Privatization of Social Security: How it Works and Why it Matters

This paper uses the Auerbach-Kotlikoff Dynamic Life-Cycle Model (AK Model) to examine the macroeconomic and efficiency effects of privatizing social security. It also uses a simple privatization proposal, the Personal Security System, as a framework to discuss a number of other issues associated with social security's privatization, including transition rules and changes in the overall degree of progressivity. According to the AK Model's simulations, privatizing social security can generate very major long-run increases in output and living standards. These gains come largely at the expense of existing generations, but not exclusively at their expense. Indeed, the pure efficiency gains from privatization can be substantial. Efficiency gains refers here to the welfare improvement available to future generations after existing generations have been fully compensated for their losses from privatization. The precise size of the efficiency gain depends on the existing tax structure, the linkage between benefits and taxes under the existing social security system, and the choice of the tax instrument used to finance benefits during the transition. When the initial tax structure features a progressive income tax, when the existing system's benefit-tax linkage is low, when consumption taxation is used to finance social security benefits during the transition, and when existing generations are fully compensated for their privatization losses, there is a 4.5 percent simulated welfare gain to future generations from privatization. But if these circumstances don't hold, the efficiency gains from privatization are likely to be smaller, possibly even negative. For example, when the initial tax structure is a proportional income tax, when benefit-tax linkage is perceived to be dollar for dollar, when the income tax rate is raised to finance social security benefits during the privatization transition, and when current generations are fully compensated, there is a 3.1 percent welfare loss to future generations. The illustrative Personal Security System shows that there are simple ways to privatize the retirement portion of the U.S. Social Security System and to credit workers for their past Social Security contributions. It also suggests that Social Security's privatization could provide more survivors' protection than the current system as well as eliminate much of the current system's seemingly capricious redistribution between two-earner and single- earner couples. But the proposal's analysis also suggests that these benefits from privatization must be set against a possible reduction in progressivity and a likely reduction in the amount of longevity insurance available to the elderly through annuities.