The Microeconomics of Social Security Privatization

Social security privatization has a little-discussed benefit, done properly it is equivalent to a cut in marginal tax rates. A problem with the current system is that there is little relationship on the margin between taxes paid and benefits received. On average, of course, those who pay more taxes get more benefits (although not proportionately there is a subsidy to low-earners). But because the rules are complex and based on average earnings over a long period of time there is little connection between your social security taxes on an additional hour of work and your social security benefits for that additional hour.

To see why this is important consider the difference between social security and an IRA. If a worker works an additional hour, earns $10 and puts $1 into the IRA he knows the $1 will produce a benefit 30 years down the line when he retires. The $1 contribution to the IRA is not a tax, it's consumption, a benefit of working extra hours. On the other hand if a worker earns $10 and $1 is taken and paid into social security there is no clear connection to retirement benefits. Social security payments, therefore, are taxes - and like other taxes they deter work effort and create a dead weight loss.

Privatizing social security, or in some other way creating personal accounts, would reestablish a link between marginal payments and marginal benefits and thus would be equivalent to a cut in tax rates.

The insight goes back to my colleague Jim Buchanan and his 1968 paper "Social Insurance in a Growing Economy: A Proposal for Radical Reform." National Tax Journal, Vol. 21 (December 1968): 386-95

See also Tyler, Arnold Kling, Victor Davis and Brad DeLong who have been discussing the political issues of social security privatization.