I’ve run two installments from the Social Security chapter of my book The Joy of Freedom: An Economist’s Odyssey.
Installment one was “Social Security is a Ponzi Scheme,” March 11, 2025.
Installment two was “Flawed from the Start and Ponzi versus Stocks,” March 14, 2025..
Here’s the final installment. Of course, all the numbers are dated. I wrote this in late 2000 or early 2001. Also, reform is much harder now than it would have been when I wrote this chapter.
The Injustice of Social Security
Imagine that someone takes a certain percent of your income every year and promises to give it back with some accumulated interest when you reach 65. There’s only one problem: You don’t think you’re going to reach age 65 because you’re now 29 and you have AIDS. You desperately need that money now to pay for medical bills, rent, and meals, but that person won’t let you have it.
I have just described how the Social Security system works. No matter how desperately you need that money now, the government won’t let you have it. If you applied to a Social Security office for a form to exempt you, the employees there would refuse to give it to you because no such form exists. There is no exit. You are locked in, and as far as the federal government is concerned, your desires, needs, and interests literally do not matter.
The AIDS example is extreme. There are millions of less extreme cases, cases of people with bad health who are unlikely to live to collect much in benefits. One such group is cigarette smokers, whose life expectancy is years less than the life expectancy of nonsmokers. Though smokers can expect to collect fewer years of Social Security benefits than nonsmokers will, they don’t pay a lower tax rate on their earnings. Another large group of people who can expect to live substantially shorter lives is black men. In 1996, according to the insurance Web page www.insure.com, a 40-year-old black man could expect to live until age 71, compared to 76 for a white 40-year-old man. In other words, the black man could expect to collect Social Security for about 5 years (the age for receipt of full benefits will be 66 by the time he retires) versus 10 years for the white man.
Another injustice arises from the way the Social Security system treats workers in state and local government, who are the only people left who can be exempt from Social Security. When retired state or local government employees spend 10 or more years in jobs covered by Social Security, they still qualify for Social Security benefits. I do not advocate that Social Security be extended to them at the start of their working lives—the solution, when you have a deep hole, is not to throw people in it. I simply point out that state and local government workers have an unfair advantage over the rest of us.
Social Security is Not Guaranteed No Matter How Much You’ve Paid
In July 1956, Ephram Nestor, a Bulgarian immigrant who had lived in the United States since 1913, was deported from the United States for having been a Communist 17 years earlier. Between December 1936 and January 1955, Nestor and his employers had paid Social Security taxes. In 1954, Congress passed a law providing that any person deported because of past Communist membership would be cut off from Social Security benefits. Nestor sued—ironically, given his Communist past—on the grounds that his rights were being denied. (Communist governments regularly trampled on people’s rights and murdered millions of innocent people.) The Supreme Court, in Nestor v. Flemming, found, equally ironically given their presumed anti-Communism, that Congress could do what it wished, and if that meant cutting off people who had paid into a fund that they had mistakenly thought guaranteed them a pension, that was just too bad. Of course, the Supreme Court dressed it up in fancier language than I’m using, but the tone was remarkably similar. Here’s one of the Court’s key sentences:
To engraft upon the Social Security system a concept of “accrued property rights” would deprive it of the flexibility and boldness in adjustment to ever-changing conditions which it demands and which Congress probably had in mind when it expressly reserved the right to alter, amend or repeal any provision of the act.
In other words, too bad.
Abolish Social Security in Slow Motion
The first step is to recognize that we have been lied to. There is no trust fund, Social Security is a Ponzi scheme, and it’s a lousy deal for almost everyone. Therefore, the best solution to these problems is to abolish Social Security. That way, we could be free to decide when, how much, and in what form to save. We don’t have that freedom now.
Those of us who decide to invest in stocks linked to such broad indexes as the Standard & Poors’ 500 or the Russell 2000 are likely, over time, to accumulate a multiple of what we would get from Social Security. Those who want to invest in bonds because they fear the ups and downs of the stock market could do so. Those who want to invest by buying a rental property could do so. Those who wish to save only a little for retirement and to work through their sixties and seventies could do so. The great virtue of freedom is that it would allow each of us to make decisions about how we want to spend our money.
It’s true that the vast majority of us aren’t experts on how to invest our money. But we can hire experts, which is what we do when we invest in mutual funds. Moreover, there is one issue on which each of us has incredible expertise that no one else shares: Each of us knows what we want.
Absent Social Security, would people save for their own retirement? Many people are skeptical because those on the verge of retirement save so little: In 1991, for example, the median financial assets of households with heads aged 55 to 64 were only $8,300, and the median net worth, including the value of the home, for all households headed by someone under age 65 was only $28,000.[1] What these skeptics don’t realize, though, is that Social Security is one of the main reasons why so many people don’t save. As Martin Feldstein has pointed out, someone with average earnings over his whole lifetime who retires at age 65 with a “dependent” spouse receives benefits equal to 63 percent of his earnings the year before retirement.[2] Since such a person’s Social Security benefits are not taxed, this is equivalent to about 80 percent of pre-retirement net-of-tax income. If you think Social Security will provide for your retirement, why bother saving?
Most Americans alive today would be better off if we didn’t have Social Security. But how do we get from here to there? There are many possible transitions that could benefit almost everyone. Here’s a rough sketch of one such transition. It is in two parts. The first part consists of steps that should be taken even if the goal is just to preserve Social Security and avoid steep tax increases on younger generations. The second part is composed of measures to abolish Social Security in slow motion.
First, simply to preserve Social Security without increasing taxes, the three steps needed are to (1) increase the retirement age, (2) change the benefits formula, and (3) change the indexing of benefits. The current age for receiving full Social Security benefits is 65, but that number was set in the 1930s. Back then, 65-year-old men could expect to live an extra 12 years, and 65-year-old women could expect to live 13 more years. Today those numbers are 15 and 19 respectively, and work for virtually everyone is much less physically demanding than it was then. The age for full receipt of Social Security benefits is already slated to rise to 66 in 2009 and 67 in 2027. But this could be raised in stages to 70 by, say, 2017, giving people ample time to adjust their plans. Along with this increase, the early retirement age for partial benefits could be raised from 62 to, say, 66.
Raising the retirement age, of course, further hurts smokers, black men, and other people who tend to die earlier. Therefore, a related reform should be an option under which anyone who wants it can receive the equivalent of, say, six years of benefits as a lump sum. That way, those who expect to die early would not be left high and dry, as the government leaves them today if they have no dependents.
The benefit formula could also be altered. Built into the benefit formula are steady increases in real benefits as long as real wages rise. The average annual benefit per retiree in 1995, for example, was $7,510. According to Feldstein and Samwick, if there were no change in the system, the average annual benefit (in 1995 dollars) will be $8,790 in 2016 and $9,290 in 2023.[3] Instead, benefits could be frozen in real terms so that the average benefit in 2023 is no higher than it is today.
Finally, Social Security benefits are indexed to the Consumer Price Index. The Boskin Commission, appointed by the federal government to study the CPI,[4] found that the CPI overstated inflation by about one percentage point a year. Reforms implemented in response to the Boskin Commission’s report have cut this overstatement to about half a percent a year. The government could start now to index to the CPI minus this half percentage point. If it did so, then this reform, combined with the reform to CPI calculations that has already taken place, would cause benefits to grow less quickly. These changes taken together—raising the retirement age to 70, indexing benefits to a truer measure of inflation, and freezing real benefits—would eliminate the funding crisis and would probably allow some modest decreases in the Social Security tax rate today. Then people should be allowed—allowed, not forced—to save the difference between the old payroll tax and the new lower payroll tax in an Individual Retirement Account.
Even with all those changes, though, we would still be left with a government-run compulsory Ponzi scheme. But government is not our parent; it simply has no business telling us how much we must save for our old age. It has even less business pooling our “savings” (taxes) with other people’s taxes and then deciding how much we get back, based loosely on how much we paid in (don’t earn too much), our income when retired (don’t save too much), our marital status (marry someone who didn’t pay Social Security taxes), and our age (live long). Therefore, we should end Social Security gradually.
Why end it gradually rather than immediately? Because Social Security is a chain letter that makes many current and future retirees depend on being able to tax younger generations in order to get something back for their taxes. That, as Franklin Roosevelt rightly figured, is what makes the transition problem so tough. The only way to end the program is to start sometime. The government could start by telling everyone under a certain age, say 30, that he or she will not collect Social Security. Then cut the payroll tax rates of people under 30 to, say, 5 percent (split between employer and employee) of their incomes. Allow these younger people to save the 5.6-percentage-point difference (between the old 10.6 percent tax and the new 5 percent tax) in an Individual Retirement Account.
If polling data are to be believed, 70 percent of Generation X thinks that Social Security will not be there when they retire. That means that 70 percent already think they’re paying taxes for nothing in return. The bad news is that my proposal merely confirms their suspicion; the good news is that it cuts their tax rate as a bonus. Social Security would then be virtually abolished in about 60 years.
Such a transition is not ideal for young workers, who would do better if they could invest the whole 10.6 percent. So, if I had been advising Franklin Roosevelt in 1935, I would have said, “Franklin, don’t do this.” Unfortunately, in 2001, we’re trying to plan our way out of the mess that this Machiavellian man created. Under this transition, people under 30 would continue to pay into a system from which they would get nothing. It sounds unfair that people under age 30 would be paying for nothing—and it is unfair. But it’s not worse in principle than making them continue to pay a higher payroll tax into a system from which they can earn a very low—or even negative—rate of return. Moreover, those who took the amount by which their payroll tax was cut and invested in stock-index funds would likely end up better off than if the current system went on unchecked.
Consider, for example, a worker who decides, at age 20, to invest all of his or her 5.6 percent in stocks, does so until age 67, and reinvests dividends along the way. Then, if the stock fund yielded a real return of 7 percent, he or she would end up with annual retirement income equal to 122 percent of his or her pre-retirement income, versus the much smaller 42 percent that is promised under current law, and the even smaller 29 percent that is payable with the current Social Security tax rate.[5] That same worker, if he or she invested in a 50/50 mix of stocks and bonds yielding a return of 5 percent, would end up with retirement income equal to 56 percent of pre-retirement income, which is still well above what he or she can get from Social Security.[6]
I would add one other reform. I would allow anyone who is at least 45 years old and who has paid Social Security taxes for at least 10 years to immediately leave the Social Security system. A person who left would never be allowed back in and would give up all claim to past taxes paid and future benefits; but he or she would no longer pay Social Security taxes. I haven’t actuarially costed out this proposal. I don’t even know how it would affect me. But here’s one thing I do know: If this choice were offered to me, I would take it in a New York minute. I wouldn’t bother to compute the amount I would lose from no longer qualifying for Social Security and the amount I stand to gain from never again paying Social Security taxes. Why would I, a rational, numerate, analytic economist, not make these calculations? Because I value freedom highly, and I would give up a lot not to have the federal government treat me like a helpless, irresponsible waif. (But if you wait and give me the choice when I’m say, 55 or older, I’ll do a much more careful calculation.) I might be extreme in this respect, but I’d bet a few million other people are like me. With us out of the system, the federal government loses our tax revenues for the next 20 years—but it doesn’t need them as much during this period because it will collect payroll taxes in excess of benefit payouts. Then, when the government faces a financial crunch during the 2020s and 2030s, it will not have to pay us benefits.
One Possibly Bad, and Two Definitely Bad, Proposals for Social Security Reform
Some economists and politicians who have studied the long-run problems with Social Security have advocated two other ways to change the system. One change is privatization, whereby the government lets people out of a substantial portion of the payroll taxes they pay and forces them to save the difference in a personal savings account. There are two differences between privatization and my proposal for abolition. First, under virtually all of the privatization proposals, people would be forced to save. So such proposals do little for those who wish to spend their money through their lifetime and to work beyond normal retirement, or for those who are ill now and want to use their money for health care. The government is still left dictating to people how much, and when, they should save. If a 40-year-old would rather spend that money on a trip to California or to Europe, for example, he or she cannot. The government says he or she must save and is willing to enforce that at gunpoint. The second problem is that most such proposals would cut the payroll tax by a larger amount than under my proposal, and because they don’t change the retirement age or adjust the benefits formula or the over-indexing of Social Security, they would leave the system with a large shortfall between payroll taxes collected and benefits paid out to current recipients.
Some people have suggested that the federal government sell its land and other assets as a way of making up the shortfall. Asset sales are an excellent idea, but their power should not be overstated. Pete Peterson, chairman of the Blackstone Group, a private investment bank, estimated that the federal government’s assets, as of September 1995, were worth $2.3 trillion, compared to unfunded liabilities for Medicare and Social Security totaling $15.3 trillion.[7]
Other privatization advocates, especially economists, have considered the huge shortfalls in the future and have detailed how the transition would be handled. Here’s where privatization gets nasty because, in all these proposals, taxes would increase dramatically and very soon.
Take, for example, Kotlikoff’s proposed Personal Security System. He would end the portion of the current payroll tax that is used to fund old-age benefits.[8] This is not a bad idea, but to finance the transition, Kotlikoff would impose a national sales tax at a rate of close to 10 percent. The rate would fall to about 2 percent, claim Kotlikoff and Harvard economist Jeffrey Sachs, within 40 years.[9] When’s the last time you’ve heard of a sales tax rate falling that much? In U.S. history, sales tax rates have almost always gone in one direction, and that direction is up.
Five pro-privatization members of President Clinton’s advisory council on Social Security voted for a plan formulated by Carolyn Weaver of the American Enterprise Institute and Sylvester Schieber of Watson Wyatt Worldwide that would increase taxes. They would divert 10 percentage points of the payroll tax, half of which would finance a flat benefit paid to all retiring workers and half of which would go into a personal security account. To make up the shortfall, Weaver and Schieber advocate an additional payroll tax of 1.5 percentage points that would last 70 years, and additional federal debt of $1.2 trillion.[10]
Privatization advocates worry that if nothing is done now, taxes will rise even more in the future. But if nothing is done now, then benefits will be cut later because there is simply no way that the U.S. government can get away with imposing payroll tax rates of 18 percent. In fact, one of the main supporters of the current system, former Social Security Commissioner Robert Ball, has said that he fears a taxpayer revolt against current payroll tax rates.[11]
The irony is that many believers in freedom who would otherwise lead that revolt are instead advocating their own tax increase. They would replace the possibility of a major tax increase later with the certainty of a tax increase today. Would-be privatizers should instead draw a line in the sand and say, “No more tax increases.” Then those who want the current system would have to deal. Social Security is a mess. But as Martin Feldstein has said, when you’re in a hole, at least quit digging.
The second bad proposal, which many people have advocated recently, is to have the government invest in stocks. The problem is that the government’s Social Security tax revenues are so huge that within 10 years or so, the federal government would own a substantial fraction of U.S. stocks. What government controls it has great difficulty leaving alone. The federal government would almost certainly use its power to dictate business policy for many of the firms in which it held substantial ownership. Also, the government could use its funds to make bad investments. This is what Pennsylvania’s government employees’ pension plan did in the 1970s when it financed a Volkswagen plant that closed just a decade later.
The third bad proposal, made by Pete Peterson and others, is to impose an “affluence test” for receipt of Social Security, Medicare, and other benefits. If your income exceeds $40,000, according to Peterson’s proposal, you would lose 10 percent of your federal benefits for every additional $10,000 of income you make.[12] So, a family making $50,000 and receiving $12,000 in federal benefits would lose $1,200. A family making $100,000 and receiving $12,000 in benefits would lose 60 percent of that $12,000, or $7,200.
Aside from the difficulty of enforcing such a plan (“Mr. Smith, we just learned that your income last year was $10,000 higher than the previous year; please send us a check for $1,500, which is 10 percent of the cost of your hip replacement.”), there is a fundamental moral objection. The affluence test would penalize people who make the same income as others their whole life, but who save more and earn a return on these savings. Someone who never saved, but instead spent money on restaurant meals, nice cars, or trips to Europe would benefit more than someone who gave up some of life’s luxuries to build a nest egg. The tax system—with taxes on dividends, interest, and capital gains—already discriminates against savers. An “affluence” test would increase this discrimination.
You might argue that events outside people’s control, such as high medical bills or large inheritances, are the cause of much of the disparity in wealth of people nearing retirement. But according to economists Steven Venti and David Wise, such uncontrollable life events have little impact on people’s wealth at retirement. Instead, most of the differences in people’s wealth in their later years are due to one simple factor: the percentage of their income that they chose to save.[13] The affluence test is also economically objectionable: It would deter retirement saving, which is, after all, one of the main ways that people save.
Conclusion
The government cannot be trusted with our pensions. Government officials have little incentive to care for us as well as we would care for ourselves. They are particularly bad when it comes to long-term planning because they rarely look beyond the next election. And when they do look far ahead, as Roosevelt did, it can be more for mischief than for good. Johnson and Nixon increased Social Security benefits dramatically, even though this meant that taxes would have to increase dramatically in the 1970s and 1980s. They didn’t seem to care a whit about that. Because the Social Security system is unsustainable in its current form, simply to keep the system in existence without further tax increases requires that the government gradually raise the retirement age to about 70, apply more accurate inflation indexing to benefits, and reduce the real growth in benefits that is currently scheduled to occur. But that would still leave us with an expensive Ponzi scheme that is always threatening to get worse. It would also leave us with a system that arbitrarily and unjustly takes wealth from black men, smokers, high-income people, people with AIDS, and single people, and gives to white men, nonsmokers, low-income people, and married couples with one partner not working. It also would keep the government in the position of making our pension choices for us.
Therefore, the Social Security system should be abolished. This can be done so as to allow retirees and those within 30 years of retirement still to get benefits, while freeing younger people to save for their own retirement and be better off than they would have been under the current system. Our pensions should not be based on a scheme that, when carried out by private parties, causes them to be sent to jail.
[1] Martin Feldstein, “The Missing Piece in Policy Analysis: Social Security Reform,” National Bureau of Economic Research, Working Paper #5413, January 1996, p. 13.
[2] Feldstein, “Missing Piece,” p. 13.
[3] Feldstein and Samwick, “Transition Path,” p. 22, Table 2.
[4] “Toward a More Accurate Measure of the Cost of Living,” Final Report to the Senate Finance Committee from the Advisory Commission To Study The Consumer Price Index, December 4, 1996, p. ii.
[5] Derived from Stephen J. Entin, “Private Saving vs. Social Security: Many Happier Returns,” IRET Congressional Advisory, September 4, 1996, No. 56, Institute for Research on the Economics of Taxation.
[6] Entin, p. 4.
[7] Peterson, Will America Grow Up?, p. 18.
[8] Laurence J. Kotlikoff, “Privatizing Social Security at Home and Abroad,” American Economic Review, May 1996, Vol. 86, No. 2, p. 368.
[9] Kotlikoff and Sachs, “It’s High Time to Privatize,” Brookings Review, Summer 1997, p. 22.
[10] Bob Davis, “Senior Project,” Wall Street Journal, July 9, 1996, p. A14.
[11] Bob Davis, “Senior Project,” p. 1.
[12] Peterson, Will America Grow Up?, p. 167.
[13] Steven Venti and David Wise, “Choice, Chance, and Wealth Dispersion at Retirement,” National Bureau of Economic Research, Working Paper No. 7521, February 2000.