit assumption of ernment knows better.
become funded.
those who argue that the “costs of transition” In 1964, Barry Goldwater was much reviled
mean there can be only partial privatization. for suggesting that participation in Social
The payroll tax is a bad tax: a regressive tax Security be voluntary. I thought that was a
on productive activity. It should long since good idea then; I still think it is.
have been repealed. Privatizing Social Security I find it hard to justify requiring 100 per-
would be a good occasion to do so. cent of the people to adopt a government-pre-
scribed straitjacket to avoid encouraging a few
“lower-income individuals to make no provi-
Should Social Security Be sion for their old age deliberately, knowing
Mandatory? that they would receive the means-tested
amount.” I suspect that, in a voluntary system,
Should a privatized system be mandatory? many fewer elderly people would qualify for
The present system is; it is therefore generally the means-tested amount from imprudence
taken for granted that a privatized system or deliberation than from misfortune.
must or should be as well. I have no illusions about the political feasi-
The economist Martin Feldstein, in a 1995 bility of moving to a strictly voluntary system.
article in the Public Interest, argued that contri- The tyranny of the status quo, and the vested
butions must be mandatory for two reasons. interests that have been created, are too strong.
“First, some individuals are too shortsighted However, I believe that the ongoing discussion
to provide for their own retirement,” he wrote. about privatizing Social Security would bene-
“Second, the alternative of a means-tested pro- fit from paying more attention to fundamen-
gram for the aged might encourage some tals, rather than dwelling simply on nuts and
lower-income individuals to make no provi- bolts of privatization.
sion for their old age deliberately, knowing